Bill Emmott - International Author & Adviser


Obama´s Strategy Too Timid
Corriere della Sera - February 15th 2009

It feels like a slow-moving Greek tragedy, destined to end in disaster. But let us be optimistic: perhaps it will turn out to be a demonstration of clever political tactics. I am talking about the rescue package announced and achieved this week by Barack Obama´s new administration in the United States. Despite the dramatic-sounding numbers, this package is likely to be too small and too timid really to solve America´s economic and financial problems. There will have to be another package, perhaps after another financial crisis, sometime in 2009 or 2010.

            The right place to start is by defining America´s economic problem. It is experiencing a collapse in private demand, by households and by companies, because they have become too scared to hold high debts and unwilling to spend all their incomes or make investments. They are scared because they think they might lose their jobs but also because the most fundamental institutions of the economic system, the banks, are reporting huge losses and are actually or nearly bankrupt. And those domestic problems are made worse by the fact that there is now a global recession, which means that America cannot hope to export its way out of trouble (which it had managed to do in 2007).

            To deal with the problem, the Obama administration has come up with half of the solution. To substitute for collapsing private demand it has produced its huge fiscal stimulus package, which after much argument and amendment finally passed the two houses of Congress earlier this week. The true value of this plan is not clear. Its cost is said to be $789 billion, but that is a cost spread over as much as ten years. Most of it will be spent in the first two years, however. So, since America´s annual GDP is about $14 trillion, the package amounts to about 2.5% of GDP ($350 billion) in each of those years.

            This combination of spending and tax cuts will certainly help to soften the recession. But it will produce growth only if the fall in private demand turns out to be less than 2.5% of GDP, which is far from certain. Still, the package is the right approach. There is no serious alternative to running a budget deficit and increasing public debt in these circumstances. Giulio Tremonti was completely wrong when he wrote in the Corriere della Sera this week that when the economic problem is an excess of debt, the cure cannot be adding more debt. The problem is an excess of unsafe private debt, and a loss of confidence in that sort of debt. So the problem must be met by an increase in public debt, which in these circumstances of deflation and collapsing demand is a much safer sort of debt.

            Yet while this solution of using more public debt is necessary, it is not sufficient. The other part of the solution must be a decisive clean-up and restoration of the banking system. It was this part of the solution that the Obama administration failed to provide this week.

            Timothy Geithner, the new US Treasury Secretary, proposed a plan to deal with illiquid and non-performing debt at the US banks by using a combination of private and public money. The amounts of money he mentioned sounded impressive: $500 billion at first, perhaps a total of $1 trillion eventually. But this plan is unlikely to work. This so-called "toxic" debt is a problem because the market cannot agree on how to price it, so banks are unable either to write it off or to sell it. This leaves both investors and depositors with a huge doubt over the true condition of the banks´ balance sheets, and thus their solvency.

            Mr Geithner´s public+private plan represents a hope that with this limited government involvement the market will finally become willing to invest private capital and to provide a pricing mechanism. But in such dangerous economic times, a hope is not good enough. A proper, decisive solution would involve the nationalisation of America´s biggest and sickest banks, combined with a willingness to allow smaller less important banks to go bust. Nationalisation would allow bad debts to be dealt with as an internal transaction, with no need for a market-based pricing mechanism. Most important, it would be capable of convincing households, companies and investors that the worst problems in the banking system were now truly over.

            The trouble is that it would be politically controversial. It would require Congress to vote to permit the use of a lot of public money to take over and rescue the big banks. Eventually, this solution would be cheaper, as many bad debts could later be sold and the cleaned-up banks can eventually be privatised. But the up-front money would be controversial. Either the Obama administration was too timid to ask for it, alongside the big fiscal package. Or it thinks it will be easier to ask for it later.

            That might prove to be a clever political judgment. Whether it is a clever economic judgment is more doubtful. By the time the administration asks for this money, the costs will have risen and the economy may well be even weaker.


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