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The Economy is in Crisis

Avoiding a Recession

by PETER MORICI

Recessions are not inevitable adjustments built into the clockwork of a modern economy.

Businesses no longer make products on long lead times and stumble into excess inventories of cars and appliances, triggering layoffs and pauses in consumer spending. Computer-aided supply chain management and tracking customer purchases permit businesses to better align what they make to what can be sold.

Recessions still happen, because of external shocks-natural disasters and political events-and errors of judgment and greed. Sadly, rocketing oil prices and the credit and housing meltdowns bear traits of the latter.

Since 2001, the trade deficit has doubled to more than $700 billion. Oil and consumer goods from China account for more than 80 percent of the gap, and how we finance these purchases has a lot to do with our current mess.

The Bush Administrations has done little to encourage serious energy conservation-it won’t endorse attainable improvements in home furnaces and mileage standards for automobiles.

The Chinese government aggressively intervenes in foreign exchange markets-about $500 billion a year-to keep the yuan inexpensive and Chinese goods cheap in U.S. stores. The Bush Administration refuses to do much about it.

Every time a manufacturing job leaves the Middle West for the Middle Kingdom, oil consumption goes up, as Chinese farmers move to cities and require more air conditioning and amenities of urban life.

The combination of gasoline gluttony and 11 percent growth in China has sent oil prices above $90 a barrel.

In 2007 the average price of imported oil was about $62 a barrel. Next year if it averages just $77, the increase would shave $72 billion, or 0.5 percent of GDP, off U.S. buying power.

To finance imports, Americans borrow and sell assets to foreigners. Saudi princes and the Chinese government have bought chunks of Citigroup, the Blackstone Group and U.S. bonds. Consumers access funds through mortgages and other loans bundled into bonds for investors.

Banks wrote many reckless adjustable rate mortgages (ARMs), bundled those into bonds, and paid Standard and Poor’s to assign those securities high ratings. Common are homeowners, who have refinanced five times in five years, owe six times their income, and drive a Lexus.

Each month, thousands of ARMs are resetting to higher rates, homeowners can’t make the payments and are defaulting on loans, banks are taking big hits on their balance sheets, and bond and credit markets are in turmoil.

Home prices are falling and credit is too expensive for worthy homeowners and sound businesses. Just a five percent drop in the value of existing homes translates into $95 billion annually in lost consumer spending.

Add to that the impacts of oil prices and tight credit on businesses, and overall spending could drop $250 billion or close to 2 percent of GDP. Add the usual multiplier effects-when the banker does not buy bread, the baker doesn’t buy flour, and the farmer gets stuck with his grain-and we could have a recession.

The Federal Reserve and Treasury Department have been fairly agnostic about this prospect and should do more to avert disaster.

Near term, the Federal Reserve should further lower short-term interest rates to ensure sound businesses have access to credit at reasonable terms. As needed, it should buy 10- and 20-year Treasury securities to keep down long-term interest rates.

Treasury should organize, for immediate action by Congress or through the private sector, a three-year program to permit homeowners, who can make payments, to convert ARMs to fixed-rate 6.5 percent mortgages. That would require federal guarantees or subsidizing private insurance, and such intervention is usually not desirable, but the economy is in a crisis.

Longer-term, Treasury Secretary Paulson should prod necessary banking reforms. These include new management and business practices at bond rating agencies and getting rid of the off-book banks-structured investment vehicles invented by Citigroup and others that borrow in the short-term commercial paper market to make shaky ARMs. Federally charted banks that are not allowed such loose practices, and doing so off books smell of fraud.

Raising automobile efficiency to an average 55 mpg is not far fetched and could be accomplished sooner than 2030, as suggested by Senator Clinton.

Finally, if China insists on subsidizing U.S. purchases of yuan to finance exports, the U.S. government can tax conversion of dollars into yuan to ensure those exports are sold at market prices in the United States. Washington could use the revenue to pay off the bonds held by Peoples Bank of China.

PETER MORICI is a professor at the University of Maryland School of Business and former Chief Economist at the U.S. International Trade Commission.