The dangers of Obama's public-works juggernaut

Given the risks, it'd be wiser to let economic nature take its course.

President-elect Barack Obama has promised to jolt the American economy out of its depressionary spiral with the mother of all fiscal stimuli. While Mr. Obama seems to have little choice in this policy matter, his desperate gambit has a high probability of failure – and may make the recession worse. Don't believe the Washington chorus: We can't spend our way to economic recovery.

Though politically unpalatable, the wiser approach would be to let economic nature take its course. Such tough love, while painful, is the surest way to a healthy recovery in both jobs and asset prices.

Obama's choices are very limited, in part because US monetary policy is broken. The US economy has reached a critical recessionary point where any additional interest-rate cuts will do little to coax reluctant investors back into the game. Rates are already close to zero, so there's not much left to cut in any case. That leaves only fiscal policy.

Like any economy, America's gross domestic product (GDP) is driven by four elements: consumption, business investment, exports, and government spending. The first three elements are in free fall. That leaves the government as the "spender of last resort."

Obama is betting heavily that massive government spending will create millions of new jobs. Still, it must be asked: Why does Obama prefer a fiscal policy geared toward increased spending rather than the tax cuts he promised ad nauseam during his campaign?

The answer is painfully simple – and illustrates the Bush-crafted box Obama finds himself in. Beleaguered consumers would probably not spend any new tax cuts but rather pay off debts – or stuff them under the figurative mattress.

That's why Obama is taking a cue from Franklin Roosevelt and planning to invest massively in public-works projects, such as repairing the nation's crumbling roads and bridges, expanding broadband access, and creating "green" jobs.

Yet even this ambitious plan – a product of the Keynesian belief in government efforts to induce spending and investment – may not achieve its intended result.

First, and foremost, there is the matter of how Obama's mother of all budget deficits will be financed; there's talk of $700 billion in new spending over the next two years. There are only two politically feasible ways: sell bonds or print money (raising taxes is off the table.)

With bond financing, one of two things can happen – both bad. The first possibility is that China will accelerate what it has been doing for years – buy America's bonds to finance the US budget and trade deficits. The clear danger is that America will sink deeper into China's debt, thereby (further) mortgaging its future while exposing itself to political pressures over everything from trade policy to Taiwan.

A second possibility is that China, preoccupied with its own weakening economy, will not finance America's debt but use its reserves internally.

In this scenario, the US Treasury Department will be forced to sell US government bonds into a credit-constrained market. This will drive up interest rates and "crowd out" business investment. This is why fiscal policy often fails – any rise in less-productive government spending is more than offset by a fall in typically far more productive business investment.

The third possibility may be most dangerous of all – printing extra money. Mechanically, this involves the US Treasury issuing new bonds to finance the deficit. Rather than these bonds going to public market, the US Federal Reserve buys them – while printing enough new money to pay the bill. The increase in the money supply would almost certainly debase the US dollar and cause an inflationary spike that would prematurely choke off recovery.

The dangers do not end there.

There are also the well-known "size and timing" problems. It's very difficult to calculate exactly how much fiscal stimulus is needed – too little doesn't get the job done, too much ignites inflation. It also takes a lot longer for government spending to work its stimulative magic than monetary policy. This is because new infrastructure takes significant time to plan and build. Moreover, in the worst-case scenario, the full impacts of a fiscal stimulus come long after the economy has fully recovered and wind up overheating the economy, causing inflation problems.

In light of all these dangers, would it not be better to simply let economic nature take its course? Falling prices of real assets such as oil, food, homes, and cars would eventually rekindle demand. Falling prices of financial assets such as stocks and bonds would set the stage for a bull market recovery, with all its salutary effects on consumption and investment.

Has America gotten so soft and so fearful that its citizens run to the government during a recession? We must at least have this debate before setting out on such a perilous course.

Peter Navarro is a professor at the Paul Merage School of Business, University of California-Irvine, a CNBC contributor, and author of "The Coming China Wars."

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