WILLIAM GALSTON MAY 4, 2009
During his first 100 days in office, President Obama has honed his economic program, and his defense of it. There is no longer any question about what he intends to do. As the croupiers in Monte Carlo say, les jeux sont faits. The remaining uncertainties are these: Will it work? If so, how long will it take? And what are the likely political consequences?
The short answer to the first question is, we don't know. Much depends on the willingness of private investors to buy troubled assets and take them off the balance sheets of major financial institutions. The White House has offered investors strong incentives to do just that. If they take the bait, confidence in the banks would rise and lending would likely resume in a matter of months. If they don't, the administration would probably have to go back to Congress for more money (on top of the $700 billion already appropriated for the Troubled Asset Rescue Plan)--a tough sell at best. After all, the White House designed its plan in part to avoid a confrontation with Congress.
Thanks to economists Kenneth Rogoff and Carmen Reinhart, we know a bit more about how to answer the second question--that is, how long Obama's recovery plan may take to work. Based on their comparative analysis of 18 major postwar financial crises (all in the developed world), Rogoff and Reinhart reach three key conclusions:
First, declines in asset values are "deep and prolonged." Over six years, housing prices fall, on average, 35 percent. Over three and a half years, stock collapses average 55 percent.
Second, falling asset values spill over into the real economy. Unemployment rose an average of seven percent over the period of decline, which averaged four-plus years. Production fell more than nine percent, though the downturn, which averaged about two years, was shorter for unemployment.
Third, in the years following a crisis, government debt increases by an average of 86 percent. The main cause of this explosion is not the cost of bailing out and recapitalizing the banks, but rather the cost of falling tax revenues coupled with expensive economic stimulus packages.
It's worth noting that the U.S. crisis is unfolding faster than the crises Rogoff and Reinhart describe. After a little more than a year, housing and equity prices are nearing the Rogoff/Reinhart averages. Employment and output will likely fall less than the historical average because of the bailout and economic stimulus packages. In terms of government debt, if the Congressional Budget Office is right, the increase will be in line with Rogoff and Reinhart's findings.
As for the political consequences, well, those may be the toughest to predict. Suppose that Obama's program manages to keep the downturn akin to the deep recession that occurred early on Ronald Reagan's watch. What would that look like? The massive tax cuts and defense buildup Reagan initiated in 1981 did not halt the decline in output until late 1982. After peaking at over ten percent at the end of that year, unemployment took two full years to return to its pre-recession level. Yet Republicans--despite the fact that there were few signs of economic recovery by the time of the 1982 midterm elections--lost no seats in the Senate and gave up a relatively modest 26 in the House.
President Obama has asked the American people for patience, and he will probably get a good measure of it. If the economy grows enough to significantly lower unemployment during 2011 and 2012, the prospects for his agenda--and his re-election--will be bright. If his plan for rescuing the financial system does not work, however, the trajectory of the economy would resemble Japan's Lost Decade. In this scenario, it's hard to see how he could win reelection. Despite the myriad problems that he faces, then, Obama would do well to focus foremost on the condition of key financial institutions--and to do whatever it takes to restore their health.