Struggle for Obama to fulfil economic vows

The Straits Times (Singapore)
November 18, 2008 Tuesday

Struggle for Obama to fulfil economic vows
BYLINE: Linda Lim

WE ARE entering an era when the adage 'all politics is local' will give way to the truth that 'all economics is global'. That transition is not going to be a comfortable one for Americans.

Specifically, they will find that paying for the profligacy of the past, and meeting the obligations of the future, will require a loss of political autonomy and the surrender of many cherished ideologies of both the left and the right - from tax cuts to trade protectionism.

In international economics, the main reason the United States is 'not just another country' is its ability to borrow from foreigners in its own currency. This is because the US dollar has been a reserve currency since World War II.

When countries like Brazil or Indonesia borrow from abroad, they borrow in foreign currencies, most commonly the US dollar. If they run persistent fiscal and current account deficits, their currencies will depreciate and the burden of their foreign debt will increase.

That does not happen to the US, which can make foreigners bear the currency risk of lending to it. If the dollar falls as a result of persistent US fiscal and current account deficits, it is foreign creditors, not Americans, who suffer, since Americans can pay their foreign debts in their own currency.

One reason the dollar depreciated for more than five years prior to this July is that foreigners became less and less willing to hold the currency. Once the current unwinding of dollar carry trades, repatriation of foreign capital to shore up domestic balance sheets and panic-driven 'flight to security' - all of which have temporarily strengthened the greenback - end, we will be back in weak-dollar territory.

A number of other factors make it unlikely that foreigners will treat the US as gently as they have in the past: A deep and long US recession will cause a loss of confidence in its financial markets; and those markets, as a result of recent excesses, are likely to enter a period of regulatory stranglehold that will crimp investment returns. Sovereign wealth funds that took a beating by prematurely buying shares in US financial institutions will also become more cautious.

China's government, for one, has been excoriated by bloggers at home for devoting the country's hard-earned savings to loss-incurring US investments. It will be politically difficult for Beijing to continue bailing out the US, especially if the incoming administration and Congress accuse it of 'currency manipulation'.

In addition, the East Asian economies with surpluses - China, Hong Kong, Japan, Singapore and South Korea - have rapidly-ageing populations and will in all probability reduce their savings rates.

For these and other reasons, US President-elect Barack Obama will not be able to fulfil his economic promises to the American people. Economists agree that immediate fiscal and mone

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tary stimulus will be required to fight the recession. But beyond that, Mr Obama's longer- term promises will be undeliverable.

The Obama administration will inherit a large budget deficit, greatly increased by all the financial crisis bailouts. The deficit for fiscal year 2008 will amount to at least US $800 billion (S $1.2 trillion) and next year's deficit may hit US $1.4 trillion. Besides the bailouts, government spending typically increases in a recession, as unemployment payments increase while tax revenues shrink.

There is no way that Mr Obama can raise enough tax revenues from the top 5 per cent of income-earners to cover all that he has promised to spend on job-creation, R&D, infrastructure, health care and education, while at the same time follow through with a so-called middle-income tax cut.

Raising taxes on corporations is also a non-starter in a recession, especially since US corporate taxes are already the second highest in the developed world (after Japan).

Mr Obama cannot borrow more from Americans. They will have little to lend from their falling incomes and declining wealth. And he probably will not be able to borrow more from foreigners, who have been funding much of the last quarter-century's budget deficits and high private consumption.

The last remaining way that the US government can pay for its expenditure is to print money, just like Latin American 'banana republics' used to do. The downside is that printing money will create inflation and further devalue the dollar, which in turn will discourage foreign investments. During a severe recession, when deflation is likely, you don't have to worry about inflation, but once the global economy recovers, it will become a serious limitation.

In a sharp reversal from the Bush administration's unilateralism, multilateral policy coordination - whether in trade, monetary policy, international investment, foreign policy or environmental policy - will constrain and define the Obama administration.

The US will no longer be able to 'go it alone'. It is in for a major transition from being 'the world's sole superpower' to being 'just another country', even if it remains primus inter pares. What does this mean for that mythical creature, the 'ordinary American'?

First, wars of choice - such as in Iraq - will no longer be possible. Not only did Iraq contribute to busting the US budget, but it also undermined US national security and moral authority.

Second, two decades of tax cuts and anti-government ideology, propagated by Republicans, are over. Even after the financial crisis eases, foreign borrowing will remain difficult, local borrowing is unlikely to replace it, and there will be more government regulation of markets.

Third, for households, the days of getting into debt to live beyond their means are over. Credit will become more costly because of increased regulation, reduced foreign borrowing, a massive wave of imminent baby-boomer retirements as well as more competition with government spending for scarcer domestic and foreign savings. Excess debt and consumption will give way to thrift, downsizing and energy conservation.

Fourth, attracting foreign direct investment - to help cover the budget deficit, rescue bankrupt corporations, lift depressed asset prices, fund new private- sector technological innovations - will require foreign-friendly policies. No more CNOOC-Unocal and Dubai Ports World fiascos.

It will be a long time - beyond his second term, if he wins one - before Mr Obama's many proposed spending and tax initiatives will bear fruit.

The writer, a Singaporean, is professor of strategy at the Ross School of Business, University of Michigan. Economic Watch is a weekly column rotated among Senior Writer Tion Kwa and guest columnists.

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