Posted by Shyam Moondra
President Barack Obama has been in the oval office for only a few weeks but he has moved at a lightning speed on several fronts simultaneously. While his actions may not be perfect, he seems to have a good intellectual grasp of how the various pieces of the puzzle fit together. Undoubtedly, some critics on the other side of the political divide would say that he is on a wrong track. However, given the awful results of the George Bush presidency, it's hard to support the Republican ideological viewpoint that doing anything differently from what President George Bush did automatically puts you on a wrong track.
Never before, economic fortunes crumbled worldwide in such a short period. Low interest rates of the 1990s fueled the housing market prompted by innovative products such as sub-prime mortgages, mortgage-based securities, and credit default-swaps. The business was so lucrative that financial institutions around the world jumped on the bandwagon without ever bothering to fully assess the enormous risks involved and made a fortune. But when the FED started increasing interest rates to tame the fears of inflation, the house of cards began to crumble. Reduced demand for housing led to rapid decline in home prices that, in turn, led to the floodgate of defaults and foreclosures. The financial institutions that grabbed the mortgage-securities began to see the values of those securities evaporate and they were forced to report huge losses bringing them closure to bankruptcy.
The Obama administration moved swiftly to address the issues in a top-down as well as bottom-up fashion (as I suggested in "Combine top-down and bottom-up approaches to deal with the credit crunch," The Moondra Post, September 30, 2008) by offering assistance to the financial institutions through TARP and FED credit facilities as well as providing help to the homeowners to stay in their homes. The stimulus package, recently passed by Congress, includes tax credits for home buyers that should help reinvigorate the housing market. The Obama's proposed budget includes income-tax reductions for 95% of the taxpayers that will induce them to spend more, thereby boosting the economy. The budget also includes massive spending for infrastructure projects that would instantly create new construction jobs. In addition, the proposed budget includes long-term investments in alternative energy technologies (that will create new high-paying jobs and reduce our dependence on imported oil), health care (that will reduce health care costs), and education (that will increase our competitiveness in the world), The Obama administration's multi-pronged approach to the economic collapse is well thought out and it will yield positive results over time. While it's true that the budget proposal has many pork-barrel wasteful spending appropriations, overall, it has many more positive elements that are necessary under the present dire circumstances.
Not to forget the last piece of the puzzle, the regulatory reforms. Lack of regulations and oversight led to the collapse of the financial system. So it's not surprising that the Obama administration is aggressively moving to bring the regulatory regime to the twenty-first century. We need to regulate investment banks and hedge funds, monitor and regulate computerized trading to eliminate market manipulation (ban naked short selling, limit short selling to 1% of outstanding shares, require institutions to hold stocks they buy for a certain minimum period before they can sell those stocks, and limit trading in derivatives such as options), and impose strict capital requirements on all financial institutions (no more 40:1 leverage used by many investment banks and hedge funds).
The increased spending to jump-start the economy will certainly add to our budget deficit and national debt in the near-term. That's why President Obama is already looking beyond the near-term and he has proposed to reduce government expenditures (e.g., changes in defense contract procedures and health care reforms will save billions of dollars) and increase taxes on the richest (who prospered handsomely during the Bush years and now must give up some of those gains). It took President Bush eight years to turn a budget surplus into a huge deficit, so it's reasonable to expect that it will take a concerted effort by the Obama administration over the next several years before we see a budget surplus again.
In spite of the above dramatic initiatives, we are continuing to see unemployment on the rise and corporate profits on the decline, but the actions taken by the governments around the world create just the right conditions for an economic recovery. Lower interest rates, increased government expenditures, lower taxes for the middle-class, and regulatory reforms will boost the global economy soon. These conditions are ideal for the financial markets, so President Obama was right in his recent observation that long-term investors should start buying dirt-cheap stocks. The current average PE ratio of S&P 500 index of 12, while not as low as 6 of July 1932 and 7 of July 1982, is much lower than the latest 25-year average of 21 and 50-year average of 18. The decline in the average PE ratio from the recent peak of 44 set in 2002 is the worst since the depression of the 1930's. The conditions today are, however, very different than those in the 1980's when we had double-digit inflation and double-digit interest rates. Today, we have annual inflation rate of about 2% and fed funds rate of 0.5%. Therefore, the stocks are indeed very cheap with a huge upside potential.
Aside from the differences in policy directions, there is a stark difference in mostly reactive mode of operation of the Bush Administration and a pro-active comprehensive approach of the Obama administration. President Bush had no long-term vision and he never believed in a deep governmental involvement in free-market economy. President Obama works off a well-thought out strategic vision bringing in the full weight of the government to make his initiatives yield the results quickly. If President Obama continues to show vigor and remains a hands-on chief executive as he has been so far, chances are we will begin to see the results of his stimulus package and the proposed budget plan as early as in the second-half of 2009 and by 2010 we should be well on our way to recovery and renewed prosperity.
