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Obama courting disaster

By Peter Morici
web posted March 30, 2009

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 four trillion dollars in federal borrowing. Such deficits are unsustainable, long term; however, the President promises to borrow less in 2012, when he believes the economy will grow robustly again.

Simply, these policies do not address the root causes of the recession and will likely put the economy back in the sink.

The meltdown was caused by three great forces -- 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.

Concurrently, the United States energy policy encouraged Detroit to sell ever bigger gas guzzlers and limited domestic oil and gas development in the Gulf of Mexico and elsewhere. The cost of oil imports rocketed to fuel four thousand pound SUVs 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 imports from the Middle Kingdom and petroleum 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 five percent more than they earn or produce.

Until the credit bubble burst and banks collapsed, the Chinese and Middle East investors bankrolled it all, and Wall Street's financiers happily broker a false prosperity.

Chinese and Middle East exporters 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 credit default swaps -- insurance policies against loan defaults -- that were backed by few if any assets. Financial houses exchanged swaps in a 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.

President Obama's stimulus package will temporarily reflate demand for goods and services by replacing private borrowing from the 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 will oil expand significantly. When federal stimulus spending subsides in 2012, either foreign lenders and banks finance another round of reckless U.S. consumer borrowing, or the demand for U.S. made products will fall 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. And Secretary Geithner's plans to recapitalize banks by purchasing of toxic mortgages and securities but dodges reforming the compensation and management practices that created so much reckless lending and trashed the balance sheets of the world's larges financial institutions.

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 quickly addresses the trade deficits with China and on oil, and the poor management of U.S. banks the next decade will become hauntingly remindful of one that began in 1929. ESR

Peter Morici is a professor at the Smith School of Business, University of Maryland School, and the former Chief Economist at the U.S. International Trade Commission.


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