President Obama’s strategy to combat the recession courts disaster.
He proposes huge federal deficits from 2009 to 2011 to prop up domestic demand and break the negative feedback cycle of rising unemployment, falling incomes and sinking consumer spending, while recapitalizing the banks to get credit flowing again.
This would require nearly $4 trillion in federal borrowing. Such deficits are unsustainable over the long term. The president promises to borrow less in 2012, when he believes the economy will grow robustly again.
However, these policies do not address the root causes of the recession and will likely put the economy back in the sink.
Three great forces caused the meltdown — Chinese mercantilism, dysfunctional U.S. energy policies and Wall Street abuses.
Beginning in 1994, China artificially undervalued its currency by printing yuan to buy dollars. Coupled with export subsidies, this flooded U.S. store shelves with inexpensive Chinese goods and created a huge trade imbalance between China and the United States.
At the same time, U.S. energy policies encouraged American automakers to sell ever bigger gas guzzlers while limiting domestic oil and gas development in the Gulf of Mexico and elsewhere. The cost of oil imports rocketed to fuel 4,000-pound SUVs that were used to transport 110-pound soccer moms.
The trade deficit jumped from $65 billion in 1993 to an average of more than $700 billion annually from 2005 to 2008, or about 5 percent of GDP. Today, petroleum and imports from China account for nearly the entire U.S. trade deficit.
Simply, money spent on imported coffeemakers and oil can’t be spent on U.S.-made goods and services. To sustain adequate demand for what Americans make, Americans must spend and consume 5 percent more than they earn or produce.
Until the credit bubble burst, banks collapsed and ocean vessels and trucks were pulled out of service, Chinese and Middle East investors bankrolled it all, and Wall Street’s financiers happily brokered a false prosperity.
Chinese and Middle East ex-porters used the dollar proceeds from their large trade surpluses to buy U.S. bonds and property. That kept long-term interest rates low, permitted Americans to borrow recklessly on homes and commercial buildings, and juiced property and stock prices.
Borrowing to sustain this paper prosperity grew much more rapidly than the incomes of Americans to support bigger mortgages and rising rents on retail space. Bankers responded by writing ever more creative loans — mortgages without down payments and some loans designed to be refinanced every few years against rising property values.
Bankers found ways to lend more against investor paid-in capital, which provides their cushion against bad loans during a recession. They wrote what came to be called credit default swaps — insurance policies against loan defaults — that were backed by few, if any, assets. Financial houses exchanged swaps in a kind of grand Ponzi scheme that may take a decade to unwind.
Thirsting for million-dollar bonuses, Wall Street bankers abandoned sound risk management for Las Vegas finance. When the house of cards collapsed, credit dried up and consumer spending tanked, unemployment rocketed and President Obama inherited the biggest mess since the Great Depression.
His stimulus package will temporarily reflate demand for goods and services by replacing private borrowing from China and Middle East royals with government borrowing.
However, as the economy recovers in 2010 and 2011, U.S. imports of Chinese goods and Middle East oil will expand significantly. When federal stimulus spending subsides in 2012, foreign lenders and banks will have to finance another round of reckless U.S. consumer borrowing or the demand for U.S.-made products will decline and the economy will fall back into recession.
President Obama’s economic brew avoids addressing Chinese protectionism. His energy policies mostly focus on domestic coal and natural gas use, but generally leave efficiency standards for cars alone.
China and other nations are growing weary of holding so many dollars and bonds as the ability of the United States to service its debts is cast into doubt. Instead of another credit bubble in 2012 followed by another burst a few years later, we are likely to see yet another flop in demand and an even deeper recession.
Unless President Obama ad-dresses the trade deficits with China and on oil, and the poor management of U.S. banks, the next decade will become hauntingly similar to the period after 1929.
Peter Morici is a professor at the University of Maryland’s Smith School of Business and was chief economist at the U.S. International Trade Commission from 1993 to 1995.