The following paragraphs from Nouriel Roubini’s RGE Monitor provide an insightful look at the daunting economic and geo-political challenges facing President Obama.

Now that Barack Obama has taken the oath and become the 44th President of the United States, he faces great expectations at home and abroad to steer the U.S. and global economy out of the greatest post-war recession and financial crisis, to re-align the U.S. foreign policy stance and global standing on issues like financial sector regulation, climate change, trade talks and nuclear proliferation. He - and his team - enters with large amounts of political capital.

Obama’s public acknowledgment that the country’s economic woes will remain challenging in the near-term and will involve great adjustments, and his choice of a strong economic team are signs of optimism that the administration will be quick with policy measures. While the domestic economy (especially passing a fiscal stimulus package) will take most of his time in the short-term, the Israel-Gaza offensive indicates foreign policy concerns - especially in the Middle East and South Asia will also demand attention from the beginning of the Obama presidency.

Fiscal Stimulus
Significant growth contraction in Q4 2008 and Q1 2009 along with mounting job losses, declining asset incomes, corporate bankruptcies and tight credit conditions, mean Obama’s first priority will be to pass the fiscal stimulus package by February 2009. The payroll tax relief, extension of unemployment insurance and food stamps for low-income households included in the package will cushion vulnerable groups from the recession and boost consumer spending. However, these policies may do little to boost growth in the short-term. With only about US$100bn of around US$500bn in planned infrastructure spending expected to kick in within the first three months, the initiative may not be timely in spite of being potentially effective in boosting the economy during late 2009 and 2010.

While tax cuts will be timely, households facing financial pressure will save the proceeds rather than boost spending just as they did during Q2 2008, limiting effectiveness. Similarly, tax credits for businesses to hire workers and invest in new equipment will be ineffective in stimulating investment since firms forecasting a prolonged slump in domestic and export demand and high credit costs will cut capex plans.

However, given that state and local governments support greater spending and jobs than the federal government, grants for the recession- and budget-deficit hit states will be more effective in preventing cut backs in public services, infrastructure projects and jobs, and also partly offset declining tax revenues and slump in debt financing.

But given our estimated contraction in private demand of around US$700bn in just 2009 alone, the US$800bn-plus stimulus package distributed over two years (2009-10) might not be enough to offset the contraction in GDP in 2009. Also, the extent of job creation via the stimulus might be limited as infrastructure projects will, at best, absorb workers from real estate construction and low-end manufacturing while services and manufacturing in general will continue to witness hiring freezes due to low demand. Moreover, investment in infrastructure, renewable energy and R&D will simulate the economy and create jobs only in the medium to long run.

Hence, the prolonged slump and a very sluggish economic recovery might actually necessitate a second stimulus package. More importantly, unless the government addresses problems of bank capitalization and mortgage crisis, any fiscal stimulus will be ineffective in steering the economy out of this crisis.

Continued bank bailouts have signaled to the administration that further bank writedowns are imminent and the banking system as a whole might be insolvent. Capital injection on an ad-hoc basis, or even after banks write down bad debt to establish asset values, might only delay a broader solution for toxic assets while making inefficient use of the TARP funds. One possible solution would be the creation of a ‘bad bank’ that can buy toxic assets from banks to ease pressure on their balance sheets and help stimulate lending to the private sector.

An alternative might be to use the remaining TARP funds to extend government insurance to banks’ toxic assets. Obama’s economic team also has voiced concerns that the TARP funds have been inefficiently used by banks so far in order to absorb losses on their balance sheets, fund acquisitions and pay for compensation rather than fuel credit growth in the economy. The new administration will likely direct the remaining funds towards unclogging credit markets and renewing lending to households and firms by targeting consumers and municipalities - credit cards, mortgages, auto loans, students loans and muni bonds. Total loan losses are expected to hit US$1.6 trillion and additional negative feedbacks on MBSs and other ABSs are imminent, especially as the recession raises default by households and corporates.

Tight credit conditions and financial headwinds for households will continue to raise foreclosures and mortgage defaults. Increase in the excess home supply now poses the risk of over-correction in home prices thus leading to further bank losses and contraction in consumer spending.