Broken Beaker: November 2009

A paper I wrote for Economics about Obama, Keynesian economics, and the upcoming Green revolution.
Enjoy!

Macroeconomics : President Obama and Keynesian economics

Introduction

Barack Obama took office in January of 2009 and despite running on a campaign of hope and optimism, was already facing a mountain of economic problems. A mortgage crisis, a collapsing banking and auto industry, and increasing unemployment have plagued the Obama presidency, and have hugely influenced a lot of the decisions that the President has had to make regarding economic policy. Many Economists have argued that due to the sheer amount of economic problems that the administration has faced have led the Presidency to take a Keynesian stance towards the US economy¹. This Keynesian approach to the economy has divided not only political parties, but also the American public, and has led to a difficult start to the Obama presidency.

Background

When a candidate is running for presidency, one of the cornerstones of a presidential administration boils down to one key issue: the Economy. A president, and more broadly, the political party he is tied to, cannot make significant gains politically if there is high unemployment, high deficits, or both, and unfortunately, this has been the economic condition that Barack Obama has “inherited” from his political predecessors.

Usually the administration can choose to tackle economic problems in one of two ways; the administration can take a “hands off” approach to the economy (The Classical Approach) or it can choose to use a more Keynesian approach. Keynesians, unlike classical economists, don’t rely on the “Invisible Hand” of the free market to solve economical problems. Keynesians believe that the market is riddled with imperfections, and corrective actions need to be taken to solve problems in the short-run. Although the Obama presidency is still in its infancy, it is quite clear that the Obama White House has chosen a more Keynesian approach to the economy.

The Banking Crisis

One of the first Keynesian policies Obama enacted when entering the White House was continuing the Bush policy of investing US Tax payer dollars into US banks. Starting in 2008, nearly every U.S. bank began reporting that a lot of their mortgage-backed securities had lost a lot of value as the housing industry collapsed, and in essence, went “toxic”. This was followed quickly by the collapse of Lehman Brothers, which was feared would cause a “domino effect” in the banking industry, since all of the banks in the

United States

have such an inter-dependent relationship². To curb this banking industry collapse, the federal government decided that instead of letting the free market decide the outcome of this impending financial disaster, the government would instead bail out the banks using taxpayer funds. Although free markets, reflected in Classical economic theory, are the best way to organize market activity, this is not the case when a market collapse occurs. The Federal Government feared that if the banks in trouble did not receive capital, firms affected by the crisis would not only face bankruptcy because of a lack of liquidity, but would be unwilling to give out loans to individuals and industries that needed it. Many U.S. companies rely on easy access to loans, and if banks failed and the credit markets “Froze”, that would mean a decrease in the ability of a firm to produce, leading to a decrease in the nations PPF, a decrease in GDP, and shrinkage in aggregate demand. The government facing a potential crisis, under the guidance of Bush Treasury Secretary Hank Paulson and a policy continued under Obama’s Treasury Secretary Timothy Geither, decided that the Federal government needed to “invest” $700 Billion of taxpayer money (TARP funds) into several U.S. Banks, including Bank of America, Citibank, and Merrill Lynch³. Though this act might have prevented a worldwide credit catastrophe, and helped keep the “Circular-Flow” (Figure 1) of the economy going during its darkest time, some economists argue that banks which accepted TARP money were, effectively, nationalized⁴.

Why is distribution of TARP funds considered a Keynesian economic policy? A classical economist would have refused to get involved in the crisis, and let the “invisible hand” of the free market run its course. However, with so much at risk, and facing a potential credit crisis that could lead to an economic meltdown, the Obama Administration chose to take a more Keynesian approach by lending TARP money to banks at risk, insuring that the “Circular flow” of the economy would not be disrupted.

Federal Interest Rates

The Obama Presidency, under the leadership of Ben Bernake, has also tried to increase aggregate demand for goods by lowering the Federal Reserve interest rate to historic loans since the financial crisis hit.

The Federal Reserve is the agency responsible for loaning out money to banks, and recently has aggressively brought down interest rates to historic lows in a very short time. In mid 2008, the Federal Reserve interest rates were around 4.5%, whereas now they are as low as 0% (see Figure 2). The Federal Reserve is hoping that if it can loan money to banks at a very low interest rate, banks who receive Federal Reserve money will be willing to lend firms and individuals loans at lower rates.

From a Keynesian point of view, this is a great benefit to the economy. Why? This decrease in Federal Interest rates would help boost aggregate demand in the economy; firms, now with access to cheap capital, could hire more employees, build more factories, and increase output of goods. Hopefully, this increase of hiring and output would result in an increase in household income which would feed back into the “circular flow” of the economy, encouraging spending, and hopefully, lead to a cycle of economic growth.

If the Obama Administration and Federal Chairman Ben Bernake did not take an aggressive stance towards cutting Federal Reserve Interest rates, it could have led to a longer credit crisis. With a higher interest rate, Banks, even with TARP funds, would have been hesitant to lend money to individuals and firms.

“Green Industry”

The American Recovery and Reinvestment act⁵ was another attempt by the Obama administration to spur economic growth through reinvestment of US funds into industries that are expected to grow in the future. These industries are mostly focused on energy infrastructure and renewable energy. A classical economist would not dare interfere with the free market, however the Obama administration feels that this is a necessary step to not only increase “green” production output of energy in the United States, but also decreasing potential frictional unemployment by subsidizing job-training related to renewable energy . Essentially, the government is acting as a large household in the “Circular Flow” of the economy so that it can purchase a massive amount of goods and services, in this case, renewable energy. The government is also investing heavily into its most vital source, labor, by spending over 600$ million dollars to train a “Green” workforce. Investment in labor is one of the best ways that a society can increase its PPF model and also, with time, it’s GDP.

Conclusion

The fact that America faced such a huge financial crisis in such a short time pushed the Obama Administration to choose a more Keynesian economic policy to alleviate the escalating economic problems faced by the U.S. Keynesian policies, although they interfere with the free market, are necessary to correct market imperfections, especially in the short run. However, after writing this essay I am faced with an interesting question; if this mortgage crisis was tackled from a “free market” policy, would the US have been able to recover from this financial crisis? If the Obama administration would have taken a “Classical approach”, would the U.S. be stuck in an economical Catch-22, where banks would be unwilling to lend money because of a lack of available capital to the point that, eventually, the “Circular Economic Flow” would collapse? Also, does the recent bank bailout, coupled with soaring national debt and a reliance on consumer credit for economic growth mean that the Federal Government can no longer take a classical economical view because, in essence, the Federal Government is now a major investor in U.S. Banking firms? Is Classical Economic policy, from a federal standpoint, dead?

References

Main Article

1. National Public Radio – Obama gives Keynes his first Real-World Test

January 29^th, 2009

http://www.npr.org/templates/story/story.php?storyId=100018973

Supplementary Articles

2. Frontline PBS – Breaking the Bank

June 16^th, 2009

www.pbs.org/wgbh/pages/frontline/breakingthebank

3. CNN Money, Bank Bailout: Change is coming

January 18^th, 2009

http://money.cnn.com/2009/01/18/news/economy/bank_rescue/index.htm