Obama to Rescue - Can the New President Save US Economy?

New US president, Barack Obama has it easy in one way. A good number of people think he can't be any worse than the outgoing president, so he starts with a lot of goodwill and public support.

Unluckily for him, that's about the only way he's got it easy. He's confronted with an economy in a massive bust, and everyone's expecting him to somehow deal with it. The latest data from the US is grim. In 2008, 2.6 million jobs were lost, the most since 1945. Consumers (remember the days when the investment mantra was "don't bet against the US consumer"?) are unsurprisingly, cutting back - retail sales in December were down a whopping 9.8% year-on-year.

House prices are still suffering
House prices and construction activity are still falling, and - arguably most importantly - the banking sector is still broken. As in the UK, more and more bad news keeps coming out of banks' balance sheets, and until there's some hint that things might get better, they won't be in a position to increase lending - in fact, they'll keep cutting back.

And there's probably a lot more turmoil to come in the financial system - New York University Professor Nouriel Roubini reckons that US banks face about $1.8 trillion in losses, yet they only have $1.4 trillion in capital. In other words, they are "borderline insolvent".

Recession for the forseeable future
The economy has been in recession since the start of 2008, and doesn't look like escaping any time soon. So Mr Obama is doing what most other governments do in times of crisis - throwing money at the problem and hoping some will stick.

He's got $350 billion left over from the $700 billion that was pushed through under his predecessor. And he looks like he'll get another $825 billion to back a two-year plan to be signed off shortly. So what's he planning to do with the money?

Obama's plans
Well, there's a ragbag of measures. Some will go on infrastructure - building roads, bridges, "green technology" and other work-creation projects. About $275 billion will go on tax cuts, with most workers getting a $500 tax credit. There's also plans to give money to local and state governments, many of whom are threatened with bankruptcy or having to slash public services, as tax receipts from housing go through the floor.

On top of all this, they're working on a plan to free up the lending market - hence, no doubt, the unusually high level of interest the US media has displayed over Britain's current banking crisis - partly by buying and restructuring mortgages to give more direct help to people threatened with recession.

Job creation
Obama reckons he can create about four million jobs with these packages. But there are plenty of objections. Some people don't like tax cuts, arguing that families will save them, rather than spend them (this is a stupid argument - what you save today, you can spend tomorrow - but that's a topic for another day). Others point out that infrastructure spending takes a while to feed through to the economy.

Still others argue that the scale of the stimulus just isn't enough. They reckon that over the next two years, the slump in the US will cost the country $2 trillion compared to what it would have produced in "normal" economic conditions. Therefore, the argument goes, Mr Obama needs to spend $2 trillion.

Allowing failures to happen
But even if there was enough money to make it "work", is this really the right solution? The US has already slashed interest rates to zero or thereabouts. The Federal Reserve is printing money and the government is planning to spend. The Keynesian machine is in overdrive.

But the truth is that the economy is still weak and getting weaker. And that's because this crisis needs to run its course. US house prices have to reach a point where they're cheap, and there isn't such a drastic over-supply. That's happening gradually - builders have stopped building, prices are still falling - and the less Mr Obama interferes with that process, the sooner it will hit bottom.

And when house prices have clearly bottomed out, suddenly everyone will see that there's light at the end of the tunnel for banks (well, the ones that are left standing anyway). Even if no one has worked out by then whether to nationalise the banking system or not, investors will be able to make a decent guess at a genuine worst-case scenario, and confidence will pick up again.

Consumers to the rescue - if they can
At that point, it would be much better to have consumers who have built up some savings and so are ready to spend. It won't be so great if the government has to raise taxes massively to pay off debts it ran up during the downturn. And remember that every dollar the government borrows is one that doesn't get loaned to the private sector, which "allocates capital" - ie spends - far more efficiently than the public sector. So the deeper the government gets into debt now, the harder it will be to eventually emerge from this slump.

In any case, the biggest threat the US - and indeed, the world - faces, lies outside its border, with the problems facing another country's economy. We all know that much of the west is running into trouble, but up until recently, there's been the vague hope that China and other emerging markets could somehow make up for it.

Emerging markets not so hopeful
Some of the smarter commentators are starting to doubt that. While many are still predicting GDP growth of at least 6-8% this year, that's a far cry from the 13% seen last year. But more importantly, it could be a lot worse than that. Chinese electricity output - a pretty solid indicator of demand in a country where official statistics are hard to trust (though that's not unusual) - fell year-on-year in October and November, for the first time since 2002.

That's because the manufacturing sector is collapsing. China's economic miracle has been built mainly on exporting cheap goods to the west. So when the west stops buying, China's in trouble.

Recipe for unrest
As Albert Edwards at Societe Generale warned recently, rising unemployment will mean rising social unrest. And that's the last thing the Chinese government wants. A population might put up with an oppressive system while standards of living are rising, but if things click into reverse, they start to wonder what they've sacrificed their freedom for.
So while the US is hoping that a weak dollar will boost its own manufacturing and export industries, the Chinese won't be keen to see the dollar weaken against the yuan. It'll want to keep as many of those factories open as possible, and that means keeping its goods cheap so that overseas consumers can buy them.

But if China intervenes to keep its currency weak against the dollar, that could easily spur protectionist measures from the US, leading to trade war. If that happens, and global trade collapses as a result, then we really could be looking at a repeat of the Great Depression.

The topic owner is John Stepek.

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