Michael Wilson assesses the economic problems facing Barack Obama as he exchanges the winds of Illinois for the hot air of Washington

By the time you read this, you’ll probably have heard just about all you ever want to hear about Barack Obama’s “Kennedy moment”. Just like in 1961, when John F Kennedy first arrived in the White House, the new Democrat incumbent has positioned himself at the centre of a wave of sheer political optimism that is bringing him cross-party support from all over the country.

Obama has responded to these hopes by appointing a cabinet of experts that includes people of all persuasions - Republicans, Democrats, friends and sometimes enemies, in his pursuit of a new beginning for America. Everybody wants to be a part of this success story - and that’s not surprising. America has a long history of joyously reinventing itself in times of trouble, and there is every chance that it can succeed again this time.

Singing the same hymn
Actually, the fact that so very many Americans want a new beginning in the first place is only partly due to the staggering ineptitude of his predecessor, George W Bush, who will surely go down as the most flawed president of the last 70 years. Having inherited a massive budget surplus from his predecessor Bill Clinton, Dubya had turned it into the biggest deficit in history by the time he left the White House.

Having promised a ‘humble foreign policy’ at his inauguration in 2001, he had led a team which had ridden roughshod over every international or diplomatic sensitivity in the book. Having launched an unpopular war against Iraq on bogus grounds, he had then fatally mishandled the Hurricane Katrina disaster in 2005 and had gone on to appoint hard-line senior judges and attorney generals from among his close associates who did not always prove themselves up to the job. By the end, Dubya was scoring the lowest approval ratings in US history.

Blind faith
But right now, the reason America loves the idea of Barack Obama is that it simply can’t see a way out of the present financial crisis, and that it is trusting him to give the nation a sense of direction. The US economy is soundly into recessionary territory, with industrial production down 6 per cent and with a 1.3 per cent economic shrinkage forecast for 2009. Unemployment is nudging 7 per cent, which is the worst in 20 years, and the stock market had lost 35 per cent in the 12 and a half months to mid-January. Mr Obama’s best hope is that, by generating public optimism during his early months, he can help America pull itself out of the mire by its bootstraps.

Fortunately America is good at this trick too. In the terrible economic crisis of the early 1980s, President Ronald Reagan’s indefatigable optimism went a long way toward attracting support from abroad, which soon transformed itself into a resurgence of inward investment. Of course, Reagan also deployed a raft of tax cuts - but then, that is exactly what President Obama is doing now. And the Obama optimists can also point to the established historical fact that stock markets generally seem to recover between nine and twelve months ahead of their underlying economies. With factors like these in play, they ask, how can it possibly go wrong?

Valuing weak markets
How indeed? Well, one thing we can certainly say right now is that US stocks are looking cheap if we compare their price/earnings ratios with those of a few years ago. In mid-January 2009, according to Thomson/Reuters, a typical US stock was changing hands for the equivalent of just 11 times its current annual earnings per share - not much more than half of what investors were happy to pay as recently as 2005. (British shares, by comparison, were trading on p/es of around 9.) Surely that makes them excellent value?

Well, maybe. But sceptics are entitled to object that the normal “trailing” price/earnings measures we have been seeing are tragically flawed, because they tend to rely on the assumption that this year’s corporate earnings will be similar to last year’s - something which is by no means certain while the economy is contracting.

If America’s profits were to fall by 40 per cent this year, heaven forbid, then today’s “forward p/e” would start to look more like 18, which is roughly normal for America. This, in turn, would seem to imply that US stocks aren’t quite the bargain they appear to be! Or, if you prefer, that the stock market is ‘discounting’ a probable 40 per cent fall in profits. That’s not so good.

The Bond Problem Won’t Go Away
Practically the only thing we can say for certain is that all the various bail-outs and rescues of the last six months are going to cost the government an awful lot of money, which will have to be raised either by issuing bonds or simply opening up the printing presses. The latter is more or less unthinkable, of course: but the former seems completely inevitable. And the more new debt the government issues in 2009 and 2010, the more it will weaken the dollar. That, in turn, is likely to worry foreign treasury bond investors, who face the very real prospect of losing heavily on their dollar investments, and who might - just might - decide to run away.

After all, let’s face it, the foreigners aren’t exactly getting much of a reward as the moment. A two year T-bond is yielding only a wafer-thin 0.8 per cent yield in dollar terms, and even a ten-year bond was delivering just 2.4 per cent (in mid-January). Even the slightest upward twitch of dollar inflation, or the slightest weakening of the dollar, would trash those returns in an instant. And that is not a possibility, it’s a certainty.

Backing the bailout
But before we worry about that, let us at least try to get a handle on the sums of money that the Fed might need to raise. Sadly, the news isn’t good: even the optimists are predicting a budget deficit of US$ 1.2 trillion in 2009, or a horrifying 8.5 per cent of America’s gross domestic product.

It is not just the generous $700 billion distributions to the banks, the insurance companies and the car manufacturers that the Obama budget will have to cover. And nor is it the $300 billion of stimulus tax cuts that new president has announced, or the probable $500 billion in additional costs that the current downturn will entail once the White House gets to grips with lower employment, lower tax revenues and the like.
There is also the little matter of last year’s $120 billion spring tax rebate, which put $600 into the pocket of every taxpayer but which wasn’t due to go onto the nation’s bill until 2009 arrived and Mr Bush was safely out of the Oval Office.

The decline of the dollar
All of this must inevitably mean more debt, and all that debt will inevitably translate into a weaker currency unless President Obama can repeat Ronald Reagan’s trick of applying America’s sheer international momentum to pull in the money it needs. Of course, in those days Mr Reagan didn’t have to compete with a European Union whose economy was almost as big as his own.

Nor did he have to placate China, which is currently sitting on enough dollars to pay off Obama’s entire budget deficit, should it choose to do that. (It might still choose to do something else instead….) So, with its international dominance badly diminished by the Bush years, the new President will need to bring more energy and more diplomacy to the table than his unimpressive predecessor.

Barack Obama comes to the Oval Office with the goodwill of the world ringing in his ears. This will buy him valuable time. But there’s not much doubt that he has also inherited a poisoned chalice, which will tax his abilities to the limit in the next two years or so. With a withdrawal from Iraq high on his agenda, and with further political pressures currently building up in Iran, in Israel, and probably in Russia and North Korea too, it is a good job that he has such charisma and such a sound grasp of diplomacy. He’s going to need every bit of it.