Obama and Bernanke’s Perfect Failure

By: Guest Authors

By: William L. Marcy IV, Ph.D.

Anyone and everyone who follows the U.S. economy are hoping for a change. Sadly, that change is not forthcoming. Rather, the fiscal policy of the Obama administration during the 2009 fiscal year is a repeated policy that has failed in the U.S. and other nations. This article will examine the economic policy of the Obama administration during the present economic crisis. First, it will explain how the downturn started. Second, it will explain the problems of the Obama administration’s and Federal Reserve’s policies to correct the economic downturn in the United States.

There are several factors that led to the 2008 – 2009 economic meltdown. Significantly, the Republican Congress under the leadership of George W. Bush was responsible for unprecedented deficits and massive government spending. All of this occurred while the U.S. witnessed a negative trade imbalance owing to the fact that the United States had become a service sector economy. Accompanied with the deficit spending was spending for the Iraq War which overheated the economy. To finance this activity the U.S. borrowed from abroad, most particularly from China.

However, while borrowing from abroad the Federal Reserve under the leadership of Alan Greenspan pursued a policy of easy money (low interest rates) to stimulate the economy after September 11. This encouraged the buying and the financing of second mortgages with the hope that the value of housing would continue to increase. Moreover, owing to legislation pushed by Congressional Democrats (Barney Frank) during the George H.W. Bush and the Clinton administrations, such as the 1992 Federal Housing Enterprises Financial Safety and Soundness Act (FHEFSSA) and the Community Reinvestment Acts of 1995 and 1999, banks were encouraged to make loans to unqualified home buyers because these laws eased the credit requirements on mortgages that Fannie Mae and Freddie Mac purchased from the banks. As a result of these multiple factors, malinvestment in the housing market occurred.

When the Federal Reserve raised interest rates to control inflation, the housing bubble went bust. The crisis then spread into other parts of the economy, because the government was unable to address (or freeze) the adjustable rate mortgages, which forced unqualified homeowners to default on their loans owing to rising interest rates. With the change of administrations, the Obama administration refused to deal with the central reason for the crisis (Federal Reserve mismanagement of the economy) and is re-inflating the economy to “give it a soft landing.”

Through the Troubled Assets Relief Program (TARP) started under George W. Bush and continued by the Obama administration, banks have been given “free money” (printed money to balance their books owing to the losses they took on bad investments). Within a year, the Federal Reserve has doubled the monetary supply. Most of the money has been used to shore up failing banks, which made poor investments and loans. Within the last month (April 2009) several banks have announced a profitable first quarter. Consequently, with the improving numbers, banks will begin lending again.

If the TARP and Obama’s trillion-dollar deficit spending revive the U.S. economy, the money added to the system combined with increased consumer spending will set the stage for an inflationary spike. Moreover, owing to politics and Obama’s need to be the messianic savior of the United States, there is little support within the Federal Reserve (which is supposed to be an autonomous branch of the government) or the Obama administration to see an increase in interest rates to counter inflation, because that would cause the economy to contract. This is particularly important to consider as we head into the mid-term elections in 2010.

If the banks continue to withhold money and the stimulus fails to increase aggregate demand, the government may respond by asking for a new TARP and increased deficit spending to loosen credit markets. This would increase the possibility for greater inflation down the road.

Historically, Keynesian economics was shown to have failed with the stagflation (high-unemployment high-inflation, pay stagnant) of the 1970s. What brought the United States out of stagflation was an induced recession by Federal Reserve chief Paul Volker who maintained a policy of tight money (high interests rates), which curbed inflation by 1984.

However, within the debate over the current fiscal policy there is the question of deflation vs. inflation. The current deflation created by the banking industry’s lost assets as well as the overall 50-90% decline in the stock market, accompanied by unemployment and stagnating wages has caused a decline in consumer prices owing to a slow-down in economic activity. The theory being pursued by Obama and the Federal Reserve is that through expanding the monetary supply, deflationary forces will be reduced by inflating the economy which in turn will bolster prices and wages. As noted, Obama and Bernanke’s policies involve the government continuing to increase public debt to historic levels to fight deflation and recession.

The Federal Reserve has backed itself into a corner by printing money and by keeping interest rates at near zero levels. The policy may have a short-term positive effect as the money enters the economy. However, the long-term impact is grave.

Expanding public debt will eventually lead to higher inflation and thus higher interest rates, which will have a negative impact on growth. Obama’s deficit spending to increase aggregate demand is unsustainable because it is a false demand created by government spending, which means either borrowing money and increased inflation (which will eat away at our ability to save), or taxation which will cause further contractions in the economy. Significantly, the deficit will consume nearly 80% of our GDP by 2018. This is simply unsustainable for any economy. Moreover, as warehouse and manufacturing inventories are depleted there is going to be more money chasing fewer goods owing to the increase in the monetary supply.

Another major policy problem is the fact that these policies are being financed by China. China does not want to see its investments, (treasuries) lose money. However, the current U.S. policy is devaluing the dollar through massive deficit spending and the printing of money. China may not continue to buy U.S. treasuries and may start looking elsewhere (such as the Euro or the Rupee) for safer investments if the return on treasuries continue to depreciate. In order to attract foreign investment to sustain its deficits, the U.S. will have to raise interest rates which will then put a stranglehold on the U.S. economy, because higher interest rates means less money in circulation and thus less lending.

The scenario to compare this situation to is Japan during the 1990s. In 1990, Japan went into a recession. The recession was compounded by poor loans, the inability of the government to let banks and business go bankrupt, and the over-extension of its major industries. Japan increased public debt to historic levels to revive their economy. For Japan, this was viewed as a failure, because Japan’s economy is still stagnant and suffers from the largest per capita public debt of any country in the world.

Another example is Argentina in the 1990s. Like Argentina, the U.S. borrows money from foreign creditors while we finance unsustainable deficits. Also, the negative trade flow and the fact that U.S. is a service sector economy like Argentina in the 1990s makes it appear as though the United States’ economy is being Argentinized.

In conclusion, the Obama administration and the Federal Reserve’s economic policies designed to prevent economic hardship are setting the stage for a future economic meltdown. Interest rates will have to rise in the coming years. Moreover, as the growing national debt rises, interest rates on the debt will eat up more and more of the overall budget. What the Obama administration and the Federal Reserve are selling the American public is a short-term lie based upon political motivations.

The United States needs to pursue an austerity program similar to the “Washington Consensus” plans imposed on Latin America by the IMF after the world economic meltdown in 1980. In order to acquire IMF loans, Latin America was forced to discontinue its heterodox economic programs (massive borrowing and spending to support state sponsored import substitution industries that had failed). This means forcing banks, industries, as well as irresponsible house buyers to face bankruptcy and to restructure their debts. Moreover, it means a reduction in the size of government to set our budget deficits right. These steps are indeed painful, but their impact on the U.S. economy will be more short-term than the policies being pursued by the Obama administration and the Federal Reserve, which are sowing long-term economic instability.

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