From the March 2009 issue of Research Magazine • Subscribe!

March 1, 2009

Will Obama's Plan Rebuild the Economy?

Only the private sector, not government projects, can bring sustained economic growth.

In the 1920s, when the Soviet government was confiscating hidden gold, foreign currency and jewelry from previously wealthy citizens, a joke was making the rounds.

An old Jewish businessman gets hauled to the political police headquarters.

"We know you've got hidden valuables," they tell him. "You've got to give them to us."

"What on earth for?"

"Well, you know that we're building communism, which will be the greatest political system in the world. In order to build it, our government needs money."

"You know," said the man, "an old rabbi in my shtetl (village) used to say: 'If you don't have money, you don't start building.'"

President Barack Obama is going to start building. Even before he was inaugurated, his transition team came up with a fiscal stimulus plan, which will cut taxes for the middle class and retirees but also build and repair large chunks of U.S. infrastructure: roads, bridges and the transportation system. To be sure, Obama had been planning to invest in our creaking plant and equipment even before the economic crisis worsened during the final stages of the election campaign last year, but now, under the guise of rescuing the U.S. economy, his administration's spending package will be both larger and easier to get through Congress.

As is well known, the Federal government has no money. The Bush Administration has bequeathed to its successor over $10 trillion in government debt as well as a budget deficit measuring $1.2 trillion this year. Nevertheless, the Obama Administration is planning to go even deeper into hock and borrow at least an extra $800 billion.

Aside from the odd member of the Republican Party which, having brought the nation to the brink of fiscal catastrophe, has suddenly remembered that it is the party of fiscal responsibility, there are few objections to the principle of using deficit spending as a means of stimulating the economy. Quite the contrary. Princeton economist Paul Krugman used his column in The New York Times, which helped get him the Nobel Prize last year, to warn that the Obama stimulus package was nowhere near enough. He advocates a government spending package at least 2.5 times higher, or $2 trillion.

Depression History

The question is whether the Obama stimulus will create enough jobs to make up for the 2.6 million jobs lost in the course of 2008, revive bank lending and consumer borrowing and turn the economy around. The answer, paradoxically, depends on a previously obscure academic controversy about the course of the Great Depression.

For four decades after World War II, the mechanism by which the U.S. economy came out of the Depression was very clear. Franklin Roosevelt established his famed Works Progress Administration and began pouring public cash into massive public projects on an enormous scale exemplified by the Tennessee Valley Authority. These projects put millions of jobless Americans back to work, the economy started moving and eventually the Depression was overcome.

That "eventually," however, didn't satisfy everyone. Already in the 1970s and 1980s some economists began to point out that while in the early years Roosevelt's New Deal did indeed spur economic growth, the effect was short-lived and by the second half of the 1930s the economy began sliding again. President Roosevelt, who previously had been cautious about John Maynard Keynes' recommendations advocating deficit spending, began borrowing heavily during his second term. Yet, the Depression wasn't fully defeated and the recovery didn't come about until World War II, when the economy was shifted to a war footing, millions of men were drafted into the Armed Forces and the budget deficit reached 30 percent of GDP.

Government projects, it seems, are able to stimulate the economy, and even produce some corollary economic activity, but only as long as they last. Once the public money runs out and the projects stop, so does their effect on the economy. Only the private sector has the ability to grow continuously and generate output year after year by producing profits and investing a portion of those profits into on-going business.

The Soviet government, which attempted to build a prosperous economy based on rational government planning and public property, without any concept of personal gain and profit, failed miserably. Despite its pervasive apparatus of repression, communism eventually collapsed under the weight of its economic inefficiencies.

But there is really no need to delve into such extremes as Soviet communism to find glaring examples of the public sector's inefficiency. In Japan, the government spent two solid decades pumping enormous sums into infrastructure projects. It built, repaired and rebuilt every road, bridge and public building twice over, with bureaucrats hard at work inventing new make-work projects. Yet, economic stagnation endured.

To keep its public works going, Japan increased its government debt from less than 50 percent of GDP in 1980 to over 170 percent currently. In 1999-2005, while the economy hardly grew at all, the fiscal deficit measured more than 7 percent of GDP.

But at least Japanese consumers own enormous household savings, which they hold in what they regard as very secure Japanese government bonds. As a result, the government has always been able to finance its deficit and to keep its bond yields extremely low. Not so in the United States. Our savings rate has been declining for years and in 2005-2007 measured less than 1 percent. The $2 trillion or so in new borrowing that the U.S. Treasury is projected to issue this year may yet overwhelm the Treasuries market.

No Alternative

There is no plausible alternative to the Obama plan currently, at least not on the political horizon. But this doesn't mean that it is going to work. Its most salient shortcoming is conceptual. The current crisis is the result of excessive borrowing and of living above our means. It seems unlikely that this kind of crisis can be lastingly overcome by even more borrowing and more spending.

Since the advent of the U.S. subprime mortgage crisis in 2007, which began to spread worldwide last year, a notion took root that it is an American phenomenon, that fat American consumers over-consumed and as a result virtuous global producers have had to suffer.

This is obviously too simplistic. On a fundamental level, the global crisis stems from a mismatch between supply and demand. Thanks to modern technology, the global economy has overcome the age-old challenge of producing enough goods and services for everyone. Now, any kind of production can be scaled up at will. Technology also increases productivity and reduces demand for labor, even as the world population continues to grow. It now stands at some 6.2 billion, and even the most optimistic projections see it peaking midway through the century at around 9 billion -- 50 percent more people than today.

Moreover, the enormous populations of India, China, Russia, Eastern Europe and other parts of the world recently rejoined the global economic system after 50 to 80 years in a self-imposed exile. All these factors put systemic downward pressure on wages. In other words, our economic system has been remarkably efficient at producing a virtually unlimited number of goods and services, but it has not been very good at providing sufficient demand.

Over the past 20 years, the U.S. consumer has been willing to increase consumption and to fund it by borrowing mainly from foreign creditors, thanks to the dollar's status as a reserve currency. The result has been worldwide prosperity. Greater wealth spread around the world, but it was based on a number of asset price bubbles, all of which were underpinned by the biggest of them all, the U.S. debt bubble.

That bubble has now burst, triggering the deflation of all other bubbles. The free lunch has come to an end and, lo and behold, the bill has gone out to everyone who partook of it. Until a new sustainable system of funding global consumption can be developed, economic prosperity of the kind we have seen over the past two decades is unlikely to return.

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Alexei Bayer runs KAFAN FX Information Services, an economic consulting firm in New York; reach him at abayer@kafanfx.com. His monthly "Global Economy" column in Research has received an excellence award from the New York State Society of Certified Public Accountants for the past five years, 2004-2008.

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