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Obama's Stimulus Plan: When is There "Too Much" Stimulus?

By Martin Hutchinson
Contributing Editor
Money Morning/The Money Map Report

The Congressional Budget Office's announcement Wednesday that 2009's budget deficit was going to be $1.19 trillion – before a nickel of President-elect Barack Obama's stimulus plan has been included – raises a crucial question for the U.S. economy: Is there too much stimulus, and what effect would too much stimulus have?

There is certainly more stimulus than in any previous recession. The benchmark Federal Funds rate is essentially at zero, which has never previously been attempted, while inflation is still positive. The money supply has been increased by almost 20% in the last three months, which one would normally expect to lead to higher inflation.

On the fiscal side, the $1.19 trillion deficit forecast by the CBO is 8.3% of gross domestic product (GDP), considerably higher than the previous record of 6% of GDP in the recession-ridden year of 1983. And that deficit calculation doesn't include President-elect Obama's stimulus plan, which at $800 billion over two years could add $400 billion to the deficit and push it to more than 10% of GDP.

With both monetary and fiscal stimulus stronger than ever before in peacetime, the government is running the economy absolutely flat-out. Only if you thought the government had no effect at all on economic activity could you believe that recession and deflation would continue.

The initial rationale for all of this stimulus was the unprecedented nature of the housing finance disaster, with drops in market prices and loan-loss levels not seen since the Great Depression. Had the U.S. banking system imploded – as it seemed destined to back in September – the resulting recession could indeed have rivaled the Great Depression.

However the $350 billion from the first tranche of the Troubled Assets Relief Program (TARP), mostly invested directly into bank capital (although a number of banks admittedly used the taxpayer-provided infusion to play "let's make a deal"), appears to have stabilized matters.

JP Morgan Chase & Co. (JPM), for example, is expected to make losses of around $2 billion in the fourth quarter of 2008 – a nasty result to be sure but by no means unexpected in a quarter when stock markets dropped 20% and illiquidity was at its height. With $25 billion of new capital from Uncle Sam, JP Morgan now has plenty of wiggle-room to survive – even in an extended downturn.

In 2009, further trouble may lurk for the weaker U.S. banks, but strong banks like JPM should gain market share and do quite well.  

With liquidity now largely restored by both the TARP and by federal asset purchases, there would seem no reason why the banks' corporate lending should be any more restricted than in previous moderate recessions. In those circumstances, the unprecedented fiscal and monetary stimulus should, in the short-term, produce a stock market bounce, an economic recovery, a dramatic run-up in the price of gold, and soaring inflation, in that order.

The conventional wisdom is that the U.S. economy will have a very difficult first half, but that recovery may appear in the second half of 2009.

These things are very difficult to predict, but my money would be on precisely the reverse scenario: The stock market will be strong in the short-term, and economic numbers will turn around quite rapidly, perhaps even producing modest first-quarter GDP growth, and quite robust economic growth in the second quarter.

By late summer, however, the resurgence in inflation and financing difficulties in the U.S. Treasury bond market will cause an increase in long-term interest rates, accompanied by a reassessment of the U.S. Federal Reserve's 0% short-term interest rate policy.

That will cause the stock market to reverse direction and head downward.

Serious consumer price inflation will take longer to appear. But by the end of the year and in the first half of 2010, prices will be rapidly rising. Accordingly, both the Fed and the Obama administration will have to begin reversing their stimulative policies, raising interest rates and cutting public spending – or even raising taxes. The policy reversal will cause a second economic downturn, but one that's of a very different nature from the first.

The current downturn has been caused by a collapse in asset prices, and has been reversed by exceptionally strong monetary and fiscal stimulus policies. However, the second downturn will be sparked by a crisis in the long-term bond markets, will be more concentrated on the real economy than on just the financial sector, and is likely to be much more prolonged since fiscal and monetary policies will be forced to be restrictive.

Monetary policy will have to be tightened to fight surging inflation, while fiscal policy will foster a lengthy battle in the administration and in Congress between the economic necessity of austerity and its hugely unattractive political effects.

Reversing such extreme fiscal and monetary policies will be exceptionally painful, and the second leg of the recession will thus be exceptionally damaging to U.S. corporate profits and to U.S. stock prices. The stock market is likely to take out its November lows by a considerable margin, although at its nadir it will offer patient investors an exceptional long-term bargain – just as it did in 1932, 1949 and 1982, with high real long-term returns for those bold enough to invest.

Currently, the balance of probabilities favors a rising market in the short term – perhaps even rising quite sharply because of the exceptional strength of the current monetary and fiscal stimulus. Gold and gold-mining shares should do particularly well.

Let's enjoy this projected short-term bull run while it lasts!

[Editor's Note: As this market analysis underscores, the ongoing global financial crisis has changed the investment game forever. Uncertainty is now the norm and that new reality alone has created a whole set of new rules that will help determine who profits and who loses. Investors who ignore this "New Reality" will struggle, and will find their financial forays to be frustrating and unrewarding. But investors who embrace this change will not only survive – they will thrive. The "Geiger Index," a new service featuring Money Morning Investment Director Keith Fitz-Gerald, has already isolated the new rules that govern this new reality, and has also unlocked the key to what Fitz-Gerald likes to refer to as "The Golden Age of Wealth Creation." The Geiger Index system allows Fitz-Gerald to predict the price movements of broad indexes, or of individual stocks, with a high degree of certainty. And it's particularly well suited to the volatile, uncertain market that we're all facing right now. Check out our latest report on these new rules, and on what investors must do to pursue profits and wealth in this new market environment.]

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  1. Gordon Foreman | January 9, 2009

    There is a natural rhythm and cycle to markets and life, and when we try to force them against their natural rhythms, bad things happen. In this case, I would liken the efforts of Obama, and Bush before him, to the old analogy of trying to make a baby in a month by getting nine women pregnant.

    I expect that the undesired consequences are going to far outweigh the desired ones, assuming the desired consequences ever show up at all.

  2. Carlos E. Comesana | January 9, 2009

    1,19 Billion ??!!!! is 1,19 Trillion!!!! This article lacks a good review before publication.

  3. curt young | January 9, 2009

    A big deal was made in Congress of the 700 billion TARP funds. Yet 3 wks ago the Fed. says "we are going to buy 500 billion of junk from FANNY and FREDDY". This is not the only program they dump in billions not in the TARP. Where do these funds come from?

  4. Gary Wardell | January 11, 2009

    How can consumer price inflation set in? Are home prices expected to rebound? Auto sales are still in decline. Not much chance of inflated prices. Retail sales are slow.
    Oil is $30 to $50 instead of $150.
    Are we looking for inflation in Food and health care?

  5. Gregory K. Soderberg | February 26, 2009

    When all new money is created and placed into circulation as a loan, there is no way to pay the debt. There is nothing to pay the debt with except more debt. The debt must constantly grow. Clearly, if we were paying the debt it would not constantly grow. The 'Hit' of growing the money supply as loans comes when the interest starts coming due.

    The unpayable, compounding Interest is what causes price pressure or inflation.

    The only solution is to once again create and spend all new money into circulation debt-free as a payment for production that benefits the public. Money supply increases with productivity gains. No Inflation. No new debt. No New taxes. Tax cuts, cash flow. Something to make final payment with.

    Of course, before we could implement this principle again, we would have to get honest with ourselves and each other and admit that our current mature and unsustainable, debt-monetary system is corrupt, fraudulent and destructive.

  6. David Brown | March 24, 2009

    Why dothese articles never seem to have a date whenthey are written/pbulished?

Trackbacks

  1. […] The "steeply sloping yield curve" is bond-market jargon for a situation where long-term bond rates are far above short-term money market rates. In this case, the Fed has forced money market rates down to nearly zero, but has had much less effect on long-term bond rates, which have shown a tendency to rise, both because of the escalating budget deficit and because of the possibility of recurrent inflation arising from the Fed's rapid expansion of the money sup…. […]

  2. […] control. Refinance your house before interest rates begin rising dramatically to cope with the almost-certain after-effects of current stimulus spending. And by all means make sure that whatever debt you take on is debt you can afford to pay […]

  3. […] February retail sales – excluding automobiles – were up 0.7%; January non-auto retail sales also being revised upwards to plus 1.6%. We may still have a few months of decline to go, but it seems increasingly likely that the U.S. economy will bottom out around the middle of the year – although the ongoing banking problems and huge budget deficits are virtually certain to prevent a rapid economic rebound. As we’ve said repeatedly, once the economy bottoms out, however, the additional infused capital is likely to serve as a seriou…. […]

  4. […] February retail sales – excluding automobiles – were up 0.7%; January non-auto retail sales also being revised upwards to plus 1.6%. We may still have a few months of decline to go, but it seems increasingly likely that the U.S. economy will bottom out around the middle of the year – although the ongoing banking problems and huge budget deficits are virtually certain to prevent a rapid economic rebound. As we’ve said repeatedly, once the economy bottoms out, however, the additional infused capital is likely to serve as a seriou…. […]

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