Obama takes middle road on stimulus and taxes that leads nowhere

Bloomberg News is reporting that U.S. state governments will begin cutting spending in order to meet budgetary constraints as the Obama administration’s transfers to local government will not be enough to offset reveue shortfalls.  These cuts will offset any federal stimulus, endering the $787 stimulus package recently enacted less effective, an issue I raised in early January.

In my view, it has become ever more apparent that the Obama administration is caught in some sort of muddle, trying to fudge between the calls for fiscal discipline from conservatives and the calls for stimulus from liberals.  Obviously, it is in Obama’s nature to lead by consensus, and he has looked for an inclusive political and economic strategy since he came to office.  However admirable these intentions may be, this middle path is unfortunate because it will leave no one satisfied.  Moreover, taking this middle path on the economic front — some stimulus but not massive stimulus, some tax cuts but also some increased spending, increased spending now but tax increases or budget cuts in a few years – is the worst of all outcomes; the economy will not gain enough traction to get the desired ‘jump-start’ and stimulus will ultimately be seen as ineffective.  If the Obama Administration later attempts to return to Congress for more of the same after a failed stimulus bill, it will find a more skeptical response.

States are cutting spending and increasing taxes because aid in the $787 billion economic stimulus signed by President Barack Obama last week isn’t enough to balance their budgets, governors meeting in Washington said.

“States have a cumulative deficit that is more than double the money we get,” said Pennsylvania Governor Edward Rendell. Even with the stimulus, “there’s not a state in this union that’s going to be able to wipe away all its problems.”

The U.S. economic crisis dominated talk as the National Governors Association held its annual winter meeting in Washington this weekend. The Dow Jones Industrial Average hit its lowest level since 1997 last week. Government reports showed industrial output sank in January for a sixth time in seven months and housing starts plunged 17 percent. Companies from General Motors Corp. to Alcoa Inc. are slashing jobs and cutting production as the recession threatens to become the worst slump in the postwar era.

Rendell, chairman of the governors group, said Pennsylvania cut $1 billion from its budget and raised $218 million in additional revenue with taxes on tobacco and other products. The stimulus, even with about $100 billion in infrastructure spending for states, is no cure-all, he said.

“States are not off the hook,” Rendell, a Democrat, told reporters yesterday.

Economic Toll

The economic meltdown continues to take its toll: 43 U.S. states report the need for additional spending cuts or tax increases before their current budget years end, the Denver-based National Conference of State Legislatures reports. Thirty-four states face additional budget gaps as they prepare spending plans for the 2009-10 fiscal years.

“Almost on a daily basis, we’re hearing reports that revenues are coming in below forecasts,” said Corina Eckl, NCSL’s fiscal program director.

Adding to the problem are accelerating Medicare and Medicaid costs and infrastructure that has been neglected for decades and is forcing states to play a costly game of catch-up.

“We’ve got revenues that do not grow with inflation and we have expenses that do,” said Delaware Governor Jack Markell, a Democrat. “There’s no system in the world that can succeed with that kind of disconnect.”

Governors welcomed the $787 billion stimulus legislation signed into law Feb. 17 by President Obama as a source of much- needed, albeit temporary, financial assistance. About $100 billion of that is set aside for state road-building, bridges, and other infrastructure spending.

Five Percent More

Putting the money in context, Montana Governor Brian Schweitzer, a Democrat, said the stimulus will add about 5 percent to what his state usually gets in federal assistance.

Some governors also worry that some stimulus money, such as funds to extend unemployment benefits to part-time workers, could put states in the position of having to cut services or raise taxes when the federal aid runs out.

Nevertheless, Reuters has reported that President Obama plans to cut the federal budget deficit in half by 2013, meaning the stimulus will come to an end by this time. My understanding is that the President is making this pledge under counsel from fiscal conservatives within his economic team. Apparently, President Obama feels that the economy will be back on safe ground by that time.

President Barack Obama wants to slash the ballooning deficit in half by 2013, U.S. officials said on Saturday, after massively increasing public spending to stem the worst economic crisis in decades.

Obama will outline his ambitious goal when he hosts a summit at the White House on Monday on fiscal responsibility and later in the week when his administration presents a summary of its first budget, for the 2010 fiscal year.

With tens of thousands of Americans losing their jobs in the midst of a global economic meltdown, Obama has said fixing the U.S. economy is his top priority. He has acknowledged that his success or failure in that will define his presidency.

“We can’t generate sustained growth without getting our deficits under control,” Obama said in his weekly radio address in which he also announced immediate implementation of tax cuts for 95 percent of Americans as part of the effort to stimulate the economy.

An administration official said Obama was proposing to cut the deficit, which private economists project will rise to $1.5 trillion this year, through a mixture of tax increases on wealthier Americans and spending cuts.

The concern here is that the United States has become a debtor nation dependent from foreign sources to sustain low interest rates. If these sources cut back their support, the U.S. would suffer an economic blow. Just yesterday Secretary of State Hillary Clinton urged the Chinese to continue to invest in U.S. Treasury bonds.

Again, this position is admirable, but one must question whether it is realistic. Back in November, shortly after the election, I warned that this meme was likely to gain favor in Obama’s economic team and that it risked repeating the mistakes of the Great Depression and Japan.

Recently, deficit hawks have been pushing a nefarious line of argument that I need to debunk right here and right now. The line goes as follows: we need to spend government monies now to get the economy back on its feet. In a couple of years, we can signal all clear and then raise taxes on the middle class in order to reduce the deficit again, much as we did in 1993.

While I agree that deficits will need to be eliminated, this line of thinking risks a repeat of 1937-38 in the U.S. and 1997 in Japan and must be refuted.

If you look back to the Great Depression, unemployment in the United States did not hit 10% until November 1930 and things really started to unravel one year later in 1931. We hit bottom only in 1932 and 1933 with unemployment peaking at 25.6% in May 1933. It was a long hard road out of Depression from that point forward.

However, deficit hawks in the Democratic Party convinced Roosevelt to follow an anti-deficit economic policy. This induced a second sharp recession in 1937 and 1938, extended the Great Depression by another 4 years until 1941. The stock market swooned again from a Dow Jones high of 195 to as low as 97, a loss of 50%…

Can we really balloon the deficit to $1 trillion and expect business as usual in 4 to 5 years given the precedents and given the low savings and high debt? This doesn’t make sense to me. Read my post “Charts of the day: U.S. macro disequilibria” to see greater detail on some of the headwinds we face.

I would normally consider myself a deficit hawk as well. However, this is not the early 1990s. The recession will be much deeper, the possibility of systemic risk much greater. And the imbalances are much larger. I think it sensible to use this period of economic weakness to get the country on the right foot. And, quite frankly, this is not a 2-years-and-you’re-done kind of process. This is going to be a decade-long struggle to restore balance and reduce debt. I am talking about 2018 and not 2012 here.

My view here is that Obama is forging a middle path that leads to a dead-end. The stimulus is not nearly enough by half to get the job done. The proposed deficit reduction measures for 2013 are outright scary as they risk repeating a mistake from the 1930s. And the banking sector and mortgage plans, both of which I failed to mention, are dubious half-measures as well. One needs to act aggressively and proactively or not at all.

On the economic policy front, I am less than satisfied with where the United Sttes is headed.

Sources States Cut Spending as U.S. Stimulus Fails to Fix Budget Woes – Bloomberg.com Clinton Urges China to Keep Buying Treasuries – Bloomberg.com Obama aims to cut deficit in half by 2013 – Reuters

Related Reading:

Annual Editions: State and Local Government, 13/e
Tax relief: The real economic stimulus for America’s economy : hearing before the Subcommittee on Tax, Finance, and Exports of the Committee on Small Business, … session, Washington, DC, December 6, 2001
Barack Obama: Son of Promise, Child of Hope
‘Economic stimulus’ revives era of activist government.(Brief Article): An article from: New Hampshire Business Review
A Patriot’s History of the United States: From Columbus’s Great Discovery to the War on Terror

Related posts Is prophylactic protection needed for excessive stimulus? Will federal largesse be countered by state and local cutbacks? Obama’s stimulus bill is a tough sell so far Obama leads McCain by 2 points Chris Whalen critiques Obama stimulus speech

Originally published at Credit Writedowns and reproduced here with the author’s permission.

3 Responses to "Obama takes middle road on stimulus and taxes that leads nowhere"

  1. Phillip Huggan   February 22, 2009 at 5:17 pm

    The USA is the only developed country, to my knowledge, that doesn’t have progressive tax rates. Seems an obvious surplus avenue to me, but I’m Canadian.

    • Anonymous   February 22, 2009 at 7:30 pm

      Maybe Canadians have a different definition of progressive tax rates. USA tax rates go up with income level. What’s your definition of progressive?

  2. Dilip khullar   February 23, 2009 at 3:58 am

    Dear Edward,I think your analysis is succinct, clear and is based on a mix of human psychology and economics.From what I understatnd of the situation and given that the latest response from the Obama administration is a half measure, would it be more efficient for the administration to focus all resources on solving the banking crisis and housing values? On a medium term basis this would at least create macro economic conditions conducive to real growth? The fiscal stimulus, with all the politcalissues that surround it could then be introduced at a later stage. More than anything it´s just a question of priorotising issues with limited resources as opposed to being all things to all men.