Shadow Government

The audacity of borrowing (Obama budget edition)

By Phil Levy

This week's budget sketch from the Obama administration has stirred lots of partisan debate: A liberal dream come true! A conservative nightmare! For all of its occasional tedium, one of the nice aspects of economics is that markets often let you keep score in real time. And markets seem to be sending an unambiguous signal that the U.S. economy is now headed in the wrong direction.

At the heart of the debate, President Obama believes that massive spending and borrowing will ultimately strengthen the country. He regards the new proposals in health care, education, and energy as investments. Critics counter that these massive programs will bankrupt the country.

A first temptation is to look to the stock market for a verdict, and the stock market did not seem pleased. It has shown a tendency to swoon with almost every landmark moment of this administration. But supporters of the administration have argued that the stock market is too focused on the short term, that it is driven by other factors, that the market is more of a moodring than a carefully reasoned verdict. 

Fortunately, there are other markets that give a cleaner reaction. In particular, one can look at the government bond market, which is now giving the Obama plan a decided thumbs-down. The interest rate on the 10-year U.S. Government Treasury note helps set borrowing rates for corporations and households. It is not the very short term rate that the Fed has pushed near zero. It covers the same time frame that the Obama administration has now picked for its budget outlook. Unlike the stock market, there are no questions of dividend cuts, consumer fads, new competition, or management failures to muddy the picture.

This clarity led to the classic James Carville quote from early in the Clinton administration: "I used to think if there was reincarnation, I wanted to comeback as the President or the Pope or a .400 baseball hitter, but now I want to come back as the bond market. You can intimidate everybody."

A bond investor need only consider a few particular risks. There is the risk of inflation, which cuts into the spending power of the dollars investors receive later on. For foreign investors, there is the risk of a falling dollar, since they will ultimately need to convert their bond returns back into their own currency. Then there is the risk of default. That has been an important consideration for shaky businesses and emerging market basket cases, but not for a country like the United States. Until now.

In November and December, as investors panicked worldwide and rushed to the safety of U.S. government bonds, the interest rate on 10-year government bonds plunged to near 2 percent. From a low on December 30, the rate has rocketed back up to over 3 percent today, reflecting a sharp drop in the value of bonds. This is not because the rest of the world has solved its problems.

An even clearer negative verdict on Obama's approach comes from the much-maligned market for credit default swaps. These swaps function like insurance contracts that pay off if a borrower fails to make good. That insurance gets more expensive when the likelihood of default increases. The idea of a U.S. government default has recently gone from "unthinkable" to close to 10 percent over the next five years. 

So what is scaring the bond traders? Perhaps they spent last weekend reading a timely report by the distinguished economists Alan Auerbach (UC-Berkeley) and Bill Gale (Brookings). The upshot is that the United States has serious long-term fiscal challenges, between the downturn, an aging population, and major entitlement programs. None of the options for getting out of the mess looked particularly palatable. And that was before the president spoke of an extra trillion dollars for health care.

Despite claims of a new realism, the administration's budget is loaded with optimism. It assumes the economy will have a quicker and more vigorous recovery than most private forecasters predict. It assumes that individuals won't change their behavior much to avoid new, higher tax rates. It assumes that sacred cows such as mortgage interest deductibility and agricultural subsidies are ready to be made into hamburgers. And even with all this optimism, the administration predicts red ink as far as the eye can see.

Meanwhile the administration is trying to pretend the crises in the financial and housing sectors will go away on their own. Although a storm is already raging, the administration is not setting much aside for a rainy day. The IMF recently predicted potential bank sector write-downs of $2.2 trillion globally, perhaps half of that in the United States. Nouriel Roubini (NYU) suggests $3.6 trillion. Any such loss would leave the administration with a choice: borrow even more to fill the holes, or watch tax revenue shrivel up as the financial sector crumbles and the economy asphyxiates. If they continue to borrow, at some point we will test the limits of the world's willingness to lend and call into question America's status as a financial safehaven. Higher interest rates will then make a bad situation worse.

I can't say for certain that this is what is scaring the bond market. But I know it's what's scaring me. 

Shadow Government

Obama crosses (then burns) the bridge Bush built in Iraq

By Peter Feaver

President Obama is walking across the bridge the Bush team built in Iraq. No, not this bridge. Or this bridge. This bridge. He then turned around and lit a match or two to that bridge. But providing things go well in Iraq, or providing that Obama has not burned down the bridge entirely, this may all work out to be as good an Iraq policy as can be expected from the current administration. 

Let me explain.

An early name to the surge strategy given by those of us who worked on it (including some of my colleagues on this blog) was the "bridge strategy." In 2005-2006, we were pursuing an Iraq strategy that gave pride of place to training up Iraqi Security Forces (ISF) and transitioning to Iraqi leadership, so that Iraqis could eventually win the fight ("stand up, stand down"). 

There were many premises behind this strategy, but among them were these: 1) insurgencies usually fail so long as the counter-insurgents can stay in the fight long enough; 2)"long enough meant maybe as long as a decade; 3) the American public would not stand for a U.S.-led counterinsurgency resourced at the level it was then being resourced for as long as a decade; 4) through political progress we could reduce the threat to a low-enough level; 5) through accelerated training of the Iraqis we could build up an Iraqi Security Force big-enough to ... 6) shift the relative roles so Iraqis were in the lead and the United States were in support.

If that strategy had not started to collapse over 2006, then the next phase of the strategy called for accelerated training and transition to greater Iraqi leadership in 2007. However, that strategy was failing over 2006, so the Bush Administration set out to figure out what to do in a no-holds-barred internal assessment called the Iraq Strategy Review.

We were working on that review when the Baker-Hamilton commission gave us its recommendation: accelerate the training and transition to greater Iraqi leadership. (There were other elements, of course, but most were largely irrelevant or secondary to the main "what to do in Iraq" issue.) This was an oddly timed recommendation because the Baker-Hamilton Commission stated, 1) our strategy was failing, and 2) the right thing to do was to continue to implement the next phase of that strategy (though, to be sure, they certainly called it something else).

What became the president's view, and thus the dominant view of the inside team was this: we agree that we would like to implement Baker-Hamilton, but we can't do it right away. To do so would be to lose in Iraq. The security challenge of spiraling sectarian violence was too great and the ISF were too small. Handing it over to Iraqis would crack the ISF. Those forces were Humpty Dumpty -- once broken, neither they nor Iraq could ever be put together again.

What we needed was a bridge strategy, a way to get from here (December 2006) to there (the conditions under which it would be safe to accelerate train and transition). That was the surge (and all the other elements of it).

As we now know, the bridge or surge strategy was very unpopular, but it did change the situation in Iraq for the better. And it paved the way for an eventual shift back to the train and transition strategy. With his recent Iraq announcement, Obama has walked across that bridge.

Obama's Iraq speech on Friday does two things. First, with only minor modifications, his "new strategy" simply codifies the Bush plan and embraces the Status of Forces Agreement negotiated by Bush. So far so good. As Chris Brose has argued, the speech was somewhat graceless in the way that it ignored what Bush had accomplished in courageously deciding for the surge in the teeth of vicious political opposition. And it certainly was a missed opportunity for Obama to admit that he had been wrong about the surge. For a team that made so much political hay slamming Bush for never admitting he was wrong, the absence of any such grace notes was unfortunate.

Second, and more ominously, the speech attempts to set fire to the bridge by committing inflexibly to a timetable for implementing that strategy that may, or may not, prove reasonable. Put another way, President Obama has offered his own "read my lips pledge" when he says, "Let me say this as plainly as I can: by August 31, 2010, our combat mission in Iraq will end." He gives himself only the slightest amount of wiggle room when he further states: "And under the Status of Forces Agreement with the Iraqi government, I intend to remove all U.S. troops from Iraq by the end of 2011" (emphasis mine).

Here is the problem. What if the situation in Iraq requires a slightly longer timetable? What if the situation requires renegotiating the Status of Forces Agreement? What if Iraqis ask President Obama for some sort of longer-term strategic partnership that would further cement gains in that region, and do so at an acceptable cost? By that point, will the inflexibility and domestic political point-scoring of this speech have burned any such bridges behind President Obama? Will he be trapped, or will he have the freedom of maneuver he needs to do what is in the best interests of U.S. national security at that time?

President Bush the Father ended up regretting his "read my lips" pledge when he had to break it. I wonder whether President Obama will come to a similar awkward point. 

Those are questions for the next couple years. For now, it suffices to note that Obama strolled across the bridge designed by President Bush and built by General Petraeus, Ambassador Crocker, and all the brave men and women working for them. That is worth at least a cheer or two.