Economy will be the driving force

President-elect Barack Obama inherits a rapidly deteriorating economy that will likely dominate most of his first term, requiring massive federal spending to avoid a recession of historic scale and constraining his ability to carry out his domestic agenda, analysts said.

The extent of the economic problems was underscored yesterday as stocks plunged on recession worries. The Dow Jones industrial average fell 486 points to 9,139.27.

Obama will need to focus his first year on trying to keep an already deepening recession from getting worse, analysts said. In the next two years, he'll need to fix the financial system and extricate the government from its extraordinary intervention into the banking sector, they said. Moreover, Obama might have to scale back his spending and tax proposals to deal with budget deficits that could hit $1 trillion a year, according to economists.

Then, in his third year, 2011, the first baby boomers become eligible for Medicare, the government health insurance program for the elderly, and begin a demographic wave that could swamp all other federal spending.

"Recession, bailouts, healthcare, energy," said Allen Sinai, chief economist at Decision Economics, a Boston financial market advisory firm. "I've never seen so long a queue of economic, financial, and societal problems that have to be addressed."

In his victory speech, Obama acknowledged that "the challenges tomorrow will bring are the greatest of our lifetime."

"The road will be long. Our climb will be steep," he said. "We may not get there in one year or even one term but America - I have never been more hopeful that I am tonight that we will get there."

Sinai and other economists said Obama needs to address the recession almost immediately by working with the lame duck Congress and Bush administration to pass a stimulus package to pump as much as $300 billion into the economy through tax cuts, increased unemployment benefits, aid to states, and spending on roads, bridges, and public works. Waiting until January, when he takes office, would risk an even more severe recession.

"We need another stimulus package, and we need to do it in a way that is decisive, with a huge amount of resources," said Robert Murphy, a Boston College economics professor. "Sooner is definitely better than later."

In Washington yesterday, House Speaker Nancy Pelosi said she would push for a stimulus package in a lame duck session.

At this point, analysts said, a stimulus package would only lessen the severity of the recession, not prevent it. Many economists predict the economy will spiral downward until the middle of next year, and unemployment will continue to rise until the end of 2009, peaking as high as 8 percent. Unemployment was 6.1 percent in September.

Yesterday, the Institute for Supply Management, a professional group that conducts closely watched surveys of business conditions, reported the service sector contracted sharply in October, following the manufacturing industry into recession. Job losses, meanwhile, are accelerating. US employers cut nearly 160,000 jobs in September and many economists believe companies slashed another 250,000 jobs last month. The Labor Department reports October employment tomorrow.

The weak economy may also complicate Obama's tax plans, analysts said. In the short term, it could make it difficult for Obama to quickly fulfill a campaign promise to raise taxes on wealthy individuals and businesses. Raising taxes during a recession can further hurt the economy because it takes away money that otherwise might be spent on goods and services, according to economists.

In the longer term, the deficit could also make it difficult for Obama to deliver his promised middle-class tax cut, analysts said. President Clinton had to give up a tax cut after he took office in 1993 because of a weak economy and high deficits.

Obama will also immediately be required to help struggling homeowners avoid foreclosure, as well as implement the $700 billion government bailout that is intended to revive the faltering financial sector. The Bush administration is investing US tax dollars directly in banks and taking ownership stakes as a way to provide banks with sufficient capital to keep credit flowing for consumers and businesses.

Once the economy and credit markets stabilize, then Obama and Congress should attempt long-term fixes for the financial system, analysts said. That will require not only improving regulation of the industry here in the United States, but working with foreign regulators on oversight internationally.

But economists caution Obama to not overreach and impose too much regulation on the financial sector. Ultimately, they said, growth depends on a flexible economy in which capital flows freely and investors take risks needed to fuel innovation.

"The trick is to thread the needle," said Robert Litan, vice president of research and policy at the Kauffman Foundation of Kansas City, which studies and promotes entrepreneurship. "You need to fix the system, and keep it safe, but not make it so rigid that it deters risk taking."

Obama will likely be approaching the end of his term before he can turn his attention to long-term policies, such as improving education and investing in science, technology, and research and development, including alternative energy. By then, however, he may well have to turn his attention to cutting deficits, caused by the recession and government efforts to combat it.

That's likely to require a combination of tax increases and spending cuts, analysts said. With the first wave of baby boomers turning 62 this year, making them eligible to collect Social Security, Obama may be forced to address the exploding long-term costs of Social Security and Medicare, which political leaders have long put off. That, too, could require tax increases and spending cuts.

"I remember warning in the '90s that the very first baby boomers would retire in 2008," said Jeffrey Frankel, an economics professor at Harvard University's John F. Kennedy School of Government who served on Clinton's Council of Economic Advisers. "Now, here we are in 2008, and we still haven't done anything about it."

Robert Gavin can be reached at rgavin@globe.com.