Recession looms: Can we steer clear?

Recessions are not inevitable adjustments built into the clockwork of a modern economy.

Businesses no longer make products on long lead times and stumble into excess inventories of cars and appliances, triggering layoffs and pauses in consumer spending. Computer-aided supply-chain management and tracking of customer purchases allow businesses to better align what they make to what can be sold.


However, recessions still happen, because of external shocks - natural disasters and political events - as well as errors of judgment and greed. Rocketing oil prices and the credit and housing meltdowns are indications of the latter problems.

But it might not be too late to avoid a recession, if a few practical steps are taken.


Since 2001, the U.S. trade deficit has doubled to more than $700 billion. Oil and Chinese consumer goods account for more than 80 percent of the gap, and how we finance these purchases has a lot to do with our current mess.

China sells its yuan for dollars and other currencies in foreign exchange markets - about $500 billion a year - to keep the yuan inexpensive and Chinese goods cheap in U.S. stores. The Bush administration refuses to do much about it.

Every time a manufacturing job leaves the Midwest for the Middle Kingdom, oil consumption goes up as Chinese farmers move to cities and require more air conditioning and amenities of urban life. The combination of gasoline gluttony and 11 percent growth in China has sent oil prices near $100 a barrel.

So far this year, the average price of imported oil was about $62 a barrel. Next year, if it averages just $77, the increase would shave $72 billion, or 0.5 percent of GDP, off U.S. buying power.

To finance imports, Americans borrow money from and sell assets to foreigners - about $600 billion a year. Saudi princes and the Chinese government have bought chunks of Citigroup, the Blackstone Group and U.S. bonds.

Then there's the home mortgage issue. Banks wrote many reckless adjustable-rate mortgages, and bundled those into bonds for sale to investors. Standard and Poor's and other bond rating agencies were paid by the banks (not investors) to evaluate those bonds' risk of default - and they consistently assigned ratings to mortgage-backed securities that understated those risks.

Each month, thousands of adjustable-rate mortgages are resetting to higher rates, homeowners who can't make the payments are defaulting on loans, and banks are taking big hits on their balance sheets. Bond and credit markets are in turmoil.

Home prices are falling, and credit is too expensive for many worthy homeowners and sound businesses. Just a 5 percent drop in the value of existing homes translates into $95 billion annually in lost consumer spending.


Add to that the effects of oil prices and tight credit on businesses, and overall spending could drop $250 billion - or close to 2 percent of GDP. Consider the usual multiplier effects (when the banker does not buy bread, the baker doesn't buy flour, and the farmer gets stuck with his grain) and we could have a recession - unless the government acts swiftly.

In the near term, the Federal Reserve should further lower short-term interest rates to ensure sound businesses have access to credit at reasonable terms. As needed, it should buy 10- and 20-year Treasury securities to keep down long-term interest rates.

Treasury should push for a three-year program to permit homeowners who can make the payments to convert adjustable-rate mortgages to fixed-rate, 6.5 percent mortgages. That would require Congress to provide federal guarantees or subsidize private insurance. Such intervention is usually not desirable, but the economy is in a crisis.

In the longer term, Treasury Secretary Henry M. Paulson Jr. should spur necessary banking reforms by encouraging financial institutions to voluntarily alter practices that have served them poorly and proposing appropriate legislation to Congress.

Reforms should include implementing new management and business practices at bond rating agencies and getting rid of the off-book banks - structured investment vehicles invented by Citigroup and others that borrow in the short-term commercial paper market to make shaky adjustable-rate mortgages.

On the energy front, the Bush administration has done little to encourage serious conservation. For example, it won't endorse attainable improvements in energy efficiency for home furnaces and mileage standards for automobiles. But raising automobile efficiency to an average of 55 mpg is not far-fetched and could be accomplished before 2030.


Finally, if China insists on subsidizing exports by maintaining an undervalued currency, the U.S. government can tax conversion of dollars into yuan to ensure that China's exports are sold at market prices in the United States. Washington could use the revenue to pay off the bonds held by the People's Bank of China, gradually freeing us from the stranglehold of Chinese debt.

Peter Morici is a professor at the University of Maryland School of Business and former chief economist at the U.S. International Trade Commission. His e-mail is