Smith Faculty Opinion Article	March 24, 2008
By Dr. Peter Morici, Professor of International Business                                                                       E-MAIL       WEB SITE

Digging Out of the Recession

The U.S. economy is in recession with no end in sight. Falling housing prices are blamed, but the root causes are bad economic policies and lousy banking practices.

U.S. imports exceed exports by more than $700 billion, thanks mostly to expensive oil and lopsided commerce with China. To finance this gap, Americans sell bonds and other securities to foreigners, and Wall Street banks, like Citigroup and Merrill Lynch, recycle those funds to American consumers.

U.S. consumers borrow from mortgage companies, local banks and finance companies through mortgages, auto loans and credit cards. Those firms sell the loans to Wall Street banks, who bundle loans into bonds for sale to big fixed income investors. The Chinese government, Middle East royals and other foreign investors purchase huge sums of such U.S. interest bearing securities.

Last year, this scheme started coming unglued, because many homeowners borrowed more than their paychecks and home values could support. Loan officers encouraged home buyers to exaggerate incomes on mortgage applications and hired real estate appraisers that would inflate home values. Wall Street disguised bad loans in complex derivatives, instead of creating simple bonds, which fooled fixed income investors into believing they were buying securities backed by solid loans. Other rouses propagated like aggressive adjustable rate mortgages, and bogus credit default swaps alleged to make risks disappear.

When the worst bonds failed—those backed by subprime adjustable rate mortgages—the fixed income market closed to U.S. banks.

Banks don’t have enough deposits to make all the loans the U.S. economy needs, because Americans increasingly by-pass banks, investing directly in mutual funds, retirement accounts and the like. Hence, banks must turn about half of their loans into bonds.

Now investors, ranging from U.S. insurance companies to foreign investors, are not willing to buy bonds from U.S. banks, and banks cannot make enough loans to credit-worthy homebuyers, consumers and businesses. Housing prices plummet, car sales sink, businesses can’t invest, and the economy tanks into recession.

The Federal Reserve has cut interest rates and temporarily loaned banks $600 billion dollars, but those steps help little because the bond market is closed to banks.

Moreover, foreign investors are getting nervous about all the money they have loaned Americans to finance huge trade deficits. They are fleeing the dollar by moving cash into euro denominated securities, gold, oil, and other investments.

Fixing the trade deficit will require Americans to use less gasoline and balance commerce with China. Americans must either let the price of gas double to force conservation or accept tougher mileage standards cars. Fifty miles a gallon by 2020, instead of the 35 required by current law, is achievable, but that means more hybrids and lighter vehicles.

China subsidizes exports by selling its currency, the yuan, for dollars at artificially low values in foreign exchange markets, making Chinese goods artificially cheap at Wal-Mart. The U.S. government should tax dollar-yuan conversions at a rate equal to China’s subsidy until China stops manipulating currency markets. That would reduce imports from, and increase exports to, China.

Finally, Treasury Secretary Henry Paulson and Federal Reserve Chairman Ben Bernanke are working to clean up the practices of mortgage brokers, loan officers and real estate appraisers but Wall Street banks must be willing to create simple bonds from mortgages and other loans that investors can understand and whose risks can be reasonably accessed. This is less profitable than the complex bonds and derivatives that were sold prior to the subprime meltdown.

Paulson and Bernanke should bring together the largest banks and fixed income investors, among insurance companies and the like, to lay out the requirements for such bonds and require the banks to stick to them.

Banks may resist, because plain vanilla mortgage underwriting doesn’t pay outsized fees and bonuses they have been spoiled to expect from complex derivatives. However, Americans need the banks to make mortgages and other loans to get the economy back on track, and Bernanke and Paulson have the leverage to bring them to the table—the $600 billion the Federal Reserve is loaning banks to keep them afloat.

It’s time to get realistic about using less oil and tough with China and the banks.

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