Steering Out of a Smash-Up No One Wants

U.S. President Barack Obama dramatically altered policy direction during his first State of the Union address by announcing plans to focus fully on creating jobs while doubling exports in five years.

This could put the United States on a collision course with China's export strategy. And a head-on crash, possibly centered on China's foreign exchange rate policy, might occur before America's mid-term elections in November.

No one wants confrontation, especially at such a critical time for global trade, the world's recovering economy and China's property market. But a changing political mood is steering Washington into Beijing's lane. China can respond by turning the wheel before it's too late.

The trigger for Obama's policy turnaround was the defeat of the Democratic Party in the Massachusetts election for a U.S. Senate seat left vacant when Ted Kennedy died. The Democrat tapped to succeed Kennedy was a well-known attorney general, and no serious Republic candidates had emerged until a little-known state senator, Scott Brown, accepted the GOP nomination. Brown won by a landslide.

Few doubt this was a protest vote against the Obama administration. Massachusetts voters apparently thought the country was on the wrong path and that Obama had ignored their top concern – employment – while being bogged down by an unpopular Wall Street bailout and poorly timed healthcare reform.

Why protest the bailout? In previous financial crises, big shots who contributed to bubbles went to jail; Americans expect heads on pikes after a financial crisis. Jailing even a few crooks is extremely important because it resets the system with a new psychology. For example, after the junk bond bubble burst in the 1980s, junk bond king Michael Milken and top executives at many bankrupt savings and loans went to jail. And after the IT bubble burst in 2000, jail terms were ordered for top guys at Enron, Tyco and even some Wall Street analysts.

The bubble that just burst was bigger than any in the past, yet none of the big shots went to jail. Instead, the president has dined with them and begged them to support his financial reforms. Americans see this as a farce. And if the Obama administration is unwilling to change, voters will choose someone else.

In addressing the financial crisis, Obama's team continued a Bush administration policy aimed at protecting the status quo. Obama didn't have to, but the government needed a financial system to protect the economy. It could have let the system go down before nationalizing it, leaving a clean sheet for a new system without the flaws that led to the bubble. Instead, the Obama administration created an enemy to its own financial reforms by bailing out the existing system wholesale. No one could expect the same people who benefited from the system's flaws to support abolishing them.

Since the bailout, the administration has focused its remaining energy on healthcare reform -- no doubt the biggest problem for the U.S. economy. Health costs account for 16 percent of GDP, twice as much as the OECD average, and they are growing twice as fast as the rest of the economy. The sector's excess costs are comparable to total profits for the U.S. corporate sector.
 
The truth is high costs have not brought a fair system; between 40 and 50 million Americans (or up to 16 percent of the population) have no healthcare insurance. This is the country's biggest social equality issue.

The Obama administration initially set out to address cost and coverage issues with its reform agenda. But as opposition to cost-cutting initiatives rose, the government compromised. Over time, it changed to concentrate solely on expanding coverage and spending more. Costs would be born by raising taxes on the middle class. The reform became bad for the middle class and good for a minority underclass, triggering social division as a lightning rod for middle class anger.

At the same time the biggest issue – rising unemployment – has been pushed to third place on Obama's priority list. He has been repeating Wall Street's mantra: Reviving Wall Street would revive the economy, which in turn would revive employment. And in just one year, Wall Street bounced from government bailout back to big bonuses. Yet the unemployment rate rose to 10 percent – even 17 percent if underemployment is included. Taxpayers whose money revived the Wall Street party are still looking for jobs. How could they not be angry? And so the Massachusetts election was an opportunity to vent.

Job One

Thus, Obama's new policy direction. Creating jobs is everything. Indeed, unless the administration can have a significant impact on employment soon, the Democrats could suffer a major defeat in November, even losing their majority in the House. That would be an unmitigated disaster for Obama. Facing a Republican majority in Congress, he would accomplish little. Thus, we expect Obama to make many employment-related policy decisions in coming months.

His first decision was to offer a US$ 5,000 tax credit and cap the benefit at US$ 500,000 per employer, for a total cost estimated at US$ 33 billion. That's a small amount for a US$ 15 trillion economy, and it won't be enough to change political fortunes for the Democrats. Obama needs bigger, more substantive action soon.

Obama's dilemma is that Washington's political structure won't allow substantive measures. The Senate voting system implies the opposition must support whatever the ruling party wants. As the opposition has no interest in helping the ruling party succeed, it's only willing to support what it champions. Hence, the ruling party must adopt the opposition's agenda to get anything done.

The Clinton administration passed a few measures the Republicans championed. The Bush administration did the same for the Democrats. This means, overall, nothing radical can be accomplished. When the economy is cruising along, this sort of Washington gridlock works well. But when the economy is in trouble, the system means offers no meaningful solutions.

When the government's hands are tied, the Federal Reserve gets called upon to shoulder the economic burden. But its only tool is the currency printing press. This is why the Fed usually leans toward loose monetary policy, giving the U.S. economy an inflation bias. For the past two decades, low commodity prices and global labor surplus kept inflation low, so the inflationary consequence of the Fed's bias failed to surface. Now, both factors have reversed, which means inflation is coming soon, constraining the Fed's ability. Odds are that the Fed would be forced to raise interest rates soon, and by 2012 the Fed funds rate could top 5 pecent, despite a sluggish U.S. economy.