Obama’s economic challenges

By Martin Wolf

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In electing Barack Hussein Obama to the presidency, the American people have chosen an intellectual, a prophet of unity and a man with a Black Kenyan father and a white American mother. They have, at the same time, rejected the politics of fear and division that did such damage to their country.

I am one of billions of people who find themselves astonished and delighted by this event. But the election is just the beginning. Few presidents have confronted bigger challenges than Mr Obama. Among that number must be counted two of the greatest – Abraham Lincoln and Franklin Delano Roosevelt. Mr Obama regards himself their heir. The question is whether he can come close to their exalted level.

The new president’s agenda is daunting. His country’s power is also reduced. Indeed, it was never as great as those who spoke of the “unipolar moment” believed. But the US remains the world’s greatest power and only leader. It possesses unmatched assets. The presidency of George W. Bush was a lesson in how not to use them. The Obama presidency must now be the opposite.

Events will shape Mr Obama’s priorities. But one such event is already here: the world is entering a recession, possibly the worst since the second world war. Yet he must meet this challenge in ways that preserve what is among the greatest achievements of his predecessors: the open world economy. It was under FDR and Harry Truman, both Democrats, that the US started to lead the world away from the autarkic policies of the 1930s. The US must not now turn its back on the world it shaped. Yet it may do just that, without creative and radical reform, at home and abroad.

In the short term, there is no alternative to another massive fiscal boost, strongly supported by aggressive monetary policy. Forecasters have been downgrading their views of 2009, for both the US and the rest of the world, at an extremely rapid rate (see chart). Last week the International Monetary Fund reduced forecasts for world economic growth, at market exchange rates, in 2009 from the 1.9 per cent forecast as recently as October to a mere 1.1 per cent. The advanced economies are now forecast to shrink by 0.3 per cent.

A bigger US fiscal deficit would offset the rise in the desired financial surplus – the excess of income over spending – in the private sector at a time of recession. In the early 1980s, the private sector surplus reached 6 per cent of gross domestic product (see chart). But the US would also probably run a current account deficit of 4 per cent of GDP at high levels of employment. Since the private, foreign and government balances must sum to zero, the fiscal deficit may need to be as huge as 10 per cent of GDP.

Such vast fiscal deficits are only a temporary solution. So how might they end? In the US and other countries with highly indebted private sectors, such as the UK, a return to large private sector financial deficits would be highly undesirable, even if achievable. A vastly better outcome would be bigger savings and a reduction in current account deficits. Thus, the expansion in net exports that has recently been so vital for US growth must continue (see chart).

If the US external correction is to be consistent with global growth, demand must expand vigorously elsewhere, particularly in chronic surplus countries. The new administration should lead the world towards an understanding of a point that concerned John Maynard Keynes: it is hard to accommodate countries with massive and persistent current account surpluses. The counterpart deficits, if prolonged, almost always lead to financial crises. The way out is for most surplus countries to spend more at home. The expansion programme announced by the Chinese government early this week is just a beginning. Instead of toying with protection, the Obama administration needs to focus on global imbalances. The immediate way to deal with this challenge is to demand a global fiscal stimulus, with surplus countries implementing the biggest packages.

The third element in the programme to deal with the current crisis is already under way – financing of emerging economies in difficulty. The Federal Reserve has taken the lead with its imaginative expansion of swap arrangements with central banks in a few emerging economies. But this needs to be generalised. What is needed is a much expanded version of the general agreement to borrow, through which countries provide credit to the IMF for on-lending.

Mr Obama’s legacy must be much more than crisis management, important though that is. He must also secure deeper reforms. He is right in his belief that a better safety net – universal healthcare, more generous unemployment insurance and greater support for those on low wages – is a necessary condition for acceptance of the changes brought about by global competition. That, not subsidies for failed behemoths, such as General Motors, is the way to proceed.

This means a willingness to accept that the US will need to raise its average tax level from what is, by the standards of high-income countries, a very low level. Mr Obama should start with taxation of energy: a higher price of fossil fuels is a necessary condition for plans to promote energy efficiency, reduce dependence on imports and lower carbon emissions. Personally, I believe it is time for the US to contemplate a national value added tax rather than rely so heavily on the income tax.

Just as important as these domestic reforms will be US engagement in global discussions. A huge area is climate change – a subject for a subsequent column. Another is reform of the IMF. But, to my mind, the most immediate challenge is what to do about financial regulation. The big lesson of this crisis is that policymakers did not understand what they were doing during the era of deregulation. Rather than re-regulate mindlessly, the right solution is to set up a high-level commission, charged with proposing reforms of financial structure and regulation at global and domestic levels. Mr Obama has even the obvious chairman of such a commission among his advisers: Paul Volcker, the highly respected former chairman of the Federal Reserve.

Mr Obama must, above all, build upon the achievements of his predecessors, rather than turn the US away from the world. He must push reforms that help the majority of Americans to gain from the rise of global competition. He must promote reforms abroad that will make the global economy work better. The crisis has given him a challenge and an opportunity. If he is to take the latter, he needs to become one of his country’s great presidents. Anything less would be a failure neither the US nor the world can now afford.

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