Barack Obama Is Moving to Head Off a Depression

By the speed of his actions and thequality of his judgment in choosing a cabinet, President-elect Barack Obama has made a start on restoring a vanished element of American life: confidence. Not since the Great Depression have we had such a lack of it.

The financial system—and not just ours—is panicked. President Bush wasn't exaggerating when he said at the G-20 meeting that the credit contraction and the subsequent decline of economic activity now raised the possibility of a depression that could be even worse than the Great Depression. He was, of course, breaching the current conventional wisdom that says we've learned so much that we will not revisit the Thirties. But we have not yet found a way out of our fearful predicament.

Today, the fear is so great, for example, that people continue to withdraw from money market funds despite federal insurance programs guaranteeing them. The government countermeasures have been historically dramatic yet unable to break the negative feedback loop of downward-spiraling asset prices. As prices decrease, investors are hoarding even more cash, forcing redemptions in mutual funds and hedge funds. In turn, this leads to further asset sales, producing even lower prices, and so forcing even more deleveraging and more redemptions. Only belatedly is the Treasury recognizing how crucial it is to end the epidemic of foreclosures.

When will financial markets return to normal and supply the loans that fuel the economy? We don't notice their importance when credit flows, but when it stops, as it has now, we are in grave danger. The consumer, trying to pay down debt or rebuild savings, begins to conserve cash. This makes perfect sense for the consumer. After all, household indebtedness has ballooned from $680 billion in 1974 to over $14 trillion today. Consumer debt alone is over $2.5 trillion, with the average household possessing 13 credit cards.

Must lend. Despite the significant recapitalization of banks by the Treasury, they are still hoarding cash. Banks won't lend to borrowers whose creditworthiness is declining—just like the value of the loans the banks are already holding. This in turn is causing the sharp decline in the purchase of big-ticket items like vehicles, furniture, household appliances, and other durables. Hence, we have the biggest drop in consumer spending in almost 30 years—one that is likely to grow more severe. Already this year, 1.2 million jobs have been lost. Every rung of the income and wealth ladder is affected. Everybody is overindebted.

It cannot be repeated too often that we must find a way to unfreeze the system and get credit flowing again. The problem is there are large portfolios of bank loans, other debt instruments, and stocks that banks, hedge funds, and mutual funds want to get off their books. So, there is still much to unravel, particularly since investors with liquidity are in no hurry to make major commitments. This means that we must recapitalize the banks still further but insist, as the British have done, that they lend. And if this doesn't work, the Federal Reserve will have to get into the business of lending directly to the nonfinancial sector. And of course we are going to need a massive fiscal stimulus to deal with the economic slump that is gathering momentum. It's likely that the much-talked-about $500 billion is not enough.

President-elect Obama and the Democrats are right to focus on infrastructure, commonly summarized as "bridges and highways," but it should be more than that. Mass transit (especially rail) needs great investments but has the collateral benefit of energy efficiency. To limit the investment to traditional public works programs would be to miss a consoling opportunity. Money should go also to improve our comparative advantage in the knowledge-based economy of the future through massive new scholarship programs for people willing to enter the hard sciences and for companies willing to invest in more research and development. To start to pay for the trillion-dollar deficits this will cause—and to create a more fair tax system—the Obama administration should immediately set up a commission to review the tax code and close the hundred most egregious loopholes that benefit particular political interests.