Obamanomics arrives: policy priorities for the new President

President Barack Obama faces a long economic "to-do" list in his first term. The first 100 days must focus on stabilizing the economy by fixing the financial sector and passing a well-crafted stimulus bill. These policies will set the tone for the longer-term reforms required to address budget deficits, regulatory reform, and waning U.S. competitiveness.

President Barack Obama faces a long economic "to-do" list in his first term. The first 100 days must focus on stabilizing the economy by fixing the financial sector and passing a well-crafted stimulus bill. These policies will set the tone for the longer-term reforms required to address budget deficits, regulatory reform, and waning U.S. competitiveness.

1. Fix the Banks
Obama must first fix the nation's banks if he hopes to fix the American economy. Wall Street is directly linked to Main Street: businesses unable to obtain credit cannot make payroll, service debts, or invest in new job creation. President Obama must recapitalize the banking sector, clearly articulating principles for when and how the government would intervene. Bailouts should be used only when market-failure could trigger a contagious downward spiral, and should be structured to prioritize limiting economic damage first, safeguarding taxpayer investments second and minimizing inefficiencies and distortions third. With this commitment to stability and Federal Reserve liquidity flooding into banks, lending and job creation will return as the economy stabilizes. Public opposition to the first bank bailout program may make President Obama hesitant to act, but failing to do so is a recipe for failure.

2. Craft a smart stimulus bill
If the President's first economic challenge is courage in the face of opposition, the second will be to seize the opportunity - and avoid the pitfalls - that his stimulus plan presents. How the $825 billion of proposed funds are spent - on tax cuts, transfer payments, local government grants, or investments - must balance boosting employment with investing in future growth prospects, while easing the burden on those most impacted by the recession. Numerous interest groups, some of which expect payback for votes delivered in November, will seek to push their constituents' interests over these national priorities. Succumbing to these interests or trying to make the recession painless is the fastest way to ensure that government inefficiency and the rejection of free markets stain Obamanomics with the mark of failure. The President proposed significant accountability to minimize these failures in implementing the policy but first must determine the optimal mix of tax cuts, transfers, grants and spending.

Taxes
Tax cuts that incentivize investments in future GDP growth deliver tremendous value. They act quickly, align the nation for the future, and prioritize free-market efficiency. Obama's earned income, college tuition, and first-time homebuyer credits for individuals and his business tax credits all meet these criteria. These should be retained and expanded. Conversely, Obama's plan to provide lump-sum tax cuts unrelated to GDP boosting investments - similar in nature to the failed 2008 rebate check strategy - is $140 billion better used to bolster government investments in infrastructure and education.

Spending
The $550 billion of spending outlined by President Obama includes transfer payments, grants to local governments, and investments. Transfer payments (largely extended unemployment insurance, food stamps, and college aid exceeding $100 billion) provide an immediate boost to growth and a cushion to those most impacted by the recession. Obama should extend these transfers, but must ensure that individuals have a clear path back to fruitful employment by creating jobs and providing education and job retraining programs.

The $200-plus billion in grants to local governments to maintain healthcare, education, and public safety service levels shield governments from recession much as transfers shield individuals. These grants advance worthy goals, but they allow government officials to avoid reducing costs or increasing efficiency as recessions normally force officials to do. Obama should only deliver grants to local governments that are willing to improve efficiency and cut costs before turning to grant money.

The remaining $200-plus billion is allocated to a laundry list of investment projects. Projects should be reprioritized using an investor's mindset, calculating the amount and timing of future benefits produced relative to the cost of the project. High return-on-investment projects should be prioritized, whether the return comes as GDP growth, better healthcare outcomes, or a cleaner environment.

Implementing this approach will require political courage, for some projects may be politically unpopular. To cite but one example, the plan devotes $650 million to subsidizing TV converter boxes, generating minimal economic benefits but politically popular amongst recipients. Those funds would be better spent boosting the measly $25 million allocated to charter schools - a move that benefits predominately inner-city students but might anger teacher unions who strongly supported Obama. President Obama must muster the courage to demand sacrifices from close supporters as well as those with different ideological views to pass the most effective stimulus bill.

3. Start planning to fix the deficit -- including entitlements
President Obama's short-term economic challenges seem formidable until confronted with the long-term problem of balancing the government's budget deficits - including the rapidly growing entitlement programs. President Obama rightfully notes that the issue has been ignored for too long. With near-record high popularity - and hopefully a track record of competence, cooperation, and fairness gained from his stimulus bill - the President has a strong position to negotiate long-term solutions for the consolidated Federal budget. While the President's chances for re-election may hinge on the success of his stimulus plan in diverting economic decline, the history books will focus on his resolution - or lack thereof - of this critical issue.

4. Get the regulation right
History is less likely to remember the President for regulatory reform, but the economy will certainly notice. The financial sector regulatory failure of the past two years exemplifies the need for reform. Institutions overseen by numerous different agencies failed, and the response from the Federal Reserve, Treasury Department, FDIC, and various smaller agencies seemed muddled at best. Instinctively, politicians called for more regulation. But it is not more regulation that is necessary but better regulation. Consolidating regulators, assigning exclusive jurisdiction, and focusing on fewer but more important rules lowers costs and increases effectiveness. The potential for dramatic (if underappreciated) impact on the economy earns regulatory reform a place on the President's to-do list.

5. Put government on business's side
That to-do list has so far focused on government bailouts, stimulus, and regulation. However, business, not government, drives long-term economic prosperity, and America's business environment has deteriorated relative to other nations. American businesses seem constrained by the government instead of supported by it. This must change; supporting business competitiveness should be an explicit government goal. The Obama Administration should enlist the private sector in developing a strategy to address American competitiveness. Whether investing in education and infrastructure, reforming regulatory, administrative, and judicial processes, or tailoring tax laws, government support of business is critical to growth. Encouraging businesses to invest and innovate is the only way to ensure long-term economic success. The new Administration must find ways to encourage private investment and innovation to sustain the recovery the stimulus will hopefully spark.


The President has noted that in crisis lies opportunity. Mr. Obama should seize the opportunity before him to not only lead a short-term recovery but enact policies that set a course for generations of American prosperity.

Review of the CBO’s Annual Report to Congress

In September the Congressional Budget Office (CBO) published The Budget and Economic Outlook: An Update (“The Update” references the September 2008 report).  The piece is developed to provide US Congress with a basis for comparison of current legislation to the proposed changes in tax law and spending allocations.  The report is developed in accordance to section 202(e) of the Congressional Budget Act of 1974; the CBO is instructed not to make recommendations, to simply report impartial analysis.  In addition to the annual report, the CBO publishes monthly results.  While the CBO may not be able to explicitly make recommendations, implicitly the CBO recommends that congress reign in spending, increase receipts, or both with the following statement regarding the long-term outlook, “Over the long term, the budget remains on an unsustainable path.” 

The Update paints a grim picture for the United States in terms of both the budget and economic outlook; two items that cannot be viewed in isolation.  The Update predicted a FY2008 deficit of $407B, which was actually $455B per the November 2008 Monthly Budget Review, verse $161B in 2007.  The deficit widened in 2008 as expenditures rose 8.3% year-over-year with flat revenue.  The revenue was flat primarily due to the February 2008 stimulus package.  Absent the rebates and depreciation tax credits, revenue would have increased 2.5%, lagging the growth in outlays.  The deficit is expected to remain greater than $400B (~3% of GDP) through 2009.

Absent a few years in the last 1990’s and early 2000’s, the United States has been effectively running deficits since the 1970.  The CBO’s An Analysis of the President’s Budgetary Proposals for Fiscal Year 2009 saw an end to this deficit spending, forecasting a net surplus of $0.3T over the ten year period ending 2018; unfortunately, The Update in September was in sharp contrast with an estimated aggregate deficit of $2.3T for the same period.  $1.0T of which is related to revised forecasts of outlays for defense spending in Iraq and Afghanistan; an additional $850B is a result of a downward revision in economic projections.  Outlays during the upcoming decade are forecasted in excess of the historical 40 year average of 20.6% of GDP.  While outlays are anticipated to rise during the period, receipts are anticipated rise as well from 17.3% of GDP in 2008 to 20% in 2012, resulting in a reduction in the annual deficit.

The unsustainable path is exacerbated by the aging US population.  Outlays for the foreseeable future will be categorized in three forms, Mandatory, Discretionary, and Net Interest; in Camelot not only would it only rain at night, but Net Interest would be a receipt.  Mandatory Outlays are established based on eligibility rules and benefit levels which are set in law (Medicare, Medicaid, Social Security, etc).  Mandatory outlays are the largest source of increases in outlays; healthcare costs are expected to increase from 4.6% of GDP in 2008 to 6.0% in 2018, a 30% increase over the decade.  Healthcare costs are expected to continue to explode to 12% by 2050.  Less substantially, Social Security is expected to increase from 4.3% of GDP to 5.0% by the end of the forecast period.  Over the near term, the CBO anticipates spikes in outlays for deposit insurance, unemployment, food stamps, and other payments related to the current economic recession.

Discretionary outlays are set a new each year in accordance to appropriations acts.  Discretionary expenditures are divided into defense (59% of discretionary) and non-defense (41%).  As noted earlier, defense spending was revised upward by $1.0T over the forecast period as a result of a nearly $0.1T increase in the 2009 budget, which was anticipated to continue annually during the forecasted period.  Discretionary outlays are subject to sharp swings and are difficult to forecast with substantial uncertainty in the composition of Congress and Presidential Suite.  The Update projects Net interest to jump 17% over the next year, which was developed prior to the passage of the Emergency Economic Stabilization Act of 2008.  The Update projected the national debt balance at $9,568B at the end of 2008, growing to $10,247B by the end of FY2009.  After recent treasury auctions totaling roughly $1.0T in prior three months, the US debt burden has swelled to $10,618B as of November 14, 2008.  The increased debt burden with further add to the previously forecasted 6.4% annual growth in net interest outlays reported in The Update. 

With forecasted increases in outlays, receipts will need to increase to narrow the projected deficit.  The projected deficits begin to fall in 2012 with the expiration of many tax provisions set in the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) and Jobs And Growth Tax Relief Reconciliation Act of 2003 (JGTRRA) as of December 31, 2010.  Absent Congressional action to extend the provisions regarding capital gains, dividends, and ordinary income, statutory rates will increase for the 2011 tax year.  The elimination of such provisions will increase receipts to roughly 20% of GDP in 2012 and individual tax receipts will increase from 8.2% to 10.9% by 2018.  Over the prior decade capital gains has increased as a percent of receipts substantially, absent the dramatic decline in financial markets, this increase would be expected to continue until the expiration of the temporary decrease in capital gains rate to 15%.  Depressed asset prices and an increased statutory rate will decrease the level of receipts from capital gains. 

The November 7, 2008 Monthly Budget Review provided preliminary insight on the US post-TARP.  October 2008 saw receipts decline $13B with a $63B increase in outlays, resulting in a $77B increase in the monthly deficit year-over-year.  Included in the $63B increase in outlays was $17B related to TARP.  The CBO is reporting TARP payments based on the net present value of the Government’s investment in the troubled institutions.  The Government disbursed $115B in October, which according the CBO has a net present value of $98B, thus a $17B outlay. 

With the overall macroeconomic environment worsening, unemployment at 7.5% verse a predicted 6%, rising national debt burden, and evaporating consumer confidence, the likelihood of budget surpluses in the near-term are increasingly unlikely.  The unsustainable path of budget deficits and ballooning debt burden will continue to weigh on US citizens and global citizens.  Parents are no lot saving for their children’s education; instead they are borrowing against their children’s future income.

Liar’s Poker – A Popular Book Predicts Our Demise

When asked, the average, eager, Wall Street bound undergraduate would tell recruiters their favorite book is Liar’s Poker and their favorite movie is Wall Street. Michael Lewis’s semi-autobiographical book, Liar’s Poker, is a first hand account of the rise of Salomon Bond traders, junk bonds, and mortgaged backed securities in the 1980’s. The 1980’s was an era of deregulation; the deregulation that in part lead to S&L Crisis of the late 1980’s and early 1990’s. Lewis’ 1985 Salomon Brothers analyst class is in large part running Wall Street in 2008 and those eager undergrads that so idolized the trader lifestyle, big money and even bigger egos, are left holding the bag – a largely empty bag containing pink slips and severance checks.

The flood of new mortgage instruments and consumer debt did not come without its skeptics. It appears however that this skepticism skipped a generation. With little regard to the continued escalation of debt in the US, structured products ruled the day for the past decade. Lewis highlights on page 60 of the book,

But a few of the old hands within Salomon Brothers suffered a more complicated response to their money…they were uneasy with the explosion of debt in America. (In general, the better they recalled the Great Depression, the more suspicious they were of the leveraging of America)

“That is where we are: wild, reckless, and deeply in hock, ” Lewis comments as he further points to an article in the Institutional Investor of July 1987 by Salomon Brothers’ Head of Bond Research, Henry Kaufman,

One of the most remarkable things that happened in the 1980’s was [the] sharp explosion of debt, way beyond any benchmark. It was way beyond anything you would have expected relative to GNP, relative to monetary expansion that was taking place. But it came about, I think, as a result of freeing the financial system.

Unfortunately the explosion did not stop. According to The Federal Reserve Board, the household debt ratio (ratio of debt payments to disposable personal income) increased from 10.6% in 4Q80 to 12.3% in 2Q87 (the time of Kaufman’s article). This ratio continued to balloon to a maximum 14.42% in 4Q06, settling at 13.85% for the most recent quarter ended 2Q08. Mortgage debt has lead the way growing from 8% in 1980 to nearly 14% in recent quarters.

Household debt to gross disposable income paints an even uglier picture. … UK consumers narrowly defeat the US as the most levered consumers. US household debt as a percent of household disposable income as exploded from less than 80% in 1985 to nearly 140% in 2007. The rest of the G7 has followed suit with Japan, Italy, and Germany showing substantial declines in consumer savings rates coinciding with large increases in consumer debt.

Kaufman highlighted the growth of debt as a percent of GNP. Household debt to GNP rose from 47% in 1976 to 65% in 1989. Household debt as a percent of GDP has continued to skyrocket from 49% in 1980 to nearly 99% in 2008. The substantial debt burden left little room for error for the US consumer. Slight increases in interest rates (adjustable ARMs), decreases in income (rising unemployment), and deterioration of disposable income (rising commodity prices) has rendered the US insolvent.

Deregulation brought a lot of LUV to air travel; unfortunately, similar love has not been shared with Wall Street, Main Street, or Joe the Plumber. Remember, “objects in mirror are closer than they appear” – here’s to 2028.

Funding the bailout – nation of debtors & foreign creditors

The US is a nation of debtors and once again the US plans to fix its troubles with nothing else but more debt. According to the US Department of the Treasury’s September 20 Fact Sheet, the $700B proposed “bailout” of mortgages and other troubled assets will be funded through the Treasury’s general fund.

Funding. Funding for the program will be provided directly by Treasury from its general fund. Borrowing in support of this program will be subject to the debt limit, which will be increased by $700 billion accordingly. As with other Treasury borrowing, information on any borrowing related to this program will be publicly reported at the end of the following day in the Daily Treasury Statement. (http://www.fms.treas.gov/dts/)

As of the end of July 2008, $2,676 billion of US treasuries were held by foreign governments and institutions. Nations of Savers are leading the way; Japan and China hold $593B and $519B in treasuries respectively. A similar cast of characters will be the likely purchasers of the bailout financing. Multiple concerns arise from the increase in US national debt balance: (1) Our children will pay for our mistakes in the form of interest; (2) The increased debt burden, debt service and interest, will continue to make balancing the budge more difficult; (3) Significant holdings of US treasuries may have negative implications for the US in the form of a strategic bargaining position.

The January 2008 CRS Report for Congress, “China’s Holdings of US Securities: Implications for the US Economy,” highlights the concerns of many economists with the high level of foreign debt held by our, at times less than friendly, neighbors. The report focused on the comments of two Chinese officials regarding China’s ability to tank the US dollar by liquidating large blocks of US Treasuries. This ability could be used as a bargaining chip in strategic trade negotiations, such as the US protection of the steel industry. A flood of US dollars in the market place would create a rapid deterioration of the US Dollar and an increase in interest rates (bond price declines à increase in bond yield). A decline in the US Dollar would increase the price of imports and put substantial pressure on an economy dependent upon foreign imports. A systematic depreciation in the US Dollar (as noted in my previous post) could lead to a reduction / elimination of the trade deficit (positive), but a sudden drop coupled with an increase in interest rates would make the necessary expansion of exports difficult (negative).

China probably would not have a credible threat. The US accounts for 30% of all Chinese exports, if the US Dollar depreciates substantially verse the Yuan, the US will reduce purchase of said exports. The fourth largest foreign holder of US Treasuries is “Oil Exports” (South American and Middle Eastern nations) many of which are unfriendly. Who needs who more? The US has substantial dependence on Middle Eastern oil; however, oil is denominated in US dollars. As long as oil is denominated in US dollars, major oil exports have an incentive NOT to see a precipitous depreciation in the US Dollar verse major foreign currencies.

Budgetary impact – Prior to the proposed bailout, net interest expense is expected grow by more than 8% in 2008 and 2009. Additionally, net interest accounts for nearly 2% of the US GDP. While near term the added interest expense ($700B x ~3% = $20B in annual interest expense) would have a negative impact on the current budget, the total cost is unknown, as it is unlikely for all the troubled assets to go to zero.

I am certain of two things: (1) While I do not know what, something needs to happen to restore confidence in US & Global financial institutions; (2) Americans need to start saving.