Can Obama fix the American economy?

By heeding the counsel of his financial advisers, Barack Obama may risk doing more harm than good to the American economy. But what is the alternative?

In his interview with the New York Times on May 3, 2009, President Obama said,

"I know how to ask good questions of my doctor. But ultimately, he's the guy with the medical degree. So, if he tells me, you know what, you've got such-and-such and you need to take such-and-such, I don't go around arguing with him or go online to see if I can find a better opinion than his."

We suspect that President Obama has adopted the same approach with respect to managing the US economy. In fact, in the same interview he said that he is very much influenced by the ideas of Joseph Stiglitz, Larry Summers, and Paul Volcker.

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During the interview he also expressed his admiration for Robert Reich and Paul Krugman. Although he didn't say it, we suggest that the US president is also greatly influenced by the ideas of Federal Reserve Chairman Ben Bernanke.

All these famous personalities derive their way of thinking from the writings of John Maynard Keynes and endorse heavy government involvement in the economy.

The influence of these personalities on the mindset of the US president is vividly revealed in his economy speech at Georgetown University on April 15, 2009. According to the president,

"Recessions are not uncommon. Markets and economies naturally ebb and flow, as we have seen many times in our history. But this recession is different. This recession was not caused by a normal downturn in the business cycle. It was caused by a perfect storm of irresponsibility and poor decision-making that stretched from Wall Street to Washington to Main Street. As has been widely reported, it started in the housing market... Everybody was making record profits - except the wealth created was real only on paper. And as the bubble grew, there was almost no accountability or oversight from anyone in Washington. Then the housing bubble burst. Home prices fell. People began defaulting on their subprime mortgages. The value of these loans and securities plummeted. Banks and investors couldn't find anyone to buy them. Greed gave way to fear. Investors pulled their money out of the market. Large financial institutions that didn't have enough money on hand to pay off all their obligations collapsed. Other banks held on tight to the money they did have and simply stopped lending."

Note that not even a word is mentioned about the possible responsibility of the Fed for the present economic crisis. This omission is puzzling.

Recall that the president suggested that he knows how to ask good questions. And yet it seems that when it comes to the world of economics, he has lost this skill and is not asking the relevant questions. He is not arguing with the experts.

In a typical Keynesian way, the US president argues that the crisis in the financial markets started to spread to the real economy. Consequently, all this has undermined overall demand in the economy. To prevent further deterioration, the Obama administration introduced measures to counter the economic slide.

"The first step was to fight a severe shortage of demand in the economy. The Federal Reserve did this by dramatically lowering interest rates last year in order to boost investment. And my administration and Congress boosted demand by passing the largest recovery plan in our nation's history."

There is, however, no such thing as a shortage of demand. In fact, individuals' demand is unlimited. What is scarce is not demand but rather individuals' ability to fund the demand.

For instance, an individual might have a demand for a Mercedes 600, but only have the funding for a bicycle.

In order to be able to fund a Mercedes, our individual must produce enough goods to enable him to secure the car.

A dramatic lowering of interest rates and massive government spending cannot improve the bottom line of the economy (the individual's ability to produce more and better-quality goods). Such policies can only redistribute real wealth from wealth producers to wealth consumers.

For instance, in an economy comprised of a baker, a shoemaker, and a tomato grower, imagine that another individual enters the scene. This individual is an enforcer who is exercising his demand for goods by means of force. Can such demand give rise to more output, as the popular thinking has it? On the contrary, it will only impoverish producers. The baker, the shoemaker, and the farmer will be forced to part with their product in exchange for nothing, and this, in turn, will weaken the flow of production of final consumer goods. According to Mises,

"there is need to emphasise the truism that a government can spend or invest only what it takes away from its citizens and that its additional spending and investment curtails the citizens' spending and investment to the full extent of its quantity. (Human Action, p. 737)"

This, however, is not what the president believes. He is of the view that during the current crisis government should increase and not cut its expenditure.

"To begin with, economists on both left and right agree that the last thing a government should do in the middle of a recession is to cut back on spending. You see, when this recession began, many families sat around their kitchen table and tried to figure out where they could cut back. So do many businesses. That is completely responsible and understandable reaction. But if every family in America cuts back, then no one is spending any money, which means there are more layoffs, and the economy gets even worse, that's why the government has to step in and temporarily boost spending in order to stimulate demand. And that's exactly what we're doing right now."

Here Obama accepts the terrible advice of his economists that savings are bad for the economy. If he had spent some time pondering this issue, he would have reached the conclusion that what is good for the individual is also good for the economy.

He would have discovered that the key for funding is real savings. He would have also discovered that real savings cannot be replaced with money and government outlays. It must be appreciated that government is not a wealth generator - it is a wealth consumer. The government is completely dependent on the wealth of the private sector. Hence the more government spends, the less is left for wealth generators and the weaker the economy gets.

This means that only wealth generators - and not the government and the central bank - can generate funding.

President Obama would have discovered that, unlike what his advisers are telling him, it is not possible to create something out of nothing. In order to be able to consume, individuals first must produce useful things.

After suggesting that savings are bad, the president goes on to argue that it is necessary to provide assistance to banks in order to revive credit.

"The heart of this financial crisis is that too many banks and other financial institutions simply stopped lending money. In a climate of fear, banks were unable to replace their losses by raising new capital on their own, and they were unwilling to lend the money they did have because they were afraid that no one would pay it back. It is for this reason that the last administration used the Troubled Asset Relief Program, or TARP, to provide these banks with temporary financial assistance in order to get them lending again. No, I don't agree with some of the ways the TARP program was managed, but I do agree with the broader rationale that we must provide banks with the capital and the confidence necessary to start lending again."

No, the heart of the current financial crisis is the boom-bust policies of the Fed. It is these policies that caused massive real-wealth destruction and hence weakened the economy's ability to generate real savings. Note that it is real savings that fund economic activity.

Once the process of real-funding formation comes under pressure, obviously banks' ability to lend follows suit. After all, banks are just intermediaries; they help to facilitate real savings, but they cannot generate real savings. Although banks are still reluctant to lend, they are quite happy to lend to viable borrowers. The fact that bank credit is still tight raises the likelihood that the pool of real savings is still under pressure.

The US president is of the view that somehow he could make the banks lend regardless of real savings. The only expansion of lending that the president could enforce upon banks is lending "out of thin air". This type of lending amounts to the creation of money "out of thin air" - the key factor behind the present economic crisis. To justify his policies, the US president maintains,

"Of course, there are some who argue that the government should stand back and simply let these banks fail - especially since in many cases it was their bad decisions that helped create the crisis in the first place. But whether we like it or not, history has repeatedly shown that when nations do not take early and aggressive action to get credit flowing again, they have crises that last years and years instead of months and months - years of low growth, low job creation, and low investment that cost those nations far more than a course of bold, upfront action."

Again, the president must appreciate that without the expansion of the pool of real savings it is not possible to make banks expand credit. The only credit that they can expand is "out of thin air". This type of credit can only further weaken the bottom line of the economy.

Contrary to the advice the president was given - probably by Fed Chairman Bernanke - we can suggest that the more the government tries to fix the banking sector, the worse things are likely to be. Also, contrary to Bernanke's views, it is the Fed's tampering with the US economy during the 1930s that transformed a recession into a depression.

Similarly, almost twenty years of aggressive tampering with the economy by the Japanese government and central bank has failed to meaningfully revive the Japanese economy. (This tampering has only weakened the bottom line of the Japanese economy.)

After assuring the US public that he knows how to counter the economic crisis, the president said,

"But even as we continue to clear away the wreckage and address the immediate crisis, it is my firm belief that our next task is to make sure such a crisis never happens again... We cannot rebuild this economy on the same pile of sand. We must build our house upon a rock."

His intentions are good. However, his actions have already laid the foundation for a gigantic bubble and a further weakening of economic fundamentals.

This article was written by Frank Shostak for the Mises Institute and was first published on 20 May 2009