The US economy is in a funk
By Peter Morici
Troubles at United States banks are making mortgage, credit card and business loans scarcer and more expensive. Falling home prices, rising foreclosures and high gas prices have stalled home building and consumer spending. These problems are exacerbated by the long-festering trade deficits on oil and with Asia on consumer goods and cars that tap off demand for US-made goods and services.
How the George W Bush administration (and its successor) and the US Congress respond to these challenges will importantly determine how Americans emerge from the current malaise. With the right policies, the economy can grow at 3.5% to 4% a year, perhaps a bit more. Without meaningful reforms in banking and
changes in energy and trade policies, the United States is headed for substandard growth and a declining standard of living for many workers.
Since 2005, US imports have exceeded exports by more than US$700 billion or more than 5% of gross domestic product (GDP). To finance the trade gap, Americans sell bonds and other securities to foreigners, including the People’s Bank of China and other central banks.
Until recently, money center banks and securities dealers, such as Citigroup and Merrill Lynch, recycled foreign funds to US consumers. Consumers borrowed ever-larger sums to live beyond their means through exotic mortgages, questionable auto loans and lax credit-card rules.
In the housing market, mortgage companies were aided by real-estate appraisers, who juiced estimated home values, and Wall Street bankers, who transformed shaky loans into seemingly low-risk mortgage-backed bonds for sale to insurance companies, pension funds and foreign investors. The bond rating agencies turned a blind eye and blessed these transactions.
These schemes now exposed, banks can’t securitize mortgages into bonds and must finance mortgages through more expensive certificates of deposit. US homebuyers must put up larger down payments and pay higher interest rates and fees to get loans.
The result is predictable: housing prices are falling. Builders have a 10-month supply of unsold new homes, and new home construction is down more than 55% since April 2006.
Rising delinquencies and repossessions are making similar abuses apparent in credit card and auto loans. Lenders face difficulties selling bonds to finance new loans and are increasing monthly interest rates and tightening qualifications.
Consumers can’t run up debt as easily to boost spending and live beyond their means. Sales are falling at shopping malls and restaurants, and consumer demand for US-made goods is stagnating.
Similarly, banks are making fewer loans to businesses for worthwhile projects, and business spending on commercial buildings and new equipment and software is expected to stall in the second half of 2008 and 2009.
Thanks to this grand deleveraging, economic growth has averaged only 1% a year since the fourth quarter of 2007 and is expected to continue to limp along at that pace until the second half of 2009. It will take that long for the banks to clear out all their bad loans, for most of the expected 2 million-plus foreclosures and resales of homes to be completed, and households, generally, to restore their balance sheets through more conservative spending patterns.
Getting the economy going again will require getting the banks on a sound footing, so that mortgage money and other credit are available on reasonable terms. But if the United States is to grow at a decent, sustainable pace and avoid another credit crisis and deleveraging, it must reduce its trade deficit and reliance on foreign borrowing.
Simply, trade deficits of more than 5% of GDP require Americans to spend more than 105% of what they earn to maintain demand for domestically produced goods and services and sustain GDP growth and employment. Even if foreigners are willing to continue buying US bonds, financing American consumption at that level will require the banks and finance companies to write progressively more risky loans, as they did during the last economic expansion, until debts cannot be repaid.
Inevitably, that would end in another banking crisis and credit shortage, painful deleveraging, and period of slow growth similar to the current slog, or worse.
To accomplish healthy growth, the United States must slash its trade deficit, dramatically, over the next several years. Imported oil, cars from Japan and South Korea, and consumer goods from China account for nearly the entire US trade deficit. No permanent solution to the US quagmire is possible with addressing those issues.
Global oil supply has not kept up with demand in recent years, because several important exporters, including Venezuela, Russia, Nigeria and Mexico, have shunned the investment and know-how Western oil companies can offer to sustain their production.
In recent weeks, crude oil prices have receded, somewhat, but this is because the US, European and Japanese economies are slowing and speculators face more hurdles in financing positions, and not because the basic global supply imbalance has been redressed.
Higher oil prices may be here to stay, but the technologies to reduce US oil imports dramatically are at hand. Hybrids, plug-in electric and even hydrogen-powered vehicles are no longer fanciful proposals. Coal gasification is viable at $55 a barrel for oil, and more-efficient building designs, appliances and heating systems are all possible at affordable costs.
Economists assert that the market will provide, but they fail to reckon with the fact that most epic transformations in transportation technology – canals, turnpikes and national highways, railroads and airplanes – got boosts from the government to overcome the barriers created by habits and costs of switching. For example, the biggest problem getting into production and use of hydrogen cars will be the initial investment in fueling stations and quickly achieving a critical mass of vehicles on the road to sustain them.
Japan, Korea, India and China have promoted their domestic vehicle industry by limiting imports and exploiting the open US market, and now Japan, the most mature producer, boasts Toyota and Honda as the leaders in hybrids and greener vehicles.
The US should not turn to protectionism, but rather, it should use its large market to its advantage. It should require much higher mileage standards for automobiles and offer substantial product development assistance to US-based automakers and suppliers – that includes Toyota and Honda, as well as the Detroit Three, battery makers and other suppliers – to accelerate the build-out of high-mileage innovative cars.
The condition for assistance would be that beneficiaries do their research and development and first large production runs in the US, and share their patents at reasonable cost with one another. The huge US market would attract producers from around the world and rejuvenate the US auto supply chain.
Similarly, accelerating clean coal gasification, nuclear power and the hydrogen transformation, as well as mandating much more efficient buildings and home heating systems and appliances, would propagate exciting new technologies Americans could sell around the world.
Since January 2007, the dollar has fallen 12% against the euro, and a burst of commodity and manufactured exports have helped reduce the US non-oil trade deficit. However, as the dollar has weakened against the euro, China has stepped up its intervention in currency markets to keep its yuan inexpensive and exports growing. Factoring in higher oil prices too, the overall trade deficit is down only about $20 billion.
Although China has permitted the yuan to fall by 17% since July 2005, it has increased purchases of dollars with yuan to $640 billion annually in 2008, up from $462 billion in 2007. This provides a subsidy on exports and domestic import competing products equal to about 17% of China’s GDP, and pressures other Asian nations to pursue similar currency policies lest their industries lose competitiveness to Chinese manufacturers in vital US and European markets.
Moreover, by artificially accelerating Asian growth, this policy boosts Asian oil consumption and provides the hard currency to subsidize oil imports and domestic fuel prices, further exacerbating international oil shortages.
Cutting the US trade deficit with China and other Asian exporters requires that Washington find a way to persuade Beijing and other governments to end their currency market intervention.
Negotiations have not worked. The United States may have to resort to a tax on yuan-dollar transactions at a rate directly proportional to Chinese currency intervention to reduce imports in the near term. This would encourage China to stop intervening in currency markets and redirect investment toward more domestic consumption and investment in schools, hospitals and public infrastructure. Then the tax could be removed.
That may sound radical but redressing the trade deficit with China and other Asian exporters would also require major changes in American habits too.
As China and other foreign governments ended their purchases of dollars, US Treasury securities and private bonds, Americans would have to borrow less, save more and start living on what they earn. The US government would have to cut its budget deficit to near zero, and American households would have to save 5% to 10% of their disposable income, as opposed to the near zero levels accomplished during the recent economic expansion.
Getting through the current crisis requires unusual steps in credit markets. Federal efforts to route capable but currently distressed homeowners into sustainable mortgages and Federal Reserve to help the money center banks and securities firms will help avoid economic Armageddon. The same is true of Federal efforts to assist mortgage guarantors Fannie Mae and Freddie Mac.
However, achieving a sustainable economic expansion requires strong new disciplines, from loan officers on the ground to the executive suites at those New York banks. So far, federal credit market reforms have been focused on mortgage brokers and small lenders, rather than the business models pursued by the large money-center banks and securities dealers that bundle mortgages, credit-card debt and auto loans into bonds. These firms are largely locked out of the fixed-income market for the purposes of securitizing mortgages, owing to the absence of transparency in past practices and the dearth of meaning management reforms.
The Federal Reserve should start conditioning its discount window lending to large money-center banks and securities firms to meaningful reforms in securitization and management practices, or US credit markets will take several years to rebuild.
Regional banks or other financial institutions could emerge as major bundlers of mortgages and consumer and business loans for sale to insurance companies, pension funds and foreign investors, but that would take many months to effect too.
Either way, adequate credit to both home construction and business investment will not be available before 2010. Until then, growth will be slow, and closer to 1% than 3% per year.
At that point, if positive steps have been taken to encourage substantial new investments in alternative energy sources, conservation and transportation, and to substantially cut the trade deficit with China and other Asian exporters, the US economy could grow at 3.5% to 4% for quite a long time.
Otherwise the US economy will grow in spurts above 3%, punctuated by banking crises and periods of deleveraging. In some years, growth would exceed this rate, and for others, it would be less than 1%. Overall, the pattern will be in the range of about 2% a year or less.