Reflection Series: Gross Domestic Product

"GOVERNMENT ECONOMIC REPORTS: THINGS YOU'VE
SUSPECTED BUT WERE AFRAID TO ASK!"

A Series Authored by Walter J. "John" Williams

"Gross Domestic Product"
(Part Five in a Series of Five)

October 6, 2004
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Overstated GDP growth has meant that the 1990 and 2001
recessions were much more severe than recognized, and that lesser
downturns in 1986 and 1995 were more or less missed entirely.

Introduction

The Gross Domestic Product (GDP) is one of the broader measures of economic activity and is the most widely followed business indicator reported by the U.S. government. Upward growth biases built into GDP modeling since the early 1980s, however, have rendered this important series nearly worthless as an indicator of economic activity. The analysis in this Installment will indicate that the recessions of 1990/1991 and 2001 were much longer and deeper than currently reported, and that lesser downturns in 1986 and 1995 were missed completely in the formal GDP reporting process. Furthermore, the current economic circumstance is suggestive of an early-1980s-style double-dip recession.

The distortions from bad GDP reporting have major impact within the financial system. For example, Alan Greenspan's heavy reliance on productivity gains to justify some of his policies is equally flawed, since the methods applied to GDP estimation influence the numerator in the productivity ratio. As with the CPI distortions discussed in Installment III, the Federal Reserve Chairman knows better.

With reported growth moving up and away from economic reality, the primary significance of GDP reporting now is as a political propaganda tool and as a cheerleading prop for Pollyannaish analysts on Wall Street.

Reporting Basics

The GDP is compiled and reported by the Bureau of Economic Analysis (BEA) of the Department of Commerce. Quarterly estimates are updated monthly, with the "advance" estimate published at the end of the first month following the close of a quarter. The first and second revisions are called the "preliminary" and "final" estimates. In turn the "final" estimate is revised in annual revisions (usually in July), and every five years or so a benchmark revision is published that revises all data back to 1929, the first year of formally estimated economic activity.[1]

The popularly followed number in each release is the seasonally adjusted, annualized quarterly growth rate of real (inflation-adjusted) GDP, where the current-dollar number is deflated by the BEA's estimates of appropriate price changes. It is important to keep in mind that the lower the inflation rate used in the deflation process, the higher will be the resulting inflation-adjusted GDP growth.

Due to a lack of good-quality hard data, the "advance" GDP report is little more than a guesstimate. The BEA comes up with three estimates of growth, a high, low, and most likely. The numbers then get re-massaged so that the reported growth rate is moved closer to whatever the economic consensus is expecting. There actually is a belief at the BEA that there is some value to economic consensus estimates.[2]

The estimation process does not improve much with the "preliminary" and "final" estimates. The BEA reports that 90% of ultimate revisions to the "final" estimate fall within a range of +3.1% to -2.6%. Where average growth has been about 3.5% over the years, that means that most reporting is not statistically significant. The upward bias shown in the revisions is due to what I call "Pollyanna Creep," where methodological changes regularly upgrade near-term economic growth patterns. These patterns will be explored shortly.

The GDP is a large component of the National Income and Product Accounts (NIPA), representing "the output of goods and services produced by labor and property in the United States."[3] The NIPA was the concept and development of the National Bureau of Economic Research, a private organization founded in 1920. The NBER work evolved into the BEA and the current NIPA accounting.

The NBER remains a consultant to the process and retains the position as official arbiter of U.S. recessions. At one time, the NBER did define a recession as two consecutive quarters of negative GNP/GDP growth that were not distorted by an event such as a truckers' strike.[4] The NBER used trends in indicators such as industrial production and payroll employment to time a recession's beginning and end, to the month. More recently, though, the NBER has abandoned the GDP as a recession indicator and has relied instead on those other economic series. My presumption is this change resulted from an unofficial recognition of the declining value of the GDP reports. In theory, the NBER is apolitical, although the timing of some of its recent calls on the ends of recession are suspect. Specifically, there is no such thing as a jobless recovery. If jobs are being lost, the economy still is in recession.

There Is a Problem in the Basic Structure

As part of the NIPA, the construct of the GDP is heavily reliant on economic theory for composition, unlike other data series such as retail sales or the trade deficit, which are relatively simple surveys that end up contributing to the GDP estimations.

The related Gross National Product (GNP) is the broadest U.S. economic measure and includes the GDP plus the balance of international flows of interest and dividend payments. For net debtor nations such as Guinea-Bissau and the United States, GDP usually will show the stronger growth than GNP, since the outflow of interest payments does not get charged against economic activity. For this reason, the United States switched its primary reporting from the GNP to the GDP in 1991. Put in perspective as of the "final" estimate of second-quarter 2004, annualized real GDP growth was 3.3%, down from 4.5% in the first quarter, while GNP growth for the same period was 1.9%, down from 3.9%.

I respect the intellect and creativity of those who have anchored their careers in academia. Frankly, though, most economic theories have little practical use in the real world. Concepts such as free trade being a boon to the world's economy [5], a weak currency helping turn a nation's trade deficit[6], or personal income including what the average homeowner would receive from himself in rental income if he charged himself to live in his own house, fall in to the "not in the real world" category.[7]

Varied academic theories, often with strong political biases, have been used to alter the GDP model over the years, resulting in Pollyanna Creep, where changes made to the series invariably have had the effect of upping near-term economic growth. Whether the change was to deflate GDP using "chain-weighted" instead of "fixed-weighted" inflation measures, to capitalize rather than expense computer software purchases, or to smooth away the economic impact of the September 11th terrorist attacks, upside growth biases have been built into reported GDP with increasing regularity since the mid-1980s.

The accompanying table shows the net impact of these changes over time. The GNP level for various years from 1929 through 1980 and GDP for 1980 and 1990 are shown in billions of current dollars. Once set, these GNP/GDP levels should not change. With redefinitions and methodological shifts, however, earlier periods have been restated so as to be on a consistent basis with the latest reporting. Accordingly, the GNP/GDP levels are shown as they were reported variously in 1950, 1984 and at present.[8]

What becomes evident when looking at these data is that the biggest reporting changes have taken place since 1984 and have accelerated coming forward in time. For example the 1980 GDP that had been reported as $2.708 trillion in 1992 had crept up by 2.9% to $2.786 trillion based on 2004 reporting. The 1990 GDP, however, had Pollyanna Creep of 5.3% over the same period.

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POLLYANNA CREEP

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                              Change in

                              Reporting

Year   1950    1984     2004   2004/1992

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   GNP (Billions of Current Dollars) 

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1929  103.8    103.4    104.4    +0.97%

1933   55.8     55.8     56.7    +1.61%

1940  101.4    100.0    101.7    +1.70%

1950  284.2    286.5    295.2    +3.04%

1960   --      506.5    529.5    +4.54%

1970   --      992.7   1044.9    +5.26%

1980   --     2631.7   2823.7    +7.30%

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   GDP (Billions of Current Dollars)

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                              Change in

          As Reported         Reporting

            in 1992    2004   2004/1992

----------------------------------------

1980          2708.0   2785.5    +2.86%

1990          5513.8   5803.1    +5.25%

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Double-Entry Bookkeeping

The NIPA effectively is a double-entry bookkeeping system, where an item on the consumption side of the ledger, in the GNP/GDP accounts, is offset on the income side of the ledger, in Gross Domestic Income (GDI) accounts. In theory, the GNP and the GDI should be identical. In practice they rarely are, with the latest "statistical discrepancy" showing GNP to be $67 billion, or 0.6% higher than the GDI. This is due to the BEA's inability to reconcile the two series.

Part of the problem is that source data often are estimated without regard to actual numbers otherwise available. As an example of how far from reality the GNP/GDP/GDI reporting has gone, consider data from a high quality and unbiased resource: the Internal Revenue Service (IRS).

Based on its analysis of income tax returns, the IRS reports that, "For the second consecutive year, Adjusted Gross Income (AGI) fell, decreasing by 2.3% to $6.0 trillion for 2002. This represents the first time since prior to 1950 that total AGI reported on individual tax returns has fallen for two successive years."[9]

While one might expect to see some parallel income reporting in the GDI, it only happens by coincidence. Although the BEA considers the IRS data, it never has been able to reconcile the differences between GDI assumptions and IRS reality. Of course, the BEA sticks with the GDI assumptions, which have income rising in 2001 and 2002. The following table shows some of the specifics of comparable income components. Where wages and salaries are the single largest component in the GDI, they grew by 6.8% in 2002, according to the BEA, but the IRS reports a 0.4% contraction.

-----------------------------------

INCOME GROWTH 2002/2001

-- IRS VERSUS BEA

(Not Adjusted for Inflation)

-----------------------------------

Income Category       IRS      GDI

-----------------------------------

Wages & Salaries     -0.4%    +6.8%

Interest Income     -20.9%    -6.4%

Dividend Income     -14.9%    +5.1%

-----------------------------------

Part of the difference is in imputations, which gets back into the theoretical structure of the NIPA. Any benefit one receives, either living in one's own house, or receiving free checking from a bank has an imputed income component. Free checking, for example, is calculated as imputed interest income. Not only did imputed interest income account for 21% of all personal interest income in 2002, but also it grew at an annual rate of 8.3%! As an aside, renting the house you own from yourself gets imputed as 62% of total rental income.

Another issue is distortion in underlying series. The bias factors (now reported as net business birth/death modeling) inflate reported payroll employment, as discussed in this series' first installment. GDI estimates of wages and salaries are calculated off the payroll numbers and are inflated on a parallel basis.

Deflation Wonders

As emphasized earlier, the lower the inflation rate that is used to deflate the GDP, the higher will be the resulting inflation-adjusted growth.

One of the deflation stars is the computer. While computer prices have come down over time, the quadrupling and re-quadrupling of memories provided with a standard computer have, through hedonics and quality adjustments (see Installment III on the CPI), enhanced the decline in prices used in deflating computer consumption in the GDP. According BEA deflators, $1,000 computers bought in 1990, 1995 and 2000 would cost $48.63, $95.84 and $526.58, respectively, today. I bought computers in each of those time frames and could not replicate any one of them for the suggested proportionate price in deflated dollars, regardless of free memory enhancement.

One of the more significant changes to GDP inflation was made in 1996, when the deflator was shifted from fixed-weighted to a chain-weighted basis. The chain-weighted basis weights inflation for a two-year grouping of a related GDP component, rather than using the weighting of the benchmark year. One happy side effect of this change is that the components of inflation-adjusted GDP do not add up to the total, with the difference being allocated to the residual category. As of the "final" second-quarter 2004 real GDP, the residual was a negative $35.6 billion, or 0.33% of total GDP. The residual usually gets worse the more removed it is from the benchmark year, which is 2000 at present. As of the fourth-quarter 1990, for example, the residual is 13.4% of GDP. Before 1990, the BEA does not publish the detailed breakout of accounts, because of the large residual. For some reason, this bothers a number of well-reputed economists.

A Tempting Target for Manipulation

In the introduction to this series on government reporting, I mentioned political manipulation of the GNP/GDP in the Johnson and first Bush administrations that went beyond overly positive methodological changes. In both instances, my sources were consulting clients who had been involved directly in the process. In the latter instance, an individual at the BEA also confirmed the situation.

Few people argue with the GNP/GDP reports, so when Lyndon Johnson kept sending the initial GNP estimates back to the Commerce Department for correction, he eventually got what he wanted, and the media dutifully reported stronger than actual economic growth.

Near the end of the first Bush administration, an outside-the-system manipulation was worked. A senior member of the Executive Branch approached a senior officer of a large computer company and requested that reporting of computer sales to the BEA be inflated. This was done specifically to help with the reelection effort. The request was granted, and thanks to the heavy leverage of computer deflation, reported GDP growth enjoyed an artificial spike.

There are suggestions of other direct manipulations over time, specifically involving the Clinton administration and the current Bush administration. Most recently, a bizarre annual revision to the GDP data eliminated the 2001 recession, at least as traditionally defined with two consecutive quarters of real GDP contractions.

Where little public attention is paid to the GDI, however, it is interesting to note that the revisions did not follow the same pattern on the inflation-adjusted income side of GDP. Pre-revision numbers showed quarterly real GDP contractions in third-quarter 2000 and the first- through third-quarter 2001. In the 2004 annual revisions, second-quarter 2001 GDP growth turned positive (from -0.6% to +1.2%), breaking up any consecutive quarterly GDP declines. The patterns were repeated in revisions of the GNP. Following the latest annual revisions, however, the GDI-same as GNP in theory-showed contractions in fourth-quarter 2000, second- through fourth-quarter 2001 and third-quarter 2002.

Estimating Economic Reality

Based on my analysis of the GDP/GNP revisions and redefinitions over time, over-deflation and economic reporting as published before later political corrections, reporting of real GDP growth at present is overstated by roughly three percent per year against a more realistic, pre-Pollyanna Creep period.

Where the period of bloated GDP reporting began after the severe double-dip recession of 1980 and 1981/1982, it includes the last two recessions that were severe enough to generate reported GDP contractions. Both the 1990/1991 and 2001 recessions were deeper and longer than currently estimated. The recession from July 1990 to March 1991 (timing per the NBER) really began in late-1989 and persisted into 1992, perhaps even 1993. Such was evident in the underlying data of the time. Due to the NBER's early call of the recession's end, however, the first "jobless recovery" was seen.

Similarly, the recession that was timed from March to November 2001, began in late-2000 and persisted into 2003. Again, because of an early call to the recession's end, a "jobless recovery" was seen.

There also were economic downturns in 1986 and 1995 that were evident to most companies dealing in real world economic activity at he time. Although the contractions showed up in a number of measures, they were not severe enough to turn bloated GDP growth negative.

As the economy once again appears to be faltering, or losing traction, risk is high of renewed or a double-dip recession, of which the 2001 downturn eventually will be counted as the first leg.

I have only touched upon some of the highlights in problems with GDP reporting. Unfortunately, though widely followed, the series is probably the least meaningful of the major economic statistics followed by investors and the financial media.
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Footnotes to Installment Four

[1]Full definitions and methodologies are available at the BEA's wbsite BEA.

[2]The information on the guesstimation process is based on my conversations with individuals at the BEA during the last 25 years. The economic consensus misses turning points in the economy about 100% of the time.

[3]BEA

[4]Though the NBER now denies such a definition was ever used, the NBER supplied me with this definition in a conversation back in the 1980s.

[5]Free trade theory assumes all involved nations are at full employment. When that is not the case the wealthiest and highest salaried countries end up with a declining standard of living and redistributing their wealth to the other free-trade participants, as is the current circumstance for the United States.

[6]While currency values can have relatively quick impact on trade in pure commodities, products with quality differentiation combined with the financial and marketing creativeness of importers and exporters often bypass standard theory.

[7]This is an actual component of the income side of the GDP.

[8]BEA, various historical editions of the Statistical Abstract of the United States, Department of Commerce.

[9]Individual Income Tax Returns, Preliminary Data, 2002, IRS website IRS.

IMF Global Financial Stability Report

Systemic risks have continued to subside as economic fundamentals have improved and substantial public support remains in place. Despite improvements, financial stability remains fragile in many advanced countries and some hard-hit emerging market countries. A top priority is to improve the health of these banking systems so as to ensure the credit channel is normalized. The transfer of financial risks to sovereign balance sheets and the higher public debt levels also add to financial stability risks and complicate the exit process. Capital inflows into some emerging market countries are beginning to raise concerns about asset price and exchange rate pressures. Policymakers in these countries may need to exit earlier from their supportive policies to contain financial stability risks. For all countries, the goal is to exit from the extraordinary public interventions to a global financial system that is safer, but retains the dynamism needed to support sustainable growth.

Financial markets have recovered strongly since their troughs, spurred on by improving economic fundamentals and sustained policy support (see the World Economic Outlook Update, January 2010). Risk appetite has returned, equity markets have improved, and capital markets have re-opened. As a result, prices across a wide range of assets have rebounded sharply off their historic lows, as the worst fears of investors about a collapse in economic and financial activity have not materialized.

These favorable developments have resulted in an overall reduction in systemic risks. Overall credit and market risks have fallen, reflecting a more favorable economic outlook and a reduction in macroeconomic risks, together with support from accommodative monetary and financial conditions. Emerging market risks have also fallen. Prevailing easier monetary and financial conditions, while helpful, also point to future challenges that will need to be managed carefully.

Even with overall improvement, however, the repair of the financial system is far from complete, and financial stability remains fragile. There are still pressing challenges from the crisis. At the same time, new risks are emerging as a result of the extraordinary support provided by the policy measures that have been implemented. Indeed, unprecedented policy support has come at the cost of a significant increase of risk to sovereign balance sheets and a consequent increase in sovereign debt burdens that raise risks for financial stability in the future. Simultaneously, some major emerging market economies already have rebounded strongly, raising initial concerns about upward pressure on both asset prices and exchange rates. As a result, the timing, sequencing, and execution of exits to a newly reformed financial system will require policymakers’ deft handling.

Banks and Credit

The first major challenge is to restore the health of the banking system and of credit provision more generally. For this it is necessary that the deleveraging process under way in the banking system remains orderly and does not require such large adjustments that they undermine the recovery. The process of absorbing the credit losses is still under way, supported by ongoing capital raising. Our estimates of expected writedowns will be updated in the April 2010 GFSR; the recovery in securities prices on banks’ balance sheets suggests the estimate would be somewhat lower than estimated previously if recalculated at the present time.

Looking forward, even though some bank capital has been raised, substantial additional capital may be needed to support the recovery of credit and sustain economic growth under expected new Basel capital adequacy standards, which appear to be converging to the markets’ norms that were the basis of the October 2009 GFSR’s calculations of remaining capital needs.

Credit losses arising from commercial real estate exposures are expected to increase substantially. The expected writedowns are concentrated in countries that experienced the largest run-ups in prices and subsequent corrections and are in line with our previous estimates.

Banks not only face the task of raising more capital, but also need to address potential funding shortfalls. As noted in the October 2009 GFSR, there is a wall of maturities looming ahead through 2011–13. This bunching of financing needs is a legacy of shortening maturities during the crisis. A future retrenchment in confidence therefore could severely weaken banks’ ability to roll over this debt.

A more imminent concern is the withdrawal of special central bank liquidity facilities and government guarantees for bank debt. While the use of both types of programs has fallen as money and funding markets have stabilized, some banks remain more dependent than others on such support. Unless the weaknesses in these banks are addressed in conjunction with the withdrawal of funding support measures, there is the risk of renewed bank distress and overall loss of confidence that could have systemic implications.

Bank credit growth has yet to recover in mature markets, despite the recent improvement in the economic outlook . Bank lending officer surveys show that lending conditions continue to tighten in the euro area and the United States, though the extent of tightening has moderated substantially. Although credit supply factors play a role, presently weak credit demand appears to be the main factor in constraining overall lending activity.

Bank credit growth is continuing to contract as the credit cycle turns. Even though the cycle trough is approaching, the prospects for a strong rebound are highly uncertain. Nonbank sources of credit such as corporate bond issuance have picked up strongly, but in many cases are not large enough to offset the decline in bank lending and have, for the most part, been used for refinancing outstanding debt. The improving economic outlook will bolster both the demand for credit and banks’ willingness to lend, but as banks continue to deal with capital and funding challenges, their capacity to lend may become a more binding constraint. Uncertainty about the future regulatory framework may also weigh on bank lending decisions.

A combination of continued bank writedowns, funding and capital pressures, and weak credit growth are expected to limit future bank profitability. This highlights the need for more decisive steps to promote bank restructuring in order to ensure that banks have sufficient margins to weather future shocks and to generate additional capital buffers.

Emerging Market Inflows

While bank flows to emerging markets have yet to recover, the rebound in portfolio inflows has supported a rally in emerging market assets, particularly equities, and to a lesser extent real estate. Concerns have been raised that these inflows can lead to asset price bubbles and put upward pressure on exchange rates. This can complicate the implementation of monetary and exchange rate policies, especially in those countries with less flexible exchange rate regimes.

These inflows are being driven by a variety of factors. The initial surge in inflows in the second quarter of last year appears to have been the result of push factors, that is, changes in the desires of investors. There was a sharp renewal in risk appetite that benefited all risky assets. Investors shifted from safe havens in search of yield, given low interest rates in advanced countries. This can be seen from the decline of the dollar and treasury bond prices, and outflows from money market funds. But since the second quarter, inflows have been sustained by pull factors, namely the better growth prospects for emerging markets, particularly in Asia and Latin America. Expectations of exchange rate appreciation in these regions also have encouraged new inflows.

The rise in asset prices cannot yet be considered excessive and widespread, although there are some countries and markets where pressures have increased significantly. Property price inflation is within historical norms, with a few localized exceptions.

Further, outside of China, credit growth in many emerging markets has yet to recover appreciably. This suggests that leverage is not yet a key driver of the rise in asset prices. That said, policymakers cannot afford to be complacent about inflows and asset inflation. As recoveries take hold, the liquidity generated by inflows could fuel an excessive expansion in credit and unsustainable asset price increases.

Sovereigns Under Pressure

Financial market participants are increasingly focusing on fiscal stability issues among advanced economies. Concerns over sustainability and political uncertainties have led to a widening of credit default swap spreads for the United Kingdom and Japan in recent weeks. Other European issuers, most notably Greece, have come under more pronounced pressure after their ratings were downgraded or as uncertainty has persisted over their fiscal imbalances and consolidation plans.

Our projections of the net supply of public sector debt show a substantial increase in issuance relative to the long-run average over the next two to three years. This increase in deficits and public debt imposes some important challenges for policymakers and risks for financial stability.

At a minimum, there is a risk that the public debt issuance in the coming years could crowd out private sector credit growth, gradually raising interest rates for private borrowers and putting a drag on the economic recovery. This could occur as private demand for credit recovers and as banks are still constrained in their ability to extend credit, particularly as financial support measures are being unwound. A more serious risk is from a rapid increase in interest rates on public debt. Such a rapid run-up in rates and a steepening of the yield curve could have negative effects on a wide variety of financial institutions and on the recovery as sovereign debt is repriced. Finally, there is the risk of a substantial loss in investor confidence in some sovereign issuers, with negative implications for economic growth and credit performance in the affected countries. While this may be a localized problem, there is the risk of wider spillovers to other countries and markets and a negative shock to confidence.

Policy Priorities

Policymakers now face a difficult balancing act in judging the timing, pace, and sequencing of exit policies, both from the monetary and financial policies, as well as starting implementation of a medium term strategy for fiscal consolidation and debt reduction. Withdrawing policy support prematurely would leaves the financial system vulnerable to a re-intensification of pressures (such as in countries with weak recoveries and remaining financial vulnerabilities), while belated withdrawal could potentially ignite inflationary pressures and sow the seeds for future crises (such as in countries with risks of financial excesses and overheating).

In the near term, policies should be focused on securing financial stability, which remains fragile, to ensure that the recovery is maintained and that there is no recurrence of the negative feedback between the real economy and the financial sector. In those economies where financial vulnerabilities persist, efforts should continue to clean up bank balance sheets, ensure smooth rollover of funding, and restructure weak banks.

In those emerging market countries that are recovering rapidly, the policy priorities remain to address capital inflows through macroeconomic policies, including through greater exchange rate flexibility, and prudential measures.

Over the medium term, policies should be aimed at entrenching financial stability, which will underpin strong, sustained and balanced global growth. Public sector risks will need to be reduced through credible fiscal consolidation, while risks emanating from private financial activities should be addressed by the adoption of a new regulatory framework.

The Financial System of the Future

Overall, the exit from the extraordinary support measures implemented in the crisis must be to a financial system that is safer as well as sufficiently dynamic and innovative to support sustainable growth. Achieving this correct balance between safety and dynamism will not be easy.

Several aspects of implementation require special attention. Policymakers should be mindful of the costs associated with uncertainty about future regulation, as this may hinder financial institutions’ plans regarding their business lines and credit provision. But they should also avoid the risks associated with too-rapid deployment of new regulations without proper overall impact studies. It also continues to be vitally important that differences in international implementation of the new regulatory framework are minimized to avoid an uneven playing field and regulatory arbitrage that could compromise financial stability.

For regulatory reform to be successful, micro- and macro-prudential regulations will have to complement one another and help to effectively mitigate systemic risks. Only then can the financial system properly do its job—to intermediate flows from savers to borrowers in ways that enhance sustainable economic growth and financial stability.

To view the Figures please follow the source at
Global Financial Stability Report. GFSR Market Update

PDF version (334 kb)

(IMF, January 26, 2010)

Joseph Stiglitz on US Economy Reaction to Obama's Recovery Program

Some people thought that Barack Obama's election would turn everything around for America. Because it has not, even after the passage of a huge stimulus bill, the presentation of a new program to deal with the underlying housing problem, and several plans to stabilise the financial system, some are even beginning to blame Obama and his team.

Obama, however, inherited an economy in free fall, and could not possibly have turned things around in the short time since his inauguration. President Bush seemed like a deer caught in the headlights – paralysed, unable to do almost anything – for months before he left office. It is a relief that the US finally has a president who can act, and what he has been doing will make a big difference.

Unfortunately, what he is doing is not enough. The stimulus package appears big – more than 2% of GDP per year – but one third of it goes to tax cuts. And, with Americans facing a debt overhang, rapidly increasing unemployment (and the worst unemployment compensation system among major industrial countries), and falling asset prices, they are likely to save much of the tax cut.

Almost half of the stimulus simply offsets the contractionary effect of cutbacks at the state level. America's 50 states must maintain balanced budgets. The total shortfalls were estimated at $150bn a few months ago; now the number must be much larger – indeed, California alone faces a shortfall of $40bn.

Household savings are finally beginning to rise, which is good for the long-run health of household finances, but disastrous for economic growth. Meanwhile, investment and exports are plummeting as well. America's automatic stabilisers – the progressivity of our tax systems, the strength of our welfare system – have been greatly weakened, but they will provide some stimulus, as the expected fiscal deficit soars to 10% of GDP.

In short, the stimulus will strengthen America's economy, but it is probably not enough to restore robust growth. This is bad news for the rest of the world, too, for a strong global recovery requires a strong American economy.

The real failings in the Obama recovery program, however, lie not in the stimulus package but in its efforts to revive financial markets. America's failures provide important lessons to countries around the world, which are or will be facing increasing problems with their banks:

• Delaying bank restructuring is costly, in terms of both the eventual bailout costs and the damage to the overall economy in the interim.

• Governments do not like to admit the full costs of the problem, so they give the banking system just enough to survive, but not enough to return it to health.

• Confidence is important, but it must rest on sound fundamentals. Policies must not be based on the fiction that good loans were made, and that the business acumen of financial market leaders and regulators will be validated once confidence is restored.

• Bankers can be expected to act in their self-interest on the basis of incentives. Perverse incentives fuelled excessive risk-taking, and banks that are near collapse but are too big to fail will engage in even more of it. Knowing that the government will pick up the pieces if necessary, they will postpone resolving mortgages and pay out billions in bonuses and dividends.

• Socialising losses while privatising gains is more worrisome than the consequences of nationalising banks. American taxpayers are getting an increasingly bad deal. In the first round of cash infusions, they got about $0.67 in assets for every dollar they gave (though the assets were almost surely overvalued, and quickly fell in value). But in the recent cash infusions, it is estimated that Americans are getting $0.25, or less, for every dollar. Bad terms mean a large national debt in the future. One reason we may be getting bad terms is that if we got fair value for our money, we would by now be the dominant shareholder in at least one of the major banks.

• Don't confuse saving bankers and shareholders with saving banks. America could have saved its banks, but let the shareholders go, for far less than it has spent.

• Trickle-down economics almost never works. Throwing money at banks hasn't helped homeowners: foreclosures continue to increase. Letting AIG fail might have hurt some systemically important institutions, but dealing with that would have been better than to gamble upwards of $150bn and hope that some of it might stick where it is important.

• Lack of transparency got the US financial system into this trouble. Lack of transparency will not get it out. The Obama administration is promising to pick up losses to persuade hedge funds and other private investors to buy out banks' bad assets. But this will not establish "market prices," as the administration claims. With the government bearing losses, these are distorted prices. Bank losses have already occurred, and their gains must now come at taxpayers' expense. Bringing in hedge funds as third parties will simply increase the cost.

• Better to be forward looking, focusing on reducing the risk of new loans and ensuring that funds create new lending capacity, than backward looking. Bygone are bygones. As a point of reference, $700bn provided to a new bank, leveraged 10 to 1, could have financed $7tn of new loans.

The era of believing that something can be created out of nothing should be over. Short-sighted responses by politicians – who hope to get by with a deal that is small enough to please taxpayers and large enough to please the banks – will only prolong the problem. An impasse is looming. More money will be needed, but Americans are in no mood to provide it – certainly not on the terms that have been seen so far. The well of money may be running dry, and so, too, may be America's legendary optimism and hope.

From Guardian, March 8, 2009