How much trouble are we in?

All the real economy indicators are currently headed in the right direction toward a reasonably strong recovery, as I've noted in previous posts. The patterns in the data, that is to say historical precedent, suggest that we are on the verge of a meaningful recovery in employment, and so I have taken an optimistic view of the economy in 2010.

But I didn't count on the bizarre political events of the last week. The Democrats lose the Massachusetts Senate seat, so health care seems to be a lost cause, so Obama switches gears to attacking the banks while Democratic senators threaten not to reappoint Bernanke to the Fed, so financial markets get spooked and stock markets plummet. Further turmoil in financial markets could undue much of the good that has been accomplished in the last year.

What good? Well, in November 2008 the yield on Baa corporate bonds was 9.2 percent. Thanks to the heroic efforts of the Fed and Treasury - the provision of massive amounts of liquidity, restoration of confidence in the banking system - the rate is 6.3 percent today. This is about where the Baa rate was at the end of 2004, when the economy started to finally grow at a healthy pace. Using the rule of thumb that a one percentage point drop in the federal funds rate causes about a quarter percent drop in long-term bond rates, the 300 basis point drop in the Baa yield through extraordinary policies is the equivalent of a 1200 basis point cut in the federal funds rate. That's a lot of stimulus, and it's the main reason (ARRA being important but secondary) the economy is recovery.

But this latest sequence of events - yikes. The Obama Administration needs to right the ship and restore order and confidence fast, or the recovery could be scuttled. Four things: (1) Pass the Senate health reform bill through the House, pass some fixes through reconciliation, but get the stink of this whole issue behind you. (2) Go down to the Senate and tell them they must confirm Bernanke now. There's no upside to replacing him, and a huge downside to just the uncertainty of the reappointment. (3) We need financial reform with teeth, and I'm glad to see the Administration is finally listening to Paul Volcker. But Obama has to convince the financial sector that he's not going to go all Huey Long on them for the rest of 2010. (4) Get behind the House's jobs bill. States need relief, though I'm not wild about the tax credit for new jobs (seems there are too many ways that could be gamed). Some kind of stimulus for business investment would be a nice addition. The package doesn't have to be huge, but there should be something.

Please Barack, don't screw this up.