Obama’s honeymoon faces daunting tasks
The following paragraphs from Nouriel Roubini’s RGE Monitor provide an insightful look at the daunting economic and geo-political challenges facing President Obama.
Now that Barack Obama has taken the oath and become the 44th President of the United States, he faces great expectations at home and abroad to steer the U.S. and global economy out of the greatest post-war recession and financial crisis, to re-align the U.S. foreign policy stance and global standing on issues like financial sector regulation, climate change, trade talks and nuclear proliferation. He – and his team – enters with large amounts of political capital.
Obama’s public acknowledgment that the country’s economic woes will remain challenging in the near-term and will involve great adjustments, and his choice of a strong economic team are signs of optimism that the administration will be quick with policy measures. While the domestic economy (especially passing a fiscal stimulus package) will take most of his time in the short-term, the Israel-Gaza offensive indicates foreign policy concerns – especially in the Middle East and South Asia will also demand attention from the beginning of the Obama presidency.
While tax cuts will be timely, households facing financial pressure will save the proceeds rather than boost spending just as they did during Q2 2008, limiting effectiveness. Similarly, tax credits for businesses to hire workers and invest in new equipment will be ineffective in stimulating investment since firms forecasting a prolonged slump in domestic and export demand and high credit costs will cut capex plans.
However, given that state and local governments support greater spending and jobs than the federal government, grants for the recession- and budget-deficit hit states will be more effective in preventing cut backs in public services, infrastructure projects and jobs, and also partly offset declining tax revenues and slump in debt financing.
But given our estimated contraction in private demand of around US$700bn in just 2009 alone, the US$800bn-plus stimulus package distributed over two years (2009-10) might not be enough to offset the contraction in GDP in 2009. Also, the extent of job creation via the stimulus might be limited as infrastructure projects will, at best, absorb workers from real estate construction and low-end manufacturing while services and manufacturing in general will continue to witness hiring freezes due to low demand. Moreover, investment in infrastructure, renewable energy and R&D will simulate the economy and create jobs only in the medium to long run.
Hence, the prolonged slump and a very sluggish economic recovery might actually necessitate a second stimulus package. More importantly, unless the government addresses problems of bank capitalization and mortgage crisis, any fiscal stimulus will be ineffective in steering the economy out of this crisis.
Continued bank bailouts have signaled to the administration that further bank writedowns are imminent and the banking system as a whole might be insolvent. Capital injection on an ad-hoc basis, or even after banks write down bad debt to establish asset values, might only delay a broader solution for toxic assets while making inefficient use of the TARP funds. One possible solution would be the creation of a ‘bad bank’ that can buy toxic assets from banks to ease pressure on their balance sheets and help stimulate lending to the private sector.
An alternative might be to use the remaining TARP funds to extend government insurance to banks’ toxic assets. Obama’s economic team also has voiced concerns that the TARP funds have been inefficiently used by banks so far in order to absorb losses on their balance sheets, fund acquisitions and pay for compensation rather than fuel credit growth in the economy. The new administration will likely direct the remaining funds towards unclogging credit markets and renewing lending to households and firms by targeting consumers and municipalities – credit cards, mortgages, auto loans, students loans and muni bonds. Total loan losses are expected to hit US$1.6 trillion and additional negative feedbacks on MBSs and other ABSs are imminent, especially as the recession raises default by households and corporates.
Tight credit conditions and financial headwinds for households will continue to raise foreclosures and mortgage defaults. Increase in the excess home supply now poses the risk of over-correction in home prices thus leading to further bank losses and contraction in consumer spending. As a result, Congressional Democrats and the Obama administration will have to work on modifying the troubled mortgages and refinancing them into longer term low interest loans. But given the limited effectiveness of past government programs, the new government needs to reduce the mortgage principal to fix the problem of homeowners’ insolvency rather than just extending the maturity period or reducing the interest rate.
To encourage greater lender participation, the government will have to share the cost of modifying the loans and offer lenders a share in future home appreciation and share any losses from default on the modified loans. While Democrats favor using some of the remaining TARP funds for this purpose, estimates suggest that the cost of such a program might be as much as US$600bn to US$1 trillion, especially as home prices overcorrect downward, more homes fall into negative equity and defaults on the refinanced mortgages continue. To contain fiscal costs, the government should be the senior debt holder in the modified mortgages to benefit from future home appreciation.
Continued bank bailouts, fiscal stimulus packages and refinancing at-risk mortgages will likely push up the fiscal deficit to over US$1.3 trillion in FY2009. While these counter-cyclical spending measures are warranted to address the crisis and Obama might also delay his plan to raise taxes, the U.S. will have to consider fiscal consolidation during the recovery phase. Unless the government reforms the tax system, reduces health care costs and finances Social Security and defense needs, a structural budget deficit will continue to pose risks to the U.S. debt financing needs and the dollar for many years to come.
Meanwhile the discussion on NAFTA is likely to re-emerge in light of the President’s visit to Canada, reportedly his first foreign trip. While policy on trade agreements, the Chinese reminbi and inward-investment by foreign governments might take a backseat in the initial days of the new administration, China’s bias for an undervalued currency to support exports and the need for investments from foreign governments in the face of U.S. bank and corporate bankruptcies might rekindle these issues. Moreover, as imports and exports shrink for deficit and surplus countries respectively, U.S. will lead the world in the painful unwinding of global imbalances.
Energy and Climate Change
President Obama has emphasized that the fiscal stimulus will include support for ‘green jobs’ – jobs that support alternative energy and help to wean the U.S. from fossil fuels that are increasingly sourced abroad from unstable countries, but these will take time to have effect. However, political momentum globally may build as the next climate change conference approaches at the end of 2009. Steven Chu and other members of Obama’s energy team are expected to push for significant energy policy changes towards renewable and federal climate change legislation, including an economy-wide cap-and-trade program however the severity of the economic recession may make a gas tax unpalatable even if it is matched by offsetting payroll tax cuts.
Despite the fall in demand as global output contracts, there are obstacles in diversifying both the source of energy supplies and the type will be difficult, particularly in the short-term. Not only do the costs of alternative energy remain high, particularly as technologies are still being developed. Government policies might offset this gap.
The reduction in oil prices may deter some of the demand for drilling off the U.S. coastline even as it deters investment in alternative technologies. Similarly, environmentally costly fuel from Canada’s oil sands may find U.S. markets less welcoming, even if it spurs investment in carbon sequestration in the long-term. Already the fall in gasoline prices has deterred the purchases of hybrid vehicles, possibly reversing some of the behavioral changes that led to lower petroleum consumption in mid-2008.
The Gaza crisis pushed the Middle East and especially the Israeli-Palestinian conflict to the top of the President Barack Obama’s agenda. In particular the focus will be on trying to prevent a precarious ceasefire from contributing to regional instability. The cease-fire in Gaza could present a fresh opportunity for mediating a peace process, but Obama will be faced with a set of challenges nevertheless that may absorb a lot of U.S. political capital in the region.
The conflict had deepened a rift between the Palestinian rival political factions – Hamas and Fatah – and the lack of national unity may continue to impede the serious advancement of the Israeli-Palestinian peace process, as will divisions between Arab states. Furthermore, Israel holds parliamentary elections on Feb 10 and the commitment of the Israeli government to the peace process will vary. Finally, brokering a successful Middle East peace process involves a broad regional approach and an effort to address regional players, such as Syria and Iran and involving both tradition power brokers like Egypt, Jordan and Saudi Arabia and newer entrants like Qatar.
A set of elections in the Middle East, especially in Israel, Iraq and Iran in the first half of 2009 may provide testing times. The reduction of U.S. troops in Iraq and transfer of power to Iraqi authorities is already well under way but more details are yet to emerge regarding the exit of U.S. troops. While Obama pledged to withdraw troops from Iraq with 16 months of taking office, they might remain for some time. The President has emphasized a new approach to deal with Iran including the possibility of lower-level diplomatic engagement, but the country’s emphasis on nuclear proliferation may be difficult to shake. With the fall in the price of oil, Iran’s abilities to fund its proxies in Iraq, Lebanon and Palestine may be reduced as maintaining domestic support becomes paramount.
Regional security continues to deteriorate in South Asia with the resurgence of the Taliban in Afghanistan, growing hostilities between India and Pakistan, and a weakening alliance with Pakistan against the war on terror. Obama has regularly echoed the need for more troops to be deployed and the Senate has agreed to send additional troops almost doubling American troops on the ground. However, the daunting task of constructing a comprehensive new strategy for a region defined by endemic corruption and the lack of basic amenities remains – and the economic crisis might make it more difficult to convince fellow NATO members to also increase their military presence. By contrast, despite the persistence of North Korea’s nuclear program, East Asia is unlikely to grab as much attention. Economics will likely continue to dominate the U.S. China relationship particularly now that China’s exports are contracting and China, like the U.S. faces a hard landing.
President Obama will seek to strengthen transatlantic ties that have weakened following the Iraq war. Washington will work together with EU closely together to respond to the financial and economic crises, peace and security issues, and to stop and reverse climate change. But convincing NATO allies to increase military presence in Afghanistan may be difficult. U.S.-Russia relations have been strained by NATO’s eastward expansion, war in Georgia, gas politics, Kosovo’s independence to name a few. Despite a warning that Russia might deploy short-range missiles in the Baltic region if Washington proceeded with its missile defense shield in Eastern Europe, Moscow has signaled its willingness to reexamine relations with the U.S. under the new administration.
The U.S. and Russia may be able to make common cause regarding the nuclear threat from Iran, helped perhaps by Obama’s ambivalence about the missile defense and ruling out of a speedy NATO membership track for Ukraine and Georgia. Yet neither country will be willing to compromise on its core interests, and a divided Europe may make responding to a poorer, but still determined, Russia more difficult.
Source: RGE Monitor, January 21, 2009.
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