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When Government Spending isn’t Enough

The Obama administration faces a daunting task in steering a faltering economy back on track, but it’s important to not lose sight of the substantial power that his administration simply does not have.

The important issue will be in determining in what areas Obama is able to make an impact and what areas are less promising. The biggest areas of opportunity are in the enforcement of property rights and the rule of law, and in restoring confidence in financial markets.

Government-based stimulus can only go so far. Monetary policy affects the real interest in the short run which is the price of output today in terms of output tomorrow. Fiscal policy also may affect relative prices when it affects rates. For example, labor income taxes affect the price of leisure, sales taxes affect the price of consumption, and investment subsidies affect the price of investment. If you believe in the Ricardian Equivalence Theorem, then that’s all fiscal policy can do: affect relative prices.

The problem is that economic problems are too large for Obama to ignore. The president has inherited budget deficits expected to exceed $1 trillion this year, a $10 trillion national debt, a labor market with unemployment currently above 7% and expected to increase to 10% by 2010, and the backdrop of capital markets that have dried up. The economic crisis that began with aggressive lending practices, spiraled into a subprime and then broad-based mortgage sell-off, crippled the corporate debt and equity markets, and cut the flow of capital in financial markets has now crippled the real economy. Obama’s team must not lose sight of where the crisis of confidence began and how to assuage the problems. The problem began and will end with capital.

Capital is the lifeblood of an economy. But capital can only flow against the backdrop of well-functioning property rights and the enforcement of the rule of law. For instance, if you deposit $100 at your bank, the sine qua non that makes this transaction possible is that you believe you’ll get your $100 back and that this money will not be stolen. When this confidence is eroded because of your belief that your property, the $100, will not be returned to you, financial flows become stifled and liquidity in an economy dries up. The erosion of confidence can lead consumers and businesses to refrain from participating in financial markets. When this happens, commerce is constrained and output is crippled. There is not a single wealthy country in the world without well-developed, functional financial markets.

Therefore, Obama’s most important task is in establishing the rule of law and property rights, especially as they apply to financial markets. A unified watchdog of the financial markets must be put in place to oversee the flow of capital in our financial markets. The current system in place is inadequate: how else could the Securities and Exchange Commission have missed the $50 billion fraud enacted over decades by Bernie Madoff? How else could the SEC have allowed the “churning process” prevalent in the mortgage brokerage business get so far out of hand that “No Income, No Job, No Asset” loans became commonplace by 2006 and sowed the seeds of an industry that would catapult the economy into a recession? The problem wasn’t incompetence on the part of the SEC members. The problem was a structural inability to identify fraud and factors that would undermine faith in our capital markets because of a disjointed and small board of overseers of the US economy.

Fortunately, Obama enjoys political goodwill in his first 100 days and has an ability to enact meaningful legislation that is economically sound but potentially politically unpopular. Obama should aim to restore confidence in financial markets to get the real economy back on track and recognize the dangers of relying on government-based stimulus as a magic bullet.

February 2, 2009
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