Tuesday, February 10, 2009

US Stimulus Plan: crank economics and high risks ahead

The US is moving into uncharted territory with the massive new stimulus and bail out plans of the Obama administration. There is no serious economics input in this legislation. The spending is not properly targeted. The tax cuts are badly constructed. The benefits are minuscule in relation to the future drag on the US economy from the massive increase in public debt.

This comes on top of the Paulson-conceived TARP and the huge increase in the balance sheet of the FED with quantitative easing, which is a euphemism for printing money. Accrued liabilities on entitlement spending the US like Medicaid and Social Security remain a politically taboo subject with sums involved than dwarf the bailout and stimulus plans.

The EU is the best reference for the where things seem to be headed in the US. Europeans are far more cognizant than their American counterparts of financial risk. EU members have been struggling for many years to stay afloat and remain competitive in a global economy with high public debt loads and large entitlement programs. The result has been relatively high structural unemployment and slow growth rates. This is based partly on policies of an overvalued Euro and very rigid rules on monetary expansion.

Americans have enjoyed the status of having a reserve currency and unlimited finance for their deficits. The US played a major role in Far East economies as a vast consumer market. So countries like China, who started to generate large trade surpluses, had every interest to finance the US deficits. It was trade finance as well as a means to keep their currency low. This boosted their exports into the EU. This model did not prove sustainable however. The credit bubble in the US burst and it unleashed a systemic financial crisis. US households are over leveraged and savings rates are very low. The US is a major debitor country.

Even countries in recession like Italy with big public debt loads, have the benefit of high savings rates, for example, and a comparatively healthier banking system than the US.

The issue today is where these massive US bailout programs that entail huge deficits and raise public debt to European levels will lead us? Is this a serious panacea or is it just simply trying to pile new debts on old debts resulting in an even bigger financial pyramid that eventually collapses? Are the US authorities seriously addressing their imbalances and putting their house in order? Personally I consider the US to be a far greater risk than the EU in this crisis because of the consequences of failure.

If eventually the US programs do fail, it will have far reaching effects. So far so good since US treasuries provide the US an extremely cheap source of finance. DnB Nor Bank is projecting weak markets and contraction until the 2nd semester of 2010 with a weak recovery thereafter. If however market perception of US sovereign risk changes, there could be some big problems ahead. A fall in the US dollar and a sovereign risk problem would be a nightmare scenario much worse than the subprime crisis.

I believe that the Obama administration is acting more out of political expedience than economic logic. Unfortunately the new US President has scant knowledge of economics and public finance plus unproven administrative skills. The heavy weights in his economics team like Geithner and Summers appear to be acting more like politicians than economists. Neither of them seems to have made more than scant effort to construct a serious stimulus plan with the US Congress nor do they appear to have done any serious vetting of the legislation before approval.

Sadly only a minority in Washington seem to have any sense of the risks involved. So it is very likely that the new US administration will be spending most of their future chasing their tails to clean up the mess that is being created. Summers, of course, escaped having to deal with the dot.com crisis as Treasury Secretary the last time around, becoming President of Harvard and passing the problem on to the Bush Administration.

What is needed is to break up the present bill into smaller parts by function. Priority should be given to stabilizing and cleansing the financial system. The stimulus spending and tax cuts should be carefully constructed with cost/ benefit analysis in relation to the future liabilities in the increased public debt load on the US economy and tax increases. Quality of work is far more important in rebuilding credibility than speed of action and political speeches to impress.

The risks are presently for an L-shaped economic recovery with a long period of slow economic growth ahead.

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