How Obama can energise the economy

President-elect Barack Obama faces calls for a “stimulus” package to lift the flagging US economy. Recent asset price declines and job losses underscore these calls. Given the ineffective design of the most recent stimulus package, he would be wise to take a deep breath, then focus on several guidelines and four suggestions for action.

The first guideline is that the downturn is being driven by falling asset prices, which weaken the balance sheets of households and financial institutions, curtailing both lending and spending. Policies to stimulate the economy should focus on blunting falling asset prices.

Second, actions should be consistent with good long-term policy. Temporary tax changes do little to affect aggregate demand or marginal tax rates (on income and investments) that influence asset prices. Policies to help the housing market should avoid reinflating a housing bubble.

Third, Mr Obama should focus on policies that can be implemented quickly. For example, direct preferred equity capital injections in financial institutions can be carried out faster than buying troubled assets. Modifying mortgage contracts to make it easier for borrowers to reduce their debt takes substantial time and violates the second guideline by raising a lender’s required returns and hence future mortgage interest rates.

With these guidelines in mind, Mr Obama should consider four proposals relating to confidence, credit, capital and collateral.

Restore confidence: he should pick Paul Volcker, the former Federal Reserve chairman, as Treasury secretary. Successful economic policy in the current environment requires a leader who understands financial markets and institutions. It also demands someone who has the stature and gravitas to command respect from both sides of the political aisle. No one is more qualified than Mr Volcker. His input will also lessen the chance of a regulatory backlash that could stifle any recovery.

Restore credit: keep the Treasury focused on the health of financial institutions. Mr Obama should remind the American people, as George W. Bush’s administration failed to do effectively, that “Wall Street” and “Main Street” are not two separate worlds, but two sides of the same coin. Restoring health to financial institutions is an important part in breaking the downward spiral in asset prices. While the Fed should continue its focus on unfreezing interbank lending and the commercial paper market, the Treasury’s focus should remain the recapitalisation of financial institutions that are critical in lending to households and businesses. Normal lending will not return until more progress has been made on recapitalisation. This recapitalisation will then encourage private capital investment in financial institutions.

Bolster capital: keep taxes on saving low. The tax code offers a potent tool to blunt falling asset prices. A decision to retain current low tax rates on dividends and capital gains would be an important first step. Reducing corporate tax rates will positively affect both stock prices and investment. Charles Rangel, chairman of the House ways and means committee, has indicated interest in cutting the corporate tax rate to 28 per cent. Increased investment – the stimulative effect, along with more taxable profits reported in the US – makes this a potent stimulus that is not too costly. Some economic studies suggest that the revenue-maximising corporate tax rate is in the range Mr Rangel is considering.

Enhance collateral: break the vicious cycle of falling house prices and dislocated credit markets. Consensus forecasts predict further falls in house prices of 15 per cent over the next 18 months. Stabilising house prices is critical to repairing household balance sheets, but also limiting the fall in the value of mortgage-backed securities.

Lower mortgage interest rates, which would prevail in a more normal credit market, would, all other things being equal, raise house prices. Instead, mortgage rates are rising relative to Treasury yields. Financing mechanisms are available that would allow the government to lower the borrowing costs for the government-sponsored enterprises in the mortgage industry. This would enable them to lower mortgage rates and thus help raise house prices. These mechanisms could lower mortgage interest rates by a full percentage point, blunting house price declines at only a modest cost to taxpayers. By doing this millions of borrowers with adjustable-rate mortgages facing higher rates and new first-time homebuyers would benefit. One approach is to create a version of the 1930s-era Home Owners’ Loan Corporation to buy troubled mortgages, sharing losses among borrowers, lenders and taxpayers. Resolving the mortgage crisis would bolster confidence and reduce the desirability of bankruptcy reforms.

Bold action to stabilise asset prices will be important for strengthening household and business balance sheets and encouraging spending. Some of the steps will be expensive, but inaction is more costly. Accomplishing this may require a shift in priorities for Mr Obama from those expressed in the campaign. This shift requires leadership, but he needs a stronger economy to fund his priorities and the nation’s.


Originally published at the Financial Times and reproduced here with the author’s permission.

5 Responses to "How Obama can energise the economy"

  1. Guest   November 23, 2008 at 5:04 am

    would be more value add to discuss “specific steps” and not just an outline of what to do. Its “how to” which is so tough

  2. Bert Roberge   November 23, 2008 at 7:53 am

    I posted the following comment regarding Charles Wyplosz’s article (Good bye financial crisis, hello recession):”So now Obama is wanting to start a post WWII type jobs program. This announcement is being made during one of the worst downturns in the stock market in recent history. Although not a bad idea, the banking and credit issues are currently the main culprits driving the markets down. I wonder how Wall Street will react Monday. It seems that the U.S. government administration will say anything to get the markets to go up – but any intelligent U.S. equities investor will see that Obama’s plan proves how bad of a recession or depression we are about to enter.”The stock market manipulation continues – lets make everybody feel good so they buy and keep stocks – so the market doesn’t crash, and everyone’s 401-K’s don’t tank more than they have. Lets keep those millions of day traders pushing the buy! buttons and taking small daily losses to absorb the real impact of the stock market free fall. I wonder what will happen the day all those small investors turn off their computers and go fishing? I have already made up my mind not to buy any more equities until the DOW is at about 6,000 or the S&P hits about 620 – whichever comes first.At least Obama has indicated that it will be a prolonged and severe recession, and I respect him for that.Bert Roberge, CPA

  3. Guest   November 29, 2008 at 12:36 pm

    Re-capitalization of the banks has failed and will continue to fail as bank balance sheets and off-balance sheet “assets” are too large to be recapitalized or “guaranteed” by the US gov’t. Giving life support to a dead patient is a waste of time. There are plenty of good banks in the US to take up the slack. Let the offenders die with managed transition of the assets and deposits a la WAMU and IndyBank. Stop holding up the markets waiting for more intervention. Financial industry issues are taking hold of the real economy because recovery is being delayed by saving the big banks and none of the “assets” can be appropriately valued. Let the great derivative unwind begin!

  4. Anonymous   November 29, 2008 at 4:15 pm

    Obama is a passenger on this crashing airplane just like everyone else even if he is sitting in first class. It’s a joke that people think Obama can save anyone but himself and his croonie elitist pals. It’s an even bigger joke to think that he really wants to. When will people understand that 99.9% of government always has and always will be in it for themselves? There is the rare honest and sincere statesman like Ron Paul but Americans prefer flash and glitz, at least for now.