The Bailout and the Economy
The US trade deficit has grown to $US700 billion, which of course is money not spent on US goods and services. This has killed off well paying jobs, has slowed the economy and created unemployment.
Net imports from China and oil account for a large proportion of the US deficit and it is this that America simply must fix to rev up growth.
Yet the problem is greater than that. Even with those problems addressed, if America doesn’t fix the banks, it won’t get the economy going. Properly functioning credit markets and solvent banks are needed.
The trade deficit and banking crisis are interconnected however. The trade deficit pumps lots of dollars abroad that come back as purchases of US bonds and other securities. Foreign holdings are now about $US6.5 trillion – growing at about $US50 billion each month – and in recent years that has created cheap capital which in turn has encouraged over-leveraging from Main Street to Wall Street. It has affected homeowners and consumers from Peoria to Park Avenue.
The US economy is in crisis and to address that we need to look at three interconnected things: China, oil and the banks.
Jobs losses have been recorded every month since last December and nearly all the forecasters have the economy cycling down. Real incomes of average Americans have been falling and thousands of homeowners are going through foreclosure.
After Bear Stearns, Lehman, AIG, Fannie Mae and Freddie Mac, money centre banks have scaled back or stopped securitising the loans of their regional peers. There is a chronic shortage of conventional mortgage financing and business loans. Regional banks don’t have enough money to lend.
Last week, credit markets seized up, prompting the Treasury to propose a $US700 billion bailout that we must implement. Yet, even as some of America’s most venerable financial institutions fail, changes in management practices, compensation and corporate governance have been inadequate.
On Monday, the foreign flight from Treasuries was almost a run on the dollar, and conditions for yet another crisis are ripe.
This is a reality of doom and gloom, but there are solutions. To dig out of this mess, America has to address the trade deficit and how the banks are run. And in addressing that trade deficit, first we must look at what is happening with China.
China maintains a 40 per cent undervalued yuan by buying dollars and other currencies with yuan. Those purchases come to more than $US600 billion a year, or about 17 per cent of China’s GDP. This gives Chinese-based manufacturing a cost advantage having little to do with cheap abundant unskilled labour.
This also encourages US companies to move high productivity, well paying jobs to China, which in turn drives down US GDP and wages. Those job losses have little to do with China’s “cheap labour advantage” or what economists call comparative advantage.
The cycle continues. Beijing trades the dollars it obtains through currency market intervention for Treasuries and other US securities. This suppresses long US interest rates and in recent years, this has also decoupled the federal funds rate from long rates, helping to create the cheap, easy credit that led to foolish mortgages and reckless leveraging. This can be seen as an inverted yield curve.
US diplomacy has failed to persuade China to change its currency practices, but the alternative to diplomatic measures is to tax dollar-yuan transactions in proportion to Beijing’s intervention. That would reverse the effects of Chinese intervention in markets and encourage free trade based on comparative advantages. I believe the same should apply for other countries that manipulate their currencies.
Realigning currencies would raise US GDP by $US300 billion and bring back many well paying jobs. It would furthermore permit the Fed to effectively influence long-term interest rates once the present financial crisis is resolved.
The other big elephant in the trade deficit room is oil. The US spends over $US400 billion a year on imported oil, and a good deal of that goes into autos.
First and foremost, Americans have done too little to conserve on gasoline. CAFE standards (Congress’s Corporate Average Fuel Economy regulations) were unchanged for 32 years, and significant breakthroughs in engine technology were used to boost horsepower instead of improving fuel economy.
Finally in 2007, Congress mandated fleet averages be raised to 35 mpg by 2030 but America can – and should – seek to accomplish much more. Simply put, America has the technologies but has not applied them. Lighter materials, advanced hybrids, natural gas and eventually hydrogen can all contribute to solutions.
The US needs a three-pronged strategy. The first part is easy: higher CAFE standards. The second part is to provide product development assistance for domestic-based manufacturers, conditioned on patent sharing and first production runs in the United States. The third is a clunker trade-in subsidy, which would be a tax credit or payment to buyers who trade-in and destroy cars based on their remaining years of useful life and the trade-in mpg gain.
These measures would provide incentives to develop world class alternatives in personal transportation, produce the vehicles and components in the US, and create a new export industry. America is not going to do this with mass transit or on bicycles.
Epic historical transformations in transportation – canals, railroads, and air travel – have often required a boost from government, because switching costs are too high for incumbent firms. Someone is going to make these cars and their components eventually. The US government needs to ask whether Americans make them or pay dearly for imports.
Banking has irrevocably changed. 30 years ago banks took in deposits and loaned out money, it was nice and easy. More recently however, regional banks or their brokers wrote loans, which were then sold to money centre banks and securities dealers, which were then securitised for sale to fixed income investors. It was called efficiency, but the origins of the subprime crisis are clear.
An overabundance of cheap funds from the flood of US dollars abroad, created by the trade deficit, came back as foreign purchases of US Treasuries and securities. Fragmentation of the lending process meanwhile separated those with a stake in loan performance from those who wrote and those who securitised loans.
So-called performance-based compensation on Wall Street – the “heads I win, tails shareholders lose” bonus schemes for bankers also encouraged the whole process to speed up. Excessively complex and poorly conceived collateralised debt obligations and credit default swaps were added to the mix.
Brokers and bankers bet the shareholders’ and investors’ money for personal and company gain. Performance based compensation schemes furthermore made writing “plain vanilla” bonds against good mortgages and business loans unattractive.
All this begot dodgy loans, misrepresented risk in securities, inadequate default insurance, loan and bond failures, and the subprime crisis.
Banks and securities dealers got stuck with lots of toxic paper that they created with subprime and Alt-A loans. Money centre banks and securities dealers backed off securitising even good loans and a shortage of conventional mortgages and business loans ensued, even for prime customers.
Housing prices are now down nearly 20 per cent, far more than they were during the S&L crisis of the early 1990s. Bear Stearns, Fannie and Freddie, Lehman Brothers and AIG have collapsed or are in trouble. And now there is a massive federal bailout proposed.
The bankers that created the crisis are meanwhile escaping with their huge bonuses. Some even continue to have big paydays. This is not capitalism – which functions on rewards for good decisions and penalties for bad ones – it’s a recipe for repeated bank failures, government takeovers and the failure of our market economy.
Cultural changes at our banks and securities firms are required. Into the trash bin should go performance based compensation schemes that encourage bankers to act for their own enrichment against the interest of shareholders and clients. The Wall Street culture of entitlement must be changed and compensation has to be aligned with other industries as well as shareholder interests.
Bankers have been betting house money in a strike-it-rich culture that simply has to end. It is a corporate governance issue and while the government can mandate change, even define broad outlines, Wall Street has to articulate the details.
To fix credit markets America has before it special Fed lending facilities and the new proposed new $US700 billion Treasury rescue program to restore liquidity. What America doesn’t have, and needs, however are “pay-to-play” requirements for banks and securities dealers participating in rescue programs.
Money centre banks should be required to securitise regional bank mortgages and business loans – this time creating plain vanilla bonds. This would minimize the cost to taxpayers by raising housing prices and would reduce risk.
Principles-based banking reform is also necessary. Accountability for loans throughout the lending and securitisation chain is needed and as part of this there must be responsible credit marketing and consumer education.
America needs to stop consuming more than it produces. America needs to stop running huge trade deficits and borrowing so much from the rest of the world to pay for it.
America needs to stop encouraging manufacturers to leave the country with a dollar artificially overvalued against the yuan and other Asian currencies.
America needs to curb its oil imports by encouraging automakers and consumers to make and buy radically more fuel efficient vehicles.
America needs to require prudent and conservative banking practices and end the strike-it-rich, cowboy and bet-the-shareholders’-ranch culture on Wall Street.
The measures I am calling for are practicable and implementable: a tax on yuan-dollar transactions to achieve realignment in exchange rates; a three-pronged program to build fuel efficient vehicles; a linked participation in the Fed and Treasury programs for banks that provide vital commercial banking services; changes in bank leadership to affect reform and create a culture of service and accountability in the financial services industry.
Not too long ago, the management of the US economy and the resiliency and creativity of American capital markets were examples to the rest of the world. Now today these are things America can hardly be proud about.
America has the skills, the creativity and a magnificent work ethic to restore its vibrant economy. America can’t dally however: the American model of democratic capitalism is increasingly challenged by China and other nations. Making tough choices – and abandoning ideology, dogma and partisanship – is the only way to accomplish the reforms needed to get the American economy back on track, and again earn respect around the globe.
More importantly, these tough choices are essential to ensure the legacy of a lasting prosperity for generations to come.
This is an edited version of a speech delivered to the New York Mercantile Exchange on September 25.
PETER MORICI is a professor at the University of Maryland School of Business and former Chief Economist at the US International Trade Commission.