THERE IS A MAD POLITICAL BATTLE GOING ON OVER THE FIRST OBAMA BUDGET. Figuring out the impact of the Federal government budget (and then the general government budget too) is central to economic models and forecasting. The external account (trade and payments) weighs heavy too, and Keynesian models, as also implicit in National income Accounting standards, have long linked the two. With the credit crunch we are all at sea in determining how world trade and payments patterns will now change, and change dramatically they will (Japan has recorded its first trade deficits in living memory and China's trade surplus is down by 90%). But, while the current year ahead Government budget should be pretty much straightforward it is not at all. 
The Obama biudget is variously described as $3.6 or $3.9trillion spending. But, predicting revenue and actual deficit outcome is harder, especially when property taxes and other property income and corporate taxes and unemployment etc. are all currently volatile. The political centrists tend to show that revenue will remain flat and the deficit will relentlessly widen and this is all the fault of the Bush tax cuts. 
The decoupling of revenue and spending is not credible. The right of centre however go further. They are anxious to show that there is a take-off here that will go up like a rocket and create a deficit that alone will absorb over one third of National Income and cause all kinds of problems from bankrupting the country to undermining the credibility of the currency. Bush is credited with adding over $3.3tn to the national debt over two terms, the right-of-centre Heritage Foundation claims Obama over two terms would add $8.5tn to the national debt. The Republicans accept from surveys that 62% of voters oppose increased government spending, and by implication oppose deficit spending. 
They also argue that the Obama budget is not proper deficit spending and enjoin advisors to the administration in this e.g. Council of Economic Advisors Chairwoman, Christina Romer, wrote, “Countercyclical fiscal policy is not achieving its intended purpose” and economic advisor Jason Furman saying, “In the past, infrastructure projects that were initiated as the economy started to weaken did not involve substantial amounts of spending until after the economy had recovered”. 
And even Prof. Larry Summers who wrote, “Poorly provided fiscal stimulus can have worse side effects than the disease that is to be cured.… Fiscal stimulus, to be maximally effective, must be clearly and credibly temporary—with no significant adverse impact on the deficit for more than a year or so after implementation. Otherwise it risks being counter-productive by raising the spectre of enlarged future deficits pushing up longer-term interest rates and undermining confidence and longer-term growth prospects.” These are more code-speak signalling to show respect for recent past economic-policy orthodoxy, not empirical assessments, just the usual necessary conservative acknowledgement. In any case a general problem of consensus views is that the consensus of what economists predict has never been usefully accurate. There are reasons for this, but no excuses except one, which is that official data tends to be neither optimistic nor pessimistic enough and only picks up sudden highs and lows after 6 months when revising the data backwards. 
The counterpart to not seeing holes in the road is to project massive holes in the long run. There is a persistent fashion (first established by the Congressional Budget Office, CBO, in the mid-90s) to make unsustainable 50 year projections. Even in 2003, after a massive set of tax cuts, and in the midst of the Bush iraq war years, the centre right felt scandalized by Federal spending projections doubling as a ratio to GDP of nearly 40% by 2050. Such projections are just political tokenism and unrealistic. They also tend to talk of 'shares of' GDP, not 'ratios to' GDP, as if all of government spending is entirely a share of National Income i.e. based entirely on taking tax from taxpayers and any borrowing is ultimately a net cost to taxpayers (loading debt onto future taxpayers etc.) 
The Economic Stimulus Act of 2008 provided about $170bn in tax rebates to stimulate the economy. The CBO estimated this "would increase budget deficits (or reduce future surpluses) by $152bn in 2008 and by a net amount of $124bn over the 2008-2018 period." The American Recovery and Reinvestment Act of 2009 (passed by Congress on 13 Feb.'09) of c.$800bn of spending rises and tax cuts is estimated by the CBO of increasing the federal budget deficit by $185bn to end September (end of fiscal year '09), $399bn in '10, $134bn in '11 ($787bn over all of 2009-2019). Clearly, this is not a major fiscal impact in the short term. And, obviously, the $trillions of bailout financial interventions by government are not part of this budget. 
The Obama budget inherits a deficit spending, or fiscal gap, and adds to that. But budget authorisations do not reflect actual cash-flow impacts in the economy. Some fiscal impacts will be feeding theough from past years and current authorisation will not have material impacts until future years. Long-term data suggests that the 2008/09 recession is part of a long trough since the last recession in 2000. Serious professional economists agree with this and would say that the asset bubbles and rising debt level have followed from inability to recover to earlier growth paths because the Bush administration responded wrongly via tax-cuts, the so-called 'Jobless Recovery'. 
Political critiques aimed at the layman voters rarely consider circular multiplier effects or that money taken from some taxpayers is paid to other taxpayers (many of whom are the same people) or that a quarter of all federal revenue is obtained by taxing its own spending; they seek to politicise the budget at its face value. This is not realistic, just good politics. The US conservatives want a repeat of Bush tax cuts, not Keynesian increased spending. The same critique is transposed onto the financial bailout, deeming it Keynesian, 'throwing money at the problem' and some are calling for a Financial Services Commission to spend a year studying the problem and determining if regulation is a big part of the problem. Looking back we can see a series of problems over the past 10 years. But, it is also clear that looking at credit-market cycle-conditions gives us strong economic-cycle indcators. 
The US Federal Budget is not comparable to European Government budgets (which include more of general government budgeting). The government consumption aggregate of all rich countries is 19% ratio to GDP out of at least 30% general government budget ratio to GDP. In the US, the federal budget has a total ratio of 28% to GDP compared to European equivalents of 35-40%. US general government spending is also over 30% ratio to GDP. The full fiscal stance can only be gleaned by the general government budget level. Because of the size of the state and county tiers, there is a large differentiated distribution like the differention across European states. All this causes considerable problems for even the largest banks in forecasting the economic demand context and its impact on their balance sheets, as they are now required urgently to do. This is a new experience. It has been a long time since the last time a lot of banks failed in the S&L crisis. 
There have also been relatively short interuptions in the pattern of banks balance sheet changes in recent decades until now. 
The S&L crisis caused some investment and retail banks to be taken over while hundreds of savings & loans banks failed. The effect then was contained within the USA. This is not possible now, hence why we have a policy of securing banks and of working out the asset losses, but also the means for swapping these assets off-balance-sheet so as not to cripple lending growth (as is said to have occurred for a decade in Japan). The asset writedowns of the US as shown below are also echoed almost the same proportionately to GDP in Europe. 
BANKS AND ECONOMIC STRESS-TESTINGPrior to finding evidence, and continuing on regardless of any such evidence, that big banks are doing well in their underlying internal capital generation (net cashflow profits from traditional banking and investment banking - see my bankingeconomics.blogspot.com), some Senate and Congressional Legislators, and a constituency of millions (not least millions of bloggers) are calling for letting some big banks fail i.e. not less, but more, of what happened to Lehman Brothers! Are they totally mad or just totally mad-angry?
Two powerful Republicans on Monday called on President Obama to "let some big banks fail instead of propping them up with public money". Richard Shelby, the top Republican on the Senate banking committee, warned that the US would end up following the same path as Japan, which suffered a lost decade of economic growth by tackling its banking crisis too slowly, unless some big institutions were allowed to fail. "Close them down, get them out of business. If they're dead, they ought to be buried," Mr Shelby told ABC News. "We bury the small banks. We've got to bury some big ones and send a strong message to the market." Asked whether he was referring to Citigroup, Mr Shelby responded: "Well, whatever. Citi's always been a problem child." John McCain, senator from Arizona, who lost the presidential race to Barack Obama, said the administration had evaded the "hard decision . . . to let these banks fail". These comments coincide with a debate in the US whether Government should nationalise insolvent banks or allow the so-called "zombie" institutions to fail. The term 'zombie' has caught the popular mood. Hard to say though who are the real zombies in this debate? Some politicians repeat themselves, sticking to the same ideological line, like clockwork 'speak your weight' machines, regardless of what's going on in the economy at any one time. I guess like stopped clocks they will be right two times every 24 times.
The real problem is how to anticipate and compensate for or stop how banks cyclically respond to recession. We can see in the above graph how banks recoil in recessions by cutting loans relative to deposits by roughly 10%. Given the scale of lending in the economy having grown relative to GDP, a 10% loan reduction (partly write-offs, mainly zero new loans) would translate into 15% in ratio to GDP! That would profoundly deepen further what is already a deep eonomic trough! Deposits here include deposits by banks as well as by customers. We can see a rising trend to maximise retail assets (loans) ratio to the total of all deposits, using borrowed funds to finance corporate lending, and strive to make assets in wholesale markets more by self-financing i.e. offsettings within the markets, hence also the growth of derivatives. But, the unravelling of derivatives markets today may do less to free up bank capital than to add to accounting losses. 
The Democrats, the Obama Administrationa andn the large banks, and I would hope many others, maybe the 38% of the population who do support higher spending, all would want to avoid the same scale of deleraging of all debt as occurred after the 1929 crash, but has largely been avoided in subsequent recessions. Yet, it seems such deleveraging is what many voices on the centre-right are in fact calling for? 
Who to help, or not, among the banks, is depending on the Obama administration's 'stress tests' of 19 leading financial institutions. The banks and the government itself must be able to address questions such as those I've indicated above. Similar tests are being variously recommended for Europe's top 45 international banks. The stress-tests are to be so structured to answer an apparently simple question: can the banks balance sheets survive the economics of the next 1-2 years ahead without becoming technically insolvent, in a period of debt deflation.
The first problem is that short-range forecasting is not easy, however necessary. Some trends may appear stable, but it takes only small wobbles to make significant differences in profit and loss. Banks have to look at the big picture of the economy, the economic cycle, at the monetary conditions, the credit cycle, and how these impact banks nationally and markets globall, and then at the bank's own position within these contexts and the how balance sheet performance is thereby pushed and pulled and then also management driven. Many factors cannot be easily trend-line predicted, but some can, and it is credit market conditions alongside confidence factor indicators that give the surest cycle and recession predictions. Macroeconomists tend to look for insupportable balances, but it is innovation within banking fin ance that has many times broken those contraints. 
There is a lot in banking that is either only known for sure over longer periods thn a few quarters or which are specially and uniquely manufactured and managed at the time, not forecastable. The exercise requires designing, building, data-populating, testing, and running of several complex models that the bank do not corrently possess. The timescale to get this right is less than 6 months. One problem already stated above is that economists when viewed for consensus (taking averages of many forecast models, which weights the result toward conventional older models) never 'forecast' recessions until well after they have begun. The question is therefore can a consensus view do any better in forecasting recoveries? The Republican conservatives don't want the administration to rush in for fear of a Japanese 1990s result. But the Japan case shows the danger of waiting and holding back. 
Following the bursting property and construction bubbles at the end of the '1980s all Japanese banks became technically insolvent. The result was years of zero or negative corporate borrowing.The US administration team wants to avoid that mistake and to move forward rapidly and not spend a year in analysis. It wants the banks and US Treasury to produce comprehensive assessments in 6 months. Europe is trying to get its banks capital forecasts even quicker, within weeks.
The US Treasury team to oversee the stress-tests with FDIC has some staffing up problems too. The White House this week announced the President's nominations for 3 top Treasury jobs to fill key positions among 17 that have been vacant under Tim Geithner - Mr Krueger, Ms Wallace and Mr Cohen who have been serving as counsellors to Mr Geithner at Treasury. But, their appointments to full office-postholders are not certain. Cohen announced today he is withdrawing.
Alan Krueger, a Princeton University professor and former labour department chief economist, is proposed as assistant secretary for economic policy - a crucial position under Tim Geithner. Kim Wallace, a former congressional aide and ex-Lehman Brothers staffer, is picked for Assistant Secretary for Legislative Affairs, key to working with Congress on the financial and economic crises. But getting appointments confirmed is hard. Last week, Annette Nazareth, short-listed for deputy secretary of Treasury, a former senior staffer and commissioner with the SEC, withdrew after several interviews and vetting of her financial history. So too did Caroline Atkinson, a senior official at the IMF, who was expected to be head the Treasury's international division. Others have not been named yet because the administration is taking longer to vet candidates. Any already working as advisors (counsellors) are constrained in what they can do until formally approved as assistant secretaries (the third-rung in the administration) by the Senate. David Cohen, an ex-Clinton Treasury official and a law firm partner, was proposed for the job of tackling terrorist financing and then became the contender for the International post after Annette Nazareth withdrew. Reggie Cohen dropped his bid after an issue arose in the final stages of vetting. Not one of Geithner's 17 deputies has been confirmed. Without senior leadership, lower-level Treasury employees can't make decisions or represent the government in crucial conversations with banks and others. Obama has been blocked several times by the Senate (most spectacularly when Tom Daschle withdrew after minor tax evasion was spotted) from appointing key officials across his government, including at Treasury. Critics say this hampers the tackling of urgent issues. The second administration rung is in place, but not the third rung, and so senior heads are working round the clock. 
The Senate will grill candidates about their attitudes to the question of prudential care about tax-payers money. The tax-dollar is one of the biggest voter issues at any time in US political history. What legislators and the general public don't get is that tax-dollars and the federal budget have relatively little to do with how Treasury finances the banking sector bailouts. Government is stepping into the confidence void in banking and redirecting large assets and money flows through it, with everything part of a double-entry book-keeping i.e. whatever is paid out is backed by safely discounted assets that are interest and fee-income generating. Hank Paulson possibly made his biggest mistake with TARP by going to Congress for approval. He thereby convinced the legislators that this is their business to be political about. Legislators see only two kinds of money - tax-dollars (discretionery and non-discretionery taxing and spending) and soft-dollars (political-money, campaign contributions, lobby-money). There is a third kind, which is government activities in money-markets. Paulson let Congress think it should be involved in oversight and approval of whatever the federal government and treasury are doing with money market finance that is the main source of bank bailout funding. That maybe was a big mistake? It could be dangerous, or at least compelling drama, and something new if the government's off-budget balance sheet financial operations become as politicised as the federal budget's tax-dollars.
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