How Will the Stimulus Package Affect the U.S. Economy?

In a background where top economists have given little credence to the idea that the U.S. economy is going to recover in the next six months over the weekend, I thought it may be appropriate to visit the important impacting factors that will shape the markets in 2009. The main focus of course will remain on the US economy. We start with the stimulus package that the market appears to be so bullish about.

How quickly will the US stimulus package be approved?

Source: Society Generale - Cross Asset Research

The stimulus package expected to be announced during this month is one of the key drivers of optimism today. Seasoned observers however feel that it will take a while before the package is passed and it will have its own speed bumps. Given the amount likely to be involved (estimates are close to a trillion dollars) the process they feel will be theatrical with a lot of face saving.

These debates typically play out with the party in charge seeking far more than it wants. Then it drops demands and both sides declare victory with a compromise. We expect this battle to play out that way as well.

What kind of stimulus package is approved and how it relates to the assessed depth of the recession will be keenly observed. Remember, nobody today has a clear idea how long the recession may last (current wise thinking is until mid-2009) or how deep it is likely to be. The nature of the package will itself have a causative effect on the perception of the longevity of the recession/deflation.

How effective will it be?

The approval of the package is no panacea. There will be a number of issues to ponder over. The clarity of objective is very important, otherwise one can lose the way easily. To quote:

… to win a war, it's a good idea to map out or at least have a sense of the endgame before deploying the troops. That is, lawmakers must think about establishing yardsticks, curbs and deadlines for the money.

Otherwise, there's a risk that the historic recovery package morphs into a boondoggle that mortgages the nation's future by adding hundreds of billions to the deficit while creating a hard-to-tame bureaucracy.

Obama is also aware of that this could turn out to be black hole and a clear exit strategy is required otherwise today’s momentary happiness will turn out to be a long term sorrow story. How the growth on spending once started will be controlled is far from clear.

We're going to be focusing on the budget, to make sure that even as -- in the short term, we deal with the potentially $1 trillion-plus deficit that we're going to be inheriting and we are trying to jumpstart the economy, that we're also in the medium and long term looking at how we can get on a path of fiscal responsibility and sustainability." - Obama

Another key issue: How will success be measured? Employment will be a lagging indicator and may not allow for quick course corrections.

And the Challenge:

Allow politicians to take billions of dollars of your money and dole it out to other politicians, who then give it to other government administrators. All of whom ask you to trust that the funds will be spent wisely.

Tax Cuts: How effective will it be?

Generally speaking, economists say, permanent tax breaks boost the economy more. Why? Because consumers feel freer to spend it rather than save it since they know it's a sum they'll get every year.

Vice President-elect Joe Biden said last week the stimulus tax cut would be a "down payment on the tax relief that we promised for the strapped middle class." So the promise of permanence may have its own stimulus effect. But considering that Congress hasn't weighed in on the issue, there's no guarantee.

What happens to TARP & its cousins?

A Market Watch report says

…lawmakers are expected to enter a new round of wrangling over the uses of the $700 billion Troubled Asset Relief Program. The Bush Administration's decision to extend the financial system bailout money to automakers pushed total TARP payouts past $350 billion. The Treasury Department must now convince Congress, which is at odds over the best uses of TARP, to release the second half of the $700 billion.

The House Financial Services Committee will hold a hearing Wednesday on uses of the TARP. Separately, Treasury Secretary Henry Paulson is scheduled to speak on the government-sponsored mortgage agencies.

The prediction is

...by the time all is said and done, the Troubled Assets Relief Program (TARP) funding will go well beyond $700 billion. President Obama will request, and Congress will approve, another several hundred billion in aid. Much of that will go to homeowners, although airlines will probably get a slug of cash as will auto parts makers.

Watch out for the black hole syndrome.

When will credit flow start in right earnest?

Much of the funds infusion into the banks is being held as cash and is as large as $1 trn. While the credit situation has improved over the last two months it is still tight by relative standards. Banks coming out of this self imposed discipline will be the key to make money move/circulate. However much money the Fed pumps into the system, unless it circulates the desired effect will not be there.

This reluctance to lend is both psychological (the anchoring of a recent experience) and strategic as these institutions, post infusion of funds, have probably just about restored their capital adequacy. Now they also have a fear that the projected recessionary/deflationary scenario will create loan losses and they need sufficient strength at that time to raise further capital to ensure capital adequacy. Also with the raging unemployment and falling real estate prices any further lending may lead to good money going after bad money.

In the current context, any sign of weakness will result in downgrade by other banks/institutions as counterparty risk will be considered higher. This has its own chain effect.

This then becomes a circular problem as inadequate credit availability in turn reinforces the recessionary/deflationary forces. The thrust required to move out of this orbit -the 'escape velocity' has to be provided by the stimulus packages and massive government spending. Assuming that these packages work and bring back employment and consumer spending, it will put businesses back into business and in turn improve the asset/loan quality of banks. This comfort will then give banks the confidence to lend in right earnest.

Also covering default risk in the CDS market itself has become risky and the only insurance that anyone would trust today is that of the government or if it is government backed.

There are other implications too. As a NYT article observes:

A big worry is the future of securitization, a key mechanism of modern banking that enables banks to bundle loans and bonds into securities for sale to investors. This crucial market is moribund now that many of its creations have plunged in value. Some question when, or if, certain areas of securitization will revive.

Securitization, which works like a shadow banking system, has radically changed banking and the credit markets in recent years. Three decades ago, banks supplied $3 out of every $4 of credit worldwide. Today, because of securitization, that share has dropped to about $1 in $3.

Unless financial companies can securitize debt — which, in turn, depends on investors’ willingness to buy the bundled loans — credit will remain tight even if banks resume lending.

Thus, as and when the credit market unlocks the overall level of credit will not be the same as was experienced in 2006–07. The leveraging capability of all institutions will be drastically reduced either voluntarily and/or by market forces and/or by legislation. The aggressiveness to lend will be lacking. Modest growth objectives will be set. Many of the large banks have government in them and will find interference in the name of checks and balances.

How long will such packages take to show tangible results and provide the ‘escape velocity’ to the banks, given the political process (as touched upon in my previous post) is anybody’s guess.

Comments

[thatguy57z:]

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Jan 06 04:17 AM

[thatguy57z:]

I have to say it like it is, when I bought my home, was that myself as a single person for my retirement and that I would sell it and pocket the money with no Capitol gains. But then I let my daughter and my four grandkids move in and I love them very much and had done very well in construction and seen the housing market in 2006 start going to hell, and so I went in to commercial construction 2007 was good and was and out look for five years, until all the housing contractors started in the commercial end so five turned to two years and then 2008 and then nothing. let me leave you with some insight it my open your eyes as to whats going to happen, god bless us all. click website.

www.youtube.com/watch?...

Jan 06 04:57 AM

[vaughn:]

Obama's circa 800 billion stimulus plan will not jump start the economy. At best, it may soft the blow, at worst, it may push the US further into depression.

Consumers, in 2009, are likely to reduce spending and raise savings in the neighborhood of $1 trillion, which will dwarf whatever Obama's stimuls plan ( 500 billion spending in 2 years excluding tax cut).

Unless Obama can bring in a new 5 million immigrants each investing half a million as the condition precedent for obtaining immigration visa and buying a house using the fund (that will be 2.5 trillion new investment and a 5 million new housing demand), there is no way housing price can find the bottom in 2009. With all the bailouts going on, the real bottom of housing price may not find until sometime in 2010 or even in 2011.

I do not expect the government is capable to do the right thing. And, hence, folks, expect the unemployment hovering at 10% at the end of 2010.

Jan 07 12:07 AM