Smith Faculty Opinion Article

February 21, 2008

By Dr. Peter Morici, Professor of International Business
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 Peter Morici

Stagflation!

The chickens are coming home to roost. Reckless trade and energy policies and fraudulent banking have set up Americans for a tough bout with stagflation—rising prices and unemployment. Washington offer palliatives but no solutions.

Since 1999, the U.S. trade deficit has grown from $261 billion to $713 billion, permitting Americans to spend 5.5 percent more than their economy produced over the last four years.

Together, imports from China and petroleum account for about 80 percent of the deficit, and it is financed mostly by foreign governments and investors lending us the $700 plus billion we spend but don’t earn.

These creditors buy mostly U.S. Treasuries, other securities and property. This has kept long-term interest low and permitted a deadly run up of credit card and mortgage debt. It also financed the housing bubble.

Simply, banks applied loose standards when issuing credit cards and mortgages, rolled those loans into collateralized debt obligations and sold them in the bond market.

Americans felt rich but that was false. Most of the foreign money has not been used to start new businesses or invest in growth. About 90 percent simply purchased American IOUs and property.

Now, Americans owe foreigners about $6.5 trillion, and the Chinese government, alone, has enough cash to buy up 10 percent of all the publically traded companies in the United States.

To bankroll this process and keep its exports artificially cheap on U.S. store shelves, China maintained an undervalued currency. It printed and sold yuan and bought dollars on foreign exchange markets, which it converted into U.S. Treasuries and other U.S. debt, but these yuan are increasingly finding their way back into the Chinese economy, and pushing up inflation there and prices for imported Chinese goods here.

Now U.S. consumer prices for products like apparel, where demand is weak and high energy prices cannot be blamed, are taking off.

At the same time, hyper-growth in China and other Asian economies, fueled by artificially undervalued currencies against the dollar, has pushed the price of oil over $100 a barrel. Energy prices are up 20 percent for the year ending in January, and further surges are likely.

Shocked by rising oil prices, the Congress passed the 2007 Energy Policy Act, which requires little more in fuel efficiency for automobiles than higher gasoline prices would compel and propagates the fiction we can feed cars enough corn to end our oil addiction. Subsidizing ethanol production is pushing up grain prices, and U.S. food prices are rising 5 percent a year.

Rising prices for imported consumer goods, energy and food have pushed headline consumer price inflation to a 6.8 percent annual rate for the three months ending in January, and the core rate, which excludes food and energy, to 3.1 percent.

Compounding this mess, we learn the banks really were not really rolling consumer loans and mortgages into legitimate bonds. Instead they were slicing and dicing loans into incomprehensibly complex securities, and then selling, buying, reselling, and writing insurance on these complex contraptions to generate fat fees and big bonuses for bank executives.

The flimflam discovered, banks can no longer securitize loans into bonds, and are pulling back lending to good customers and bad for credit cards, mortgages and business loans. This negates the effects of Federal Reserve interest rate cuts by contracting liquidity.

Consumers are spending less, home prices are tanking and corporate defaults on bonds and bankruptcy filings are rising briskly. The economy is contracting, and jobs are disappearing.

The stimulus package, Federal Reserve interest rate cuts and Administration program to help distressed homeowners are all about getting Americans borrowing again. That’s like giving the hung over alcoholic another drink.

We need is to get the value of the dollar down, sharply, against the Chinese yuan, mandate realistic mileage standards for automobiles, and implement banking reforms.

Don’t hold your breath. Politically courageous Treasury Secretary Henry Paulson, Federal Reserve Chairman Ben Bernanke and Speaker Nancy Pelosi are not inclined to endorse that kind of tough medicine.

Thursday, the Federal Reserve forecasted GDP would grow 1.3 to 2.0 percent in 2008, and headline inflation would stay in a range of only 2.1 and 2.4 percent.

My stalwart wife of 36 years asked “how could that be?”

I retorted, “those Ivy Leaguers at the Fed can’t be that delusionary. Visitors must have put some recreational drugs in the water cooler.”

Peter Morici is a professor at the University of Maryland School of Business and former Chief Economist at the U.S. International Trade Commission.                                                          ►More Faculty Opinion Articles