Taking Stock of the Economy, and of the Economic Recovery Program

It is now five months (less a week) since the new Administration took office. Let's see how the economic situation has changed in the last five months and how (so far as anyone can judge) the Administration's plan of economic recovery is working.

When Obama took office, the unemployment rate was 7.2 percent and the underemployment rate (which includes workers who have given up looking for work and workers working part time involuntarily) was13.5 percent. Those figures are now 9.4 percent and 16.4 percent. The Consumer Price Index had fallen in each of the last three months of 2008, stirring fears of a deflationary spiral. But it has increased slightly thus far in 2009; as of April it stood at .4 percent (two-fifths of one percent) over a year previously. This is still deflationary in real terms, because there is some inflation, but fear of a deflationary spiral has abated.

Personal consumption expenditures have risen slightly, but mainly because of increases in gasoline prices. Retail sales of other products and services remain very weak, because of losses in income and wealth coupled with a soaring personal savings rate, which has risen from 4.2 percent five months ago (and only 1 percent a year ago) to 5.7 percent. Housing prices have continued to fall, though the Dow Jones Industrial Average has risen from 7900 five months ago to 8800 today, but most people have more wealth in housing than in stock, and housing values have continued to decline. Some professional investors and securities analysts, noting the continued increase in unemployment and underemployment, as well as in defaults (including defaults on mortgages on commercial real estate), foreclosures, credit card defaults, and bankruptcies, believe that the stock market is overvalued; they may of course be wrong.

But there is good news as well as bads. The hundreds of billions of dollars that the government has lent banks, coupled with the banks' success in raising private capital (which has enabled some of them to repay the government's loans), has saved the industry from insolvency, although lending remains constrained: between January and May of this year, banks' excess reserves (lendable cash) rose from an already astronomical $798 billion to $844 billion. So the banks are continuing to hoard. But partly as a result of the rising stock market, business investment is increasing and consumers, though not yet increasing their spending significantly, are more confident about their economic future. Fear of a depression that would approach in gravity the Great Depression of the 1930s has abated, although we do not seem to have reached the bottom of the current downturn, and no one can responsibly predict when we will hit bottom, how low that bottom will be, and how long it will take for the economy to recover.

Against this background, let me attempt an evaluation of the Administration's recovery program. It is necessary first to stress the continuity with the recovery program begun under the Bush Administration; for the initial collapse was in September, so it was four months before Obama took office. The policy of the Federal Reserve, which is an agency independent of the direct control of the President, has not I think been significantly if at all affected by the change in administrations. It has continued its policy of "easy money"--that is, of keeping the federal funds rate (the interest rate at which banks lend reserves to each other on a short-term basis) esssentially at zero (it does this by in effect buying short-term Treasury securities), in order to facilitate lending and borrowing, and buying longer-term Treasury debt, and private debt as well, to the same end of stimulating the provision of credit.

The Treasury Department, under its new management, has also maintained considerable continuity with the Bush Administration, in seeking recapitalization of undercapitalized banks; but there are new programs as well, as I'll explain.

So here are the novel measures that the Obama Administration has taken to speed recovery:

It enacted a $787 billion stimulus package, consisting about two-thirds of temporary tax reductions and increases in unemployment and health benefits, and the other third of spending on public works, such as highway construction. It is not a well designed program, and it has started very slowly. It is not well designed because much of the money earmarked for consumers (the tax cuts and benefits increases) will be hoarded rather than spent. The goal of a deficit-spending program to help pull an economy out of a depression is to have the government buy goods and services directly in order to increase employment by increasing the demand for goods and services. In other words, its supposed to be a public works program. The public works component of the $787 stimulus package may come to no more than $75 to $100 billion a year for the two and a half to three years that the program is expected to remain in effect.

And the government has been unimaginative in the design of the public works component by failing, as the economist Martin Feldstein has pointed out, to increase the kind of military spending that would put people to work. The program also omits to increase the investment tax credit, which is a device for paying private firms to invest.

Yet I regard the package, defective as it is, as an indispensable measure to build confidence among businessmen and consumers. Had the government said in January that though the "easy money" policy appeared to have failed and the bailouts of the banks and the automakers had not yet succeeded, the government had run out of ideas and therefore the American people would just have to grin and bear the downward spiral of the economy, the effect on public morale could have been devastating.

There is however a downside to the stimulus program, and it would be there even if the program had been perfectly designed. Because the national debt was already high when the depression struck, because income tax revenues plunge in a depression, and because of the hundreds of billions of dollars that the government has spent on the bank bailouts (including in "banks" A.I.G., an insurance company with an investment-bank component) and the auto bailouts, and the trillions of additional dollars that the government has committed or guaranteed in various forms (the total amount lent, invested, promised, authorized, or committed contingently in the form of guarantees, including  a trillion-dollar expansion of the Federal Reserve's liabilities, rose from $7.2 trillion in January to $12.8 trillion in March), the $787 billion committed to the stimulus program could be thought the straw that may break the federal government's fiscal back. As the government borrows more and more money, much of its from foreign governments and other foreign investors, to cover its huge deficits, interest rates rise, imperiling the recovery. The interest rate on a 10-year Treasury bond is close to 4 percent and the 30-year mortgage rate close to 6 percent, which is contributing to the continued fall in housing prices and rise in foreclosures, since mortgage interest is a major cost of home ownership.

But to blame the stimulus for our fiscal distress would be a mistake. The blame lies with Congress, which seems unwilling either to raise taxes or to cut inesssential federal spending. There is a great deal of leeway to raise taxes without significantly impairing output (think of the enormous revenues that a value-added tax would generate, with minimum administrative expense and little misallocation of resources), and there is a great deal of inessential federal spending, symbolized by our preposterous agricultural subsidies. A stimulus doesn't work if it takes the same amount of money out of private pockets that it puts into government pockets (unless it can be sure, which it cannot, that the money it is taking out of private pockets is money that is being hoarded rather than spent). When a stimulus is financed by government borrowing, there is a net short-term increase in spending, and the hope is that the additional liability will not cause people to reduce their spending in order to accumulate savings with which to pay that future liability in the form of higher taxes. Since the future is uncertain, the offset is unlikely to be complete, and so current spending will increase when the government steps in and step up its demand for goods and services.

But if the government is pursuing a reckless fiscal policy, people may get frightened and reduce their consumption expenditures. I am beginning to think its fiscal policy is reckless, because the Administration seems determined to plow ahead with an extremely costly program of health care reform even though Congress seems unwilling to fund it. I fear too that General Motors, now that it is owned by the federal government, will become a bottomless pit for federal spending. These are dangers, not certainties; but perception of danger influences behavior. The Administration is unsettling the economic environment, and the result may be to cause businesses and consumers alike to hesitate to spend, and by hesitating delay recovery and greatly reduce the efficacy of the stimulus.

The Administration's commitment to General Motors (and to a much lesser extent Chrysler) is a mistaken policy. There was a compelling case for not allowing the companies to go broke back in December, when fear of the economic situation was at its height. By the time GM declared bankruptcy, both it and Chrysler had partially liquidated, and perhaps no more was necessary, to assure they would not liquidate completely, than generous government loans. Those loans would not have committed the government to supporting the companies indefinitely, as ownership of GM is likely to do.

The remaining recovery programs of the government have, I think, been flops.

The $75 billion mortgage relief program has thus far had only trivial effects in encouraging either modification or refinancing of "underwater" mortgages (mortgages the unpaid balance of which exceeds the market value of the mortgaged property). The money is spred too thinly over the enormous number of home mortgages in default or danger of default, and the recent rise in mortgage rates seems to have nullified what little effect the program was having.

The "stress tests" of banks, conducted by the Treasury Department and the bank regulators, were exercises in public relations, much like the modification of "mark to market" accounting for banks ("mark to market" means valuing an asset on a firm's balance sheet at the asset's estimated current market value, rather than its original cost). The tests tell the investment community nothing it didn't know already.

The program of subsidizing hedge funds and other private investors to buy undervalued assets (misleadingly called "toxic assets," now absurdly renamed "legacy assets") from banks so as to "cleanse" the banks' balance sheets seems to have abandoned. Private investors didn't want to get into bed with the federal government, in light of what has happened to recipients of recovery funds from the government, and banks didn't want to sell their assets for current market value. And why should they? They are awash in cash, as I noted earlier, so what is the gain from changing an asset into its cash equivalent, by selling it? If the goal of the program is to induce overpayment for those assets in order to increase the banks' capital, this objective is more easily achieved in other ways--and it seems that it has been achieved.

With the fiscal situation so alarming and excess reserves having been built up to such a high level, the time for pouring government money into the banking system has passed.

The final recovery program of this Administration is the imposition, by a "pay czar," of limits on the compensation of managers of firms that have received federal bailouts. In fairness to the Administration, this program seems to have forced on it by outraged public opinion.

Of course if banks simply passed bailout money to their managers, the bailouts would be ineffectual. But that is not what happened. What happened was that the banks passed some of that money to their shareholders in the form of dividends, which was a kindness to the shareholders because the banks might have failed and the value of their shares therefore fallen to zero; but the "pay czar" doesn't control dividend policy. There is I think (and have written) a problem of corporate overcompensation, but it is a problem largely limited to top management and reflects the inadequacies of boards of directors to rein in compensation of top managers, mainly the CEO. That is a structural problem. The concern with compensation levels in banks does not focus on the compensation of top management, but on that of traders. Since it is not in the interest of management to overpay its traders and other subordinates, it is a problem that probably should be left to the banking industry to work out.

In the strong arming of secured creditors in the Chrysler bankruptcy, in the interference in the compensation practices of banks, in the nationalization of a major U.S. industrial concern (General Motors), and in the government's insouciance toward deficits, we see the boundary between business and government shifting in the direction of greater government control. This is an ominous development, which can only, I believe, slow the economic recovery. 






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Richard A. Posner

Richard Posner is an author and federal appeals court judge. He has written more than 2500 published judicial opinions and continues to teach at the University of Chicago Law School. More

Richard A. Posner worked for several years in Washington during the Kennedy and Johnson Administrations. He worked for Justice William J. Brennan, Jr, the Solicitor General of the U.S., Thurgood Marshall, and as general counsel of President Johnson's Task Force on Communications Policy. Posner entered law teaching in 1968 at Stanford and became professor of law at the University of Chicago Law School in 1969. He was appointed Judge of the U.S. Court of Appeals for the Seventh Circuit in 1981 and served as Chief Judge from 1993 to 2000. He has written more than 2500 published judicial opinions and continues to teach at the University of Chicago Law School. His academic work has covered a broad range, with particular emphasis on the application of economics to law. His most recent books are How Judges Think (2008), Law and Literature (3d ed. 2009), A Failure of Capitalism: The Crisis of '08 and the Descent into Depression (2009). He has received the Thomas C. Schelling Award for scholarly contributions that have had an impact on public policy from the John F. Kennedy School of Government at Harvard University, and the Henry J. Friendly Medal from the American Law Institute.

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