Even Uncle Sam Can Make a Mistake

Now it's official. The United States is in a deep and difficult recession. Is Obama correct? Should we copy the American policy?

Now it's official. The United States is in a deep and difficult recession. This was decided by the National Bureau of Economic Research this week in Washington. In the past year, we have witnessed the weakening of the dollar, the bursting of the real estate and credit bubbles and a financial hurricane that brought down banks and froze economic activity. This is also the year we saw the U.S. administration and Federal Reserve launch prodigious plans to save the economy.

Some people in Israel have suggested that we learn from the United States and also channel unlimited amounts of money into our economy. Because if the most capitalist country in the world dares to so dramatically increase its involvement in the economy, to expand government spending and intervene so blatantly in the financial markets, it is incumbent upon us to do the same, and immediately.

And indeed, the Americans' plans are immense. At first they spoke of a plan to save banks and credit institutions with $700 billion. But now President-elect Barack Obama is speaking about an additional incentive package amounting to $500 billion, because he claims that renewing economic growth in the United States is more important than the worries about expanding the budget deficit.

Is Obama correct? Should we copy the American policy?

First we have to remember that we are talking about the great power that brought itself and the entire world into the worst crisis since the 1930s because of a consumer bash of no equal and a giant budget deficit during the Bush administration. But lo and behold, the decision makers in Washington are once again going along the same track. It is as if they have not learned a thing about the reasons for the crisis. The Federal Reserve has brought interest rates down to a historic low and is funneling hundreds of billions of dollars to the market, and the administration keeps on announcing emergency plans that are increasing expenditures and deficits.

But isn't it amazing - Wall Street is not responding as expected. Downward dives on the stock market are continuing, banks are not giving loans and the people are not running to go shopping. Companies are dismissing workers and are not prepared to invest. As Obama promises more expenditures and the central-bank governor promises more liquidity, the economy takes another step back and the recession deepens further.

This is because the United States is fighting its previous war. It is using old-fashioned tools. It has not even learned the lesson from the prolonged Japanese recession that started in the 1990s and has continued to this day.

The notion that you have to increase government spending and lower interest rates to encourage economic activity is based on the Keynesian model developed 75 years ago, a naive model suited to the closed world of those days of low international trade and negligible movement of capital. It is not suited to today's open world. In the Keynesian model, for example, no attention is paid to the size of the public debt. But when America's public debt reaches 80 percent of gross domestic product, as it does today, this changes the entire economic reality and has a strong influence on the public's behavior.

When the budget deficit reaches a record 7 percent of gross domestic product, the result is a higher national debt, which leads to a loss of faith in the government and even greater uncertainty. The American public understands that the budget deficit will result in a large balance-of-payments deficit, devaluation and inflation.

The people also understand that sooner or later the administration will be forced to carry out an "emergency plan" with widespread cuts and higher taxes. They are preparing for this in advance. They are already cutting down on consumption, not buying new cars or moving to new apartments. They are also continuing to sell their holdings on the stock exchange for fear that what comes next will be even worse.

That is, the more the U.S. administration tries to spur the economy by increasing the deficit and lowering interest rates, the more the public will reduce private consumption and investments, and banks will continue to refrain from giving loans. Aggregate demand will actually drop instead of increasing, and the recession will become more difficult and prolonged.

That is precisely what happened in Japan. The government brought down interest rates to zero in the 1990s and greatly increased spending, out of the same mistaken position based on the naive Keynesian model. But the Japanese lowered consumption and investments, sinking the economy into an even deeper recession, in addition to a massive debt, the largest of all Western countries - 180 percent of gross domestic product.

The governor of Japan's central bank, Masaaki Shirakawa, was asked in May about his government's policy in the 1990s. He responded that it had "a very limited effect on the economic freeze." Therefore, we must be wary today about copying the American model. Government spending must not be expanded carelessly. The debt must not be increased in the American style.

The United States can perhaps continue to carry out a mistaken economic policy. We must not follow in its footsteps. We cannot gamble. We must not copy the Americans' lack of responsibility.