What Must Obama Do To Get Our Economy Back To Normal?
by Joseph A. Monaco, Ph.D.
Registered Principal - RJFS

The U.S. economy is in recession, the stock market is at the lowest level in over a decade and we continue to fight two wars on the other side of the planet. Prices of hard assets (real estate, lumber, copper, etc.) have been spiraling down and our budget deficit is on the rise. So what does the Obama administration need to do in order to turn things around?

Art Cashin is a frequent guest on CNBC. I got to meet Art a number of times when I worked at Paine Webber and found him to be, quite possibly, the most intelligent man I ever met. Last week I heard him say, "What Obama needs to do is raise everyone's hopes while lowering their expectations." How profound. I only wish I had said it first.

The first issue that President Obama needs to solve is "the credit crisis." Fortunately for him (and us), the solution is already underway. The imminent collapse of the banking system was avoided, thanks in large part to the swift action of Federal Reserve Board Chairman Ben Bernanke and Treasury Secretary Henry Paulson. Between the money allocated by the U.S. congress (known as the T.A.R.P.) and injections of cash provided by the Federal Reserve, more than $1-Trillion has been added to our bank reserves. Many people have chided the banks for not loaning that money out quickly enough, but one must ask why they have been so slow to do so. Remember, the banks weren't "given" that money, the government is charging them 5% for that T.A.R.P. money and therefore the banks are losing money every day that they sit on that cash. The reason for the public outcry is that most people don't understand that the primary reason for the cash injection into the banks wasn't so they could immediately loan that money out. Loaning money was the secondary objective. The primary objective was to recapitalize our U.S. banking system in order to avoid a collapse similar to what happened during the Great Depression. To that goal, so far so good!

In order to start that money moving, President Obama faces the daunting task of raising our nation's velocity. Velocity is an economic term that measures how quickly we spend the money we have. For example, let's say you have a velocity of 10%, which means if you have $100 you will spend $10. If your current pessimism causes you to reduce your velocity to 5%, then you would only spend $5 rather than your usual $10. This is what's happening in our nation and as far as I can see, only two solutions exist to this problem (one short term and one long term).

Solution One, the short term solution, is to give you another $100. You would then have $200 and presuming your velocity stays at 5%, you would be back to spending $10 and everything would return to normal. Looking at the two charts from the Federal Reserve that I inserted below you can see that "solution one" is exactly the course that our government has chosen.

As the Money Velocity chart on the left clearly shows, beginning in June 2008, our nation's velocity collapsed. If you eyeball the Money Supply chart on the right, you'll notice that about three months later our government began flooding our system with money. Empirical evidence suggests that this has indeed begun the desired effect of stabilizing our financial system. But stabilization is only a short term solution. Think of it this way: when you're sick with the flu you just want to stop throwing-up. Once you do stop throwing-up, then that's no longer enough. Now you aren't fully happy until you can resume your normal life. This is the issue Obama faces. People are no longer happy with merely ending the economic pain. He must show us how he is going to get us back to life as normal.

In order to get America back to a normal life, our government is going to have to complete the difficult and tricky task of raising our velocity while simultaneously draining that excess money. If President Obama raises our optimism too fast, our increased velocity combined with all of that extra money will cause a significant rise in inflation. On the other hand, if the Federal Reserve removes that extra cash from our economy faster than our velocity (think optimism) rises, we will dip back down into a second leg of recession.

Right now our government has made it clear; considering the risk of both recession and inflation, they consider recession "The Clear And Present Danger" and so have chosen to risk inflation over recession. My estimation is that we are indeed going to avoid a return to The Great Depression that is feared by so many. Why? Because contrary to most of the rhetoric prevalent in today's media, I am personally impressed with the soundness of the strategy and swiftness by which our government has implemented it.

I consider it sound because Paulson and Bernanke fashioned a plan that, if successful, recapitalizes our nation's banks while simultaneously profiting the government. Most people believe that it's their tax dollars that have gone to the banks. On the contrary, rather than raising your taxes to fund the plan, the government has already gone out to the world's markets and instead borrowed the money at an interest rate of about 3%. Since the Treasury is earning 5% on the money provided to our banks, that 2% spread mathematically translates into a $20-billion per year profit into our government's coffers.

I consider it swift because, if you remember, it was only four months ago that we were told that our banking system was on the brink of collapse. Think about it, in only four months people have gone from worrying if the FDIC would cover their savings once their bank became insolvent to complaining that their bank isn't loaning out money fast enough. You probably haven't even realized that you changed your thought process, but believe me, this is a colossal change in attitude in an amazingly short amount of time. I believe the banks will eventually loan out that money, but quite frankly, it isn't that easy to loan out $1-trillion quickly without repeating the lending mistakes that brought us this crisis to begin with.

In conclusion, President Obama presently has the backing of the American people. Even for those who favored McCain, it may be obvious that Mr. Obama's excellent oratory skills may be just what America needs right now. In the months before his election, we put in place the mechanisms necessary to restore the process. Now we need to restore a nation's optimism, which if done will cause a return to a more normal velocity.

To that end, President Obama, as the French say, bonne chance.

The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. Any opinions are those of Joseph A. Monaco, Ph.D. and not necessarily those of RJFS or Raymond James. Expressions of opinion are as of 2/5/2009 and are subject to change without notice.