Page last updated at 08:10 GMT, Tuesday, 20 January 2009

Obama's tough economic challenges

By Steve Schifferes
Economics reporter, BBC News

Sale at a store in New York
The US economic is set to continue to shrink in 2009

President-elect Barack Obama faces a number of challenges as he prepares to take office.

But none is more urgent than addressing the state of the US economy.

The economy has already been in a recession since the beginning of 2008, according to the non-partisan NBER - and that slowdown is expected to last at least another year, making it the longest recession since World War 2.

The rate of job loss is accelerating, with 2.6 million jobs lost in 2008 alone, and the unemployment rate has soared to more than 7%.

Some economists believe the real jobless rate, including discouraged workers and those working part-time, is closer to 14%.

The housing market is still in freefall after two years of declines, and the number of foreclosures, or repossessions, is at a record high.

The credit crunch has spread from the housing market to other sectors, with credit cards, car loans and commercial property lending all affected - as well as loans to businesses.

All this is likely to push the Federal government's budget deficit to over $1 trillion, the highest in history and more than double what it was during the last financial year.

Tackling the jobs crisis

President-elect Obama will take office with 11 million citizens out of work, and he has signalled that his highest priority will be job creation.

Expand Medicaid: $87bn
Help state governments: $79bn
Help school districts: $41bn
Higher unemployment benefits: $36bn
Rebuild roads: $30bn
Computerise medical records: $20bn
Green electricity grid: $11bn
source: House Appropriations Committee

This is the main aim of his $800bn economic stimulus plan, which he wants Congress to pass as a matter of urgency.

Mr Obama has said that he wants to invest in key infrastructure projects like roads and bridges, improved schools, and a better electricity grid.

"Let's not only provide a jump-start to the economy and immediately create or save three million jobs, but let's also put a down payment on some of the structural problems that we have in our economy," he said recently.

The House of Representatives has already proposed a version of the plan, costing $825bn, including $550bn in spending and $275bn in tax cuts.

But the House has also warned that more money might be needed.

"You have to look at this bill as not a salvation for the economy by any means," said Congressman David Obey, head of the appropriations committee.

However, there are tensions in Mr Obama's approach that have not yet been resolved.

One issue is how much to spend directly on job creation and infrastructure, as opposed to giving money to individuals and businesses through tax cuts to spend as they like.

Mr Obama promised a tax cut of $500 for individuals and $1000 for families during the election, and further tax cuts could gain vital bipartisan support.

Some economists argue that such spending has a bigger "multiplier" effect" on economic growth than direct government spending.

Jobseekers at a jobs fair in California. File photo
Unemployment is rising as the slowdown bites

Another tension is between long-term investments and construction projects, which will yield tangible returns, though not for several years, and more short-term intervention to save jobs, for example by giving grants to state governments that are laying off workers.

With the Senate also planning to produce its own version of the plan, the timetable for passing it has been slipping - with mid-February now seen as the earliest possible date.

Stabilising the financial system

The Obama administration will be saddled with half the burden of the $700bn emergency financial bail-out package that was passed by Congress in October.

People at Bank of America cash machines
Big US banking groups may need a bigger bail-out.

The first $350bn half has already been spent by the Bush administration, mainly by providing additional capital to the shaky banking system.

Even before taking office, Mr Obama was able to persuade Senate Democrats to release the further bail-out funds.

But the narrowness of the vote in the Senate (52-42) suggests that he will still face significant opposition, among both Republicans and "blue dog" conservative Democrats, to further government intervention in the financial sector.

A Congressional oversight body has already criticised the way the money was disbursed and the lack of controls over its use.

Congressional Democrats would like the next tranche of money to be used more widely to provide help to the victims of the credit crunch, including those facing mortgage default.

They would also like to impose tougher conditions on the banks that have accepted government bail-out funds.

Mr Obama has signalled his support in principle for such an approach.

But, with the banking system still weak, it is not yet clear whether the financial system as a whole has recovered sufficiently to resume lending, and how much will have to be reserved in case other financial institutions get into trouble.

Meanwhile, Mr Obama could face another minefield in his plans to strengthen regulation to prevent further crises.

Industry lobbyists, state regulators, and fractious Congressional committees could challenge his plans to find ways of protecting the public in the future - especially if it involved international agreement.

Helping the housing market

At the root of the problems in the financial sector is the decline in house prices, which are still falling at their fastest rate in recent history.

House for sale in Illinois
More than a million people have lost their homes in the US housing crisis

One of the key reasons for the decline is the still-growing number of foreclosures, and the glut of unsold, repossessed homes on the market.

As a result, the number of new homes built has tumbled by 75%, and almost a million jobs have been lost in the construction industry.

Mr Obama is being pressed to do more to provide direct aid to homeowners who are facing repossession, going beyond the Bush administration policy of voluntary renegotiation.

One idea would be to allow home owners to renegotiate smaller mortgages where their houses have lost value. But the key question relates to who should bear the loss - the banks who issued the mortgage, or the government.

In Congress, Democrats are pressing for the bankruptcy judges to be allowed to vary the terms of mortgages to help homeowners - which would push more of the costs to the financial sector - and have, perhaps surprisingly, won the backing of banking giant Citigroup.

Another long-term issue is how to restructure the mortgage market.

More than half of all mortgages are underwritten by the troubled mortgage giants Fannie Mae and Freddie Mac, which were effectively nationalised by the government during the crisis.

The Obama administration will have to decide what the long-term future of these agencies will be, and whether they should continue to be subsidised or return to the private sector.

Tackling the budget deficit

The biggest long-term problem facing the Obama administration may be the size of the Federal budget deficit.

The non-partisan Congressional Budget Office has estimated that the deficit in Mr Obama's first year in office will be $1.2 trillion, but some economists argue this could be too conservative.

Increased debt costs for government
Increased risk of inflation
Long-term pressure on dollar
Could lead to higher taxes and spending cuts later

Paul Ashworth of Capital Economics says that when you add in the cost of the stimulus package, and the additional bail-out funds, the deficit could well be over $2 trillion, or 14% of US GDP.

This is a huge sum, which amounts to two-thirds of total US government spending, and could push the share of total government debt sharply higher.

In the long run, the government also faces sharply higher costs for social security retirement payments and health care, as the "Baby Boomer" generation retires over the next decade.

And Mr Obama's ambitious plans to reform health care, extending coverage to those who are uninsured, and his green environmental initiatives could also be expensive.

The new health secretary, Tom Daschle, has already made it clear that any health care reform will have to find a way to control costs.

Mr Obama has made it clear that in the long-term, the budget deficit has to be tackled.

But will face a delicate balancing act - building political support for his economic rescue plan, while at the same time trying to build support for long-term changes in the budget.

And he will face conflict within his own party over these issue, with the "blue dog" Democrats fighting for tighter budgets in the future.

US Budget deficit

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