Is US Treasury Secretary Hank Paulson becoming as bearish – in his recent speech assessing the financial excesses and the risks to the economy – as yours truly, Nouriel Roubini?

Felix Salmon argues that Paulson effectively is and that Paulson is now in the “2008 recession” camp:

Paulson's Most Bearish Speech Ever

This is I think one of the most bearish speeches by a sitting finance minister I have ever read; I certainly can't recall anything like it from any US Treasury Secretary.

In it, Hank Paulson seems to be channelling Nouriel Roubini. He covers all the points: "unsustainable price appreciation," an "inevitable" housing correction, an "unprecedented wave" of mortgage resets, "market failure"... and all that's just in two consecutive sentences!

And the speech barely lightens up from there. Paulson talks of "excesses" and "turmoil" and "major challenges"; he says that "the price adjustment is not yet complete" in the housing market, and then returns to his theme of "stress and volatility" in the capital markets more broadly, along with the associated "inevitable challenges".

Only at the very end does Paulson attempt a weak stab at bullishness, saying that although "we will likely have further indications of slower growth in the weeks and months ahead," he expects the US economy "to continue to grow".

If I were to take my trading tips from Paulson's speeches, however, this would be a clear indication to me to start going short, just about everything. On the strength of this speech, I reckon that Paulson has now joined Summers in expecting a recession in 2008.

Indeed, short of the final wishful thinking about the economy continuing to grow, the speech is dark and pessimistic. The reason may not be a surprise: the administration is realizing that the economy is headed towards a recession during an election year and that monetary stimulus by the Fed will be too little too late and easing constrained by the risks of inflation and the risks of a disorderly fall of the dollar. Thus, the administration is prepaing itself to propose a fiscal stimulus package. Indeed already a White House spokesman approvingly spoke of the Clinton Treasury Secretary (i.e Larry Summers) reccomending such a fiscal stimulus.

And indeed yesterday Summers wrote his Financial Times column reccomending such a temporary fiscal easing targeted towards lower and middle income households. The Summers proposal is most sensible but it will clash with an administration approach towards fiscal easing that is just the opposite of what Summers is proposing in spite of White House claims otherwise: the administration wants to make the 2001-2003 tax cuts – that were targeted towards the richests households – permanent. This is both inappropriate and ineffective fiscal stimulus and the opposite of what Summers is proposing: inappropriate as strapped middle-lower income households need a tax break/subsidy; ineffective as only a temporary – rather than a permanent budget-busting - tax cut targeted towards cash strapped households would be spent and lead to a demand stimulus.

Of course, more conservative commentators – such as Kudlow and a variety of supply-siders – are now pushing for a permanent capital income tax – or corporate tax – cut as the “most effective” tax policy; this is “voodoo economics” again and the chance that such a permanent income or capital/corporate income tax cut will be passed by a democratic Congress are zilch.

So the Paulson speech is the first step of the coming political battle in an election year on which type of fiscal stimulus the country needs to avoid a now unavoidable recession and of the coming blame games on who’s fault is if we get a recession (with now even Hillary Clinton talking about the risks of a recession in 2008).

While the Summers proposal is the most sensible in terms of the appropriate fiscal stimulus it will not prevent the coming unavoidable recesssion: it will only help to make it milder. The reason is that, with large structural fiscal deficits, a much larger fiscal stimulus is now not possible.

In 2000 the US was running a large fiscal surplus – about $300 billion or 2.5% of GDP; by 2004 – after two large and unsustainable tax cuts and massive defense and national security spending increase - that surplus had evaporated into a 3.5% of GDP deficit. And while the overall deficit shrank after 2004, on a cyclically adjusted basis the structural deficit is very large now. So, unlike 2001 the US cannot afford now a massive - 6% of GDP - fiscal stimulus like the 2001-2004 one. Even the Summers proposal adds up to less than 1% of GDP. That unsustainable and reckless fiscal and monetary (Fed Funds down from 6.5% to 1%) policy stimulus in 2001-2004 was sarcastically referred to as “best recovery that money can buy” by the sensible and brilliant Ken Rogoff (a “Republican” economist who was at the time the chief economist of the IMF).

So, by using all the monetary bullets (and leading to a housing bubble) and fiscal bullets (and causing a large structural fiscal deficit) in 2001-2004, we are now in a situation where the macro policy stimulus available to address the current 2008 recession (as the economy is effectively into a recession now) is much more limited than in 2001: monetary policy easing will occur but the Fed needs to worry about lingering inflation pressures, high oil/energy/commodity prices, the risks of a disorderly fall of the dollar and the risk that foreign investors will pull the plug on the financing of the huge current account deficit and lead to a disorderly adjustment of the US external deficit.

And fiscal policy is now constrained by a large structural fiscal deficit, looming long-run entitlement spending deficits, and the lack of a large fiscal surplus buffer like the one available in 2001. Worse, with home value plunging, at the state/local level revenues are plunging and fiscal deficits rising as property tax revenues are sharply shrinking. So the overall fiscal deficit for the public sector (including both the federal government and state/local governments) is sharply rising, further constraining the room for active fiscal stimulus.

So Paulson is as bearish as yours truly as the President and the White House are becoming nervous enough about the current economic recession to call for a meeting of the inter-agency Working Group on Capital Markets (that includes the Fed, i.e. Bernanke) to figure out what the appropriate policy response to this financial and economic crisis will be. But an independent Fed has been behind the curve for a year now on its assessment of the housing, mortgage, financial crisis and its risks to the economy and in constrained in how much and how fast it can ease.

While the administration and the Treasury have taken a very hand-ons and government-intervention based – but ineffective – approach to the mortgage crisis by supporting initiatives that have either flopped (the Super-Siv plan) or are so narrow that will do little to stem the foreclosure crisis (the partial mortgage freeze plan) or that they imply the wholesale sale of large chunks of the US financial system to government-owned and non-transparent sovereign wealth funds in countries where government intervention in the economy is opaque and heavy-handed - China, petro-states in the Gulf, Singapore – (as in Paulson’s active support of the foreign governemnts’ recapitalization of the US financial system). All this from an administration that for years was extolling the merits of free markets capitalisms and the need for a laissez faire approach to the regulation and supervision of the financial system. That ideological zealotry in supporting a laissez faire approach to the financial system regulation and supervision was the first and foremost cause of the subprime and overall mortgage disaster.

And now that all the fiscal stimulus bullets have been spent – in the most reckless and unsustainable tax cut in US history – the administration is left with very limited room for a fiscal stimulus in bad times (as the hope that Congress will make unsustainable tax cuts permanent is delusional): you need to run surpluses in the fat years to be able to provide temporary fiscal stimulus in bad and lean recessionary years. While by passing permanent – rather than temporary - tax cuts during the last recession and thus avoiding a phase out of that fiscal stimulus once the economy recovered we are now stuck in a situation where the room for any meaningful fiscal stimulus – apart from a modest and temporary one like the one proposed by Summers – is gone. And while the modest Summers proposal is sound and sensible it will only reduce the length and the depth of the coming recession; like monetary policy - that is too litte too late and too constrained by other risks – such modest and now only affordable fiscal stimulus – will not prevent the 2008 recession.

We did indeed waste all our macro policy bullets in 2001-2004 in “the best recovery that money can buy” and we are now left with relatively limited room for monetary and fiscal policy stimulus. This is one of the main reasons why the 2008 recession will be more severe and protracted than the mild 2001 recession.

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