President Obama Faces Toughest Financial Challenges in U.S. History

By: Money_Morning

Martin Hutchinson writes: When President-elect Barack Obama gets sworn into office as the nation's 44th chief executive this afternoon (Tuesday), he inherits a country that hasn't been this badly off financially since the Great Depression.

And President Obama can anticipate considerable sleep loss, for the recession-plagued U.S. economy and the accompanying financial crisis aren't even the only challenges his administration faces.

He has not one, but two, medium-sized wars - one in Iraq and the other in Afghanistan - neither of which look easy to end with a fully satisfactory outcome. He has an ally, Israel, which has been threatened with annihilation by its enemy, Iran, which is straining every sinew to acquire a nuclear arsenal. He has another rogue nuclear power, North Korea, which rationally would remain quiescent because of its small size and poverty - but is its leadership rational? And he has an international terrorist conspiracy dedicated to attacking the United States, with considerable support in a large part of the globe.

Which brings us back for a closer look at the economy.

The “Difficult-to-Understand” Economic Mess is Easy to See

Many commentators have described the current economic disaster as “difficult to understand.” But that's not really true: The United States and the world in general are currently undergoing the inevitable aftermath of a decade of excessive money creation, from 1995 in the United States, and from 2001 for much of the rest of the world.

Not only did such a prolonged period of cheap money produce asset bubbles in stock, housing and commodities, it also produced a leverage bubble of excessive debt among consumers, businesses and financial institutions that must be wound down, an agonizingly painful process. The disaster was primarily caused by government, in particular the U.S. Federal Reserve and the (government-created) housing finance agencies Fannie Mae ( FNM ) and Freddie Mac ( FRE ), but there's no question that perverse management incentives in the financial sector, unsound new financial tools and sloppy regulation also played important roles.

During the election campaign, Obama and his supporters had great fun assigning blame for these troubles.

Starting today, it is now Obama's job to come up with solutions. What he has to realize - and he may already know this - is that there is a clear conflict between minimizing the current pain of recession and minimizing its duration. Actions that provide short-term relief generally create new problems that both delay the ultimate exit from the downturn and may cause a deeper economic “hole” before recovery takes place.

Short-Term Fixes May Lead to Long-Term Problems

Back in December 1929, then-U.S. Treasury Secretary Andrew W. Mellon said that the appropriate response to a downturn was liquidation of bad assets to establish a solid base for recovery quickly. His view was ignored by U.S. presidents Herbert Hoover and Franklin Delano Roosevelt , and the 12-year Great Depression resulted.

Fast forward to the present day. The George W. Bush administration and Federal Reserve Chairman Ben S. Bernanke have concentrated on short-term palliatives without worrying about long-term consequences - in both cases, their normal approach. Bailout infusions were arranged for banks without making any rules about who should get the money, or how it should be spent. Second and even third tranches of taxpayer money were given to the worst-run banks , such as Citigroup Inc. ( C ) and Bank of American Corp. ( BAC ), which seemed to be the most at risk for corporate bankruptcy.

The Fed's balance sheet was trebled in size, the monetary base doubled and the broad money supply increased at over 20% per annum, without worrying about how the tsunami of money creation might affect inflation down the road . A total of $700 billion was earmarked for financial rescue projects, without any clear direction as to how that money would be used.

At first blush, the Obama administration seems likely to continue the Bush policies. The second tranche of the $700 billion “Troubled Asset Relief Program ( TARP ) bailout is to be used more directly to support bank lending and homeowners in difficulties , while there is talk of a “bad bank” approach to dodgy mortgage-backed assets, similar to the original TARP plan, which would absorb hundreds of billions of additional bad assets.

General Motors Corp. ( GM ) and Chrysler LLC are both on short-term “life-support” bailouts expiring in March; the temptation will be to provide them with more taxpayer money to prevent the economic damage that might be caused by bankruptcy. An Obama administration economic stimulus package , currently on its way through Congress, has already reached $825 billion and may well top $1 trillion before it is finalized.

Nevertheless, Obama appears to be torn. By nature, he is a much deeper and more long-term thinker than President Bush, Bernanke or outgoing U.S. Treasury Secretary Henry M. “Hank” Paulson Jr. Obama also is surrounded by economic advisors in New York Fed President Tim Geithner , Larry Summers and former Fed Chairman Paul A. Volcker , who all are committed to a free market rather than a government-directed economy - and who, in Volcker's case at least, realize that short-term economic pain can be used to produce long-term gains that far outweigh it.

The recession of 1981-82 , produced by Volcker's tight money policy, was painful but highly worthwhile. The reason: It resulted in the disappearance of inflation and a period of almost recession-free economic growth that lasted a quarter of a century.

Thus, it absorbed its approximate parameters and would be badly damaged by the uncertainty such abandonment would cause.  However, President-elect Obama has already said that he sees the necessity of balancing the federal budget over the long haul, and with Volcker by his side he must realize that a similar course must be taken with respect to monetary policy.

If the stimulus provided produces in the next few months a modest economic and stock market “bounce,” then we can expect measures such as a sharp tightening in monetary policy. That tightening will lessen the inflationary effects of huge money supply growth, as well as the $1.5 trillion budget deficit - equivalent to 10% of gross domestic product (GDP). There may also be some attempt to rein in federal spending, and some modest tax increases, such as a rise in the gasoline tax.

The danger of monetary tightening, and still more of fiscal tightening through tax increases, is that it may push the economy deeper into recession, as did Hoover's exorbitant income-tax increase in 1932. It's a very difficult balance to maintain, and indeed may not be maintainable; the “default” trajectory from here on out is probably a severe “double-dip” recession, with the second “dip” being both inflationary and much deeper than the first. Such are the rewards of a decade of short-term thinking.

If Obama fails to produce economic recovery, his prognosis for re-election in 2012 must nevertheless be favorable. FDR achieved re-election by a record majority in 1936, having failed to end the Great Depression when other countries such as Britain had largely succeeded. Rhetoric, charisma and “hope” can doubtless produce the same result for then-President Obama.

If he produces even modest economic progress in such a difficult situation, he will deserve it.

[ Editor's Note : Money Morning Contributing Editor R. Shah Gilani, like Martin Hutchinson, a former Wall Streeter who now decodes the financial markets for investors, will be hosing a post-Inauguration " Web summit " that talks about the regime change in Washington and what it will mean for investors in the coming months.

The session this Thursday (Jan. 22) - entitled " The Regime Change in Washington Triggers War on Wall Street " - is free of charge to investors who register in advance. It will start at 7 p.m. EST.

Gilani, the editor of the " Trigger Event Strategist , " and a commentator who is known for his deep connections inside the investment-banking world of Wall Street, says those who tune in can expect to get candid insights not available on your favorite cable-TV finance show or in the business section of your local newspaper.

"Wall Street doubletalk got us into this crisis," Gilani said. "I hear more excuses than straight talk. Most of the dialogue is noise. The truth may be difficult to swallow, but without hearing it, there's not much hope for finding the right way out of the maze."

For more information on the free Webinar, please click here . For more information on the " Trigger Event Strategist , " trading service, which seeks to profit from the new investing rules that have emerged from this financial crisis.]

By Martin Hutchinson
Contributing Editor

Money Morning/The Money Map Report

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