is a professor of economics at the Robert H. Smith School of Business, University of Maryland
The U.S. economy is in recession, with no end in sight. Falling housing prices and questionable mortgages are blamed.
But digging out will require Americans to use less gasoline, get tough on trade with China, and learn to live within their means.
U.S. imports exceed exports by $700 billion annually, thanks mostly to a $400 billion petroleum deficit and a $250 billion trade gap with China. These divert consumer spending from U.S.-made products and have destroyed 2 million high-paying manufacturing jobs.
To keep the economy going, we borrow from foreigners through an elaborate scheme that permits us to consume more than we produce and that created the housing bubble and credit crisis.
Ordinary Americans borrowed from mortgage companies, local banks and finance companies. Those firms sold the mortgages, auto loans and credit card markers to Wall Street banks, which bundled notes into bonds for sale to big, fixed-income investors.
Besides insurance companies and pension funds, the Chinese government, Middle East royals, and other foreign investors were big customers for U.S. interest-bearing securities. All that easy money encouraged risky mortgages and pushed up home prices.
Last year, this scheme became 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 who 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 ruses propagated, such as 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.
Now investors, including U.S. insurance companies and foreign investors, are unwilling to buy bonds from U.S. banks, and banks cannot make enough loans to creditworthy home buyers, consumers and businesses. Housing prices plummet, car sales sink, businesses cannot invest, and the economy tanks into recession.
The Federal Reserve has cut interest rates and temporarily loaned banks $600 billion, but those steps help little because the bond market is closed to banks.
Moreover, foreign governments and private investors are getting nervous about all the money they have lent Americans and are moving cash into euro-denominated securities, gold, oil, and other investments.
To dig out, Americans will have to learn to live within their means by reducing the U.S. trade deficit.
Americans must either let the price of gasoline double to force conservation or accept tougher mileage standards for cars. Fifty miles a gallon by 2020, instead of the 35 required by current law, is achievable, but that would mean 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 M. Paulson Jr. and Federal Reserve Chairman Ben S. 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.
Paulson and Bernanke should bring together the largest banks and fixed-income investors to lay out the requirements for such bonds and require the banks to stick to them.
Banks may resist because plain-vanilla mortgage underwriting does not pay the outsize fees and bonuses they have been spoiled to expect. But 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 lending to banks to keep them afloat.
It's time to get realistic about using less oil and tough with China and the banks.