Obama's Tall Order: Fixing the Economy

The president-elect plans to move quickly, but actions he engineers will take time to show results.

By Jerome Idaszak, Associate Editor, The Kiplinger Letter

November 17, 2008

When Barack Obama takes office Jan. 20, he'll face the worst economy in decades -- with no hope of a quick or easy recovery.

First quarter gross domestic product (GDP) next year will contract about 2%, on the heels of a 4% decline in the fourth quarter of 2008. That'll be the biggest contraction since early in the presidency of Ronald Reagan when GDP fell 4.9% at the end of 1981 and 6.4% in the first quarter of 1982.

In the early Reagan era, the unemployment rate hovered between 8% and 9% in the fourth quarter of 1981 and first quarter of 1982 before peaking at 10.8% at the end of 1982. It's now 6.5% and climbing -- likely topping 8% by Dec. 2009. Inflation in the early 1980s was up about 10%, well above this year's expected increase of around 4%. But credit markets weren't as iced as they are now, and most consumers were carrying a lot less debt.

This recession is more serious than most. Typically, they get ugly fast and then end with a surge in home building and manufacturing as the Federal Reserve cuts interest rates and jobs are created. Consumers soon start spending freely, and a recovery is underway. Not this time. Expect 2 million jobs to disappear next year. And that doesn't include the additional job losses that will result if one of Detroit's auto firms folds. There are no easy fixes.

Obama's team is eyeing a massive stimulus, perhaps $500 billion or more. It will include permanent middle-class tax cuts, an extension of jobless benefits, additional funds for food stamps and aid to states for Medicaid as more workers lose insurance benefits along with their full-time jobs. That's a good menu for Martin Regalia, chief economist with the U.S. Chamber of Commerce, who says the stimulus must "be big and include everything."

Infrastructure spending will spark a big fight. Obama wants much more, including investments in alternative energy. Republicans say it will take too long to help the economy. But many Democrats say the recession will still be under way when the money kicks in, and that the jobs will be needed to sustain a healthy recovery.

Another battle: the deficit, which is spiraling out of control. It will top $1 trillion in 2009 -- 7% of GDP. That compares with a modern high of 6% in 1982, and record double digits annually from 1942 through 1945 at the height of World War II.

And the national debt has nearly doubled in eight years to more than $10 trillion. Fiscal hawks say that Congress can't help everyone who needs it. But many economists are telling Obama to boost spending and help the economy now and worry about the deficit later.

Shelve deficit concerns? Stan Collender, a veteran budget watcher who is managing director of Qorvis Communications, says a high deficit is problematic. "The concern is that at some point, the big, foreign borrowers of U.S. debt will say they simply do not need any more," he says. They won't sell their holdings, but they'll reduce what they're buying. That would send rates on corporate debt and mortgages in the U.S. higher, an unwelcome development for the economy.

One bright note: Obama can count on help from the Fed's unused firepower. The federal funds rate is heading to 0.5% by early 2009, and the Fed's other tools such as buying top-rated commercial paper will be used to keep pumping liquidity into the banking system to get lenders lending.

Another important help to the economy will come from relatively low oil and gas prices. The difference between crude oil at $147 a barrel in July and $60 a barrel in November is like adding more than one percentage point to GDP for the year. If oil stays around $80 a barrel in 2009, it will blunt the recession's severity considerably -- a lucky break for everyone

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