An Inheritance of Ashes

by Karl Reiner

The Congressional Budget Office estimates the federal budget deficit for the fiscal year ending September 30, 2009 at $1.2 trillion. That amounts to $4,000 for every man, woman and child in the United States. The rapidly soaring deficit is one of the many unresolved issues the Obama administration has inherited from the group leaving the White House.

President Obama will no doubt end the outlandish policy of launching understaffed military actions. He also sees the folly of ignoring the need to raise taxes to cover costs once the military has been committed. Although conditions are improving in Iraq, they appear to be going the other way in Afghanistan. President Obama faces a dilemma in extraditing the military from these ineptly managed interventions. He has to ensure that functioning and survivable governments are in place in these countries so the troop exit can be permanent.

Unfortunately, America’s enemies know an opportunity when they see it; they will do what they can to prolong U.S. involvement. Until a resolution is reached, the drain on the government’s financial resources will continue. The affairs in Iraq and Afghanistan cost the government over $12 billion per month.

The financial crisis triggered by the sub-prime mortgage mess continues to take its toll. The total number of questionable mortgages in the system is a staggering 25 million. The home foreclosure rate is at an all time high, with 2.3 million homeowners facing foreclosure. As a consequence, the value of the nation’s housing stock continues to slide. In some areas, housing prices could fall by an additional 20% before the situation turns around.

Nervous banks have tightened their lending requirements, resulting in a credit shortage that is slowing the economy. It has become apparent that a combination of government policies, lack of oversight and deregulation contributed to the problem. The use of credit was allowed to go nearly unchecked; it ran virtually out of control. How our national housing policy evolved from one originally designed to help provide a necessity of life into an item of rabid speculation is a question that needs to be addressed by the administration and Congress.

The rapid decline in the housing market has set off a huge chain reaction. Retail sales are slumping as worried consumers cut spending. Business investment is declining. Jobs are disappearing at an alarming pace; the unemployment rate is expected by some analysts to go to 10%. The income of the states has been clobbered. Surpluses have evaporated; the majority of states are in financial trouble. California leads the pack with a $41 billion gap in its budget.

Alan Greenspan, the former Federal Reserve Chairman, says we are in the worst economic crisis since WWII. Other observers believe we have stumbled into an economic morass that could, if not contained, end up being as damaging as the Great Depression. The policy of getting government off of the backs of the American people may have been carried to a perilous extreme. The visible rewards of deregulation came with an unseen price; they carried with them a growing degree of economic insecurity.

Deregulation removed many of the safety nets. As part of the free market conversion, the gradual change from pensions to the 401(k) shifted the responsibility for providing the safety net from business and government to the individual. The concept worked fine as long as housing and stock prices climbed; now many individuals are finding their home value and retirement savings decimated.

After more than a trillion dollars in wealth dissolved one day on the stock market, a worried Congress, pushed by the Treasury and Federal Reserve, hastily enacted a $700 billion program to buttress the sagging financial system. Thus far, it has unsteadily managed to head off a complete collapse on Wall Street and financial panic on the nation’s Main Streets.

With the U.S. projected to slide deeper into recession this year, the focus of the administration will be on restoring the nation’s economy to health. As it tackles the job, its experts face many unknowns. Developing policies that will turn things around will be difficult because there is a degree of uncertainty as to what will work. Monitoring the results of the previous salvage effort and getting the new $800 billion stimulus program that President Obama wants implemented will dominate the agenda for months to come.

The consequences of our mortgage muddle have reverberated around the globe. The shock wave set loose in the U.S. has affected China, India, Japan, Latin America and Europe. As banks collapse around the world, America’s once highly rated commercial paper has lost much of its luster. It may be some time before foreigners are willing to put a high degree of trust in our financial products.

As the current recession deepens there have been comparisons made between the present state of disarray and the Great Depression. Although the economy is troubled, the situation is not anywhere near as bad as it was during the infamous depression. During that time, stocks lost 80% of their value. Over 10,000 banks failed. The economy shrank by 31%. By 1932, the unemployment rate had reached 25%. Industrial production dropped over 46%. As the depression spread world-wide, international trade fell by two-thirds.

The Great Depression also caused massive political dislocations. Around the world, 25 countries became dictatorships between 1929 and 1939. The depression crushed recovery in Germany, helping to destroy the Weimar Republic.

In 1928, Germany was beginning to recover from the effects of defeat in World War I. Hyperinflation had been brought under control, and unemployment was beginning to dip. In the May elections, the National Socialist German Workers Party (Nazi) won just 12 seats in the Reichstag, getting less than 3% of the national vote. The onset of the Great Depression ended the recovery. As conditions worsened in September 1930, the Nazis’ vote share climbed to over 18%.

As political collations disintegrated under the strain of the economic breakdown, Germany’s citizenry became demoralized. The unemployment rate climbed to 30%. In the July 1932 elections, the Nazis received 37% of the vote. As faith in democracy continued to splinter, the Nazi party became the country’s largest political party. Its leader, Adolph Hitler, became chancellor in January 1933. Once in power, he quickly demolished the last vestiges of democracy. His malevolent policies made war a certainty.

In pre-depression Japan, shipments to the U.S. provided two-fifths of export income. The intensity of the downturn, along with popular discontent regarding limitations on the size of the navy, reinforced the appeal of the militarists. After the military gained control of the government in 1931, Japan expanded plans to secure raw materials and markets by force. It was a policy that led to Pearl Harbor.

The impact of the current economic crisis could generate its own host of bedeviling political problems. Approximately 200 million people, about 3% of the world’s population, live outside their home countries. The global economic slump will force many of them back to countries with little to offer. With expectations dashed, resentment could fuel a rise in radicalism.

As the recession deepens, millions of workers in China and India, many of them recent migrants from the countryside, are in danger of losing their jobs. Remittances to Mexico are falling, down by over 4%. With a substantial part of the population dependent on these payments, the government will be hard pressed to fill the gap.

The political ramifications of economic events are not easily predicted, but they should be expected. History has shown that people’s fears and the human desire for improvement can be easily manipulated by authoritarian leaders. The worsening state of international economic affairs may result in some unwelcome new political challenges the Obama administration will have to deal with. These are difficult times, and due to the depth and complexity of the interrelated problems, improvement will come later than most people expect.

Karl managed international trade and economic policy analysis at the U.S. Department of Commerce. He served as an acting deputy assistant secretary during the first Bush and Clinton administrations.