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Smith Faculty
Opinion Article
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January 3,
2008
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By Dr. Peter Morici, Professor of
International Business
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Recession Watch, the Jobs Report and Fed Policy
The holiday season did not bring a
lot of good economic news. Weak retail
sales, the flagging fortunes of
automakers and declining industrial
production have pundits guessing whether
the U.S. economy has entered a recession
and, if so, how long will it last.
Tomorrow, the Labor Department
releases data on December jobs creation.
The consensus forecast is for 70,000
jobs. That is hardly a robust number,
but it would indicate a slowing economy
and not one that is contracting. Unless
this number decidedly disappoints
forecasters, the economy will not record
negative growth in the fourth quarter of
2007.
Inflationary pressures should not
constrain Federal Reserve efforts to
head off a recession. Rising demand for
energy, metals and other materials are
pushing up prices, but the Federal
Reserve can do little to curb there
pressures. Robust growth in China and
elsewhere in Asia is pushing up energy
and raw material prices, and the Fed
could only marginally compensate for
these forces by constraining U.S.
growth.
Federal Reserve will aggressively cut
interest rates to combat the U.S.
slowdown, but these efforts will prove
insufficient to head off a painful
economic slowdown. Fed actions, quite
simply, continue to lag developments and
fail to indicate an appreciation of the
nature of the problems besetting
financial markets and the broader
economy.
The housing sector is in a recession,
because the secondary market for
mortgages has broken down. Investors are
reluctant to purchase mortgage-backed
bonds that are not issued by Fannie Mae
or other federally-sponsored
underwriters.
With the federally-sponsored banks
largely limited to high quality lenders
and mortgages up to $417,000, loans for
home owners and buyers with less than
perfect credit histories and mortgages
for more expensive homes are difficult
to obtain. Moreover, the expected wave
of foreclosures on adjustable rate
mortgages and the fear of further
falling housing prices have made
prospective buyers in all price ranges
reluctant to commit.
The commercial paper market still has
not adequately recovered, because the
ultimate amount of subprime write downs
at major U.S. banks is not yet known.
Balance sheets are just too weak for
normal commercial banking activity. The
Federal Reserves Auction Facility
implemented in December added liquidity,
but it is simply not enough to
fundamentally alter conditions in credit
markets.
The subprime meltdown reveals endemic
structural flaws in the U.S. banking
system. The write downs at Citigroup,
UBS and others indicate that bankers
have been overvaluing mortgage-backed
securities. The motivation is clear. The
compensation awarded bank executives who
create mortgage-backed and other
securities is directly related to the
estimated values banks assign these
complex and opaque instruments.
Mutual funds, U.S.-state run money
market funds for municipalities, pension
funds, insurance companies, and
individual investors that trusted
Citigroup and other banks now hold
worthless paper. Consequently, the
market for mortgage-backed securities
has evaporated.
The whole chain that creates
financing for mortgages has been
corrupted from loan officers to banks
that bundle loans into securities, to
bond rating agencies like Standard and
Poor’s who demand payments from banks
instead of charging investors to
evaluate mortgage-backed securities.
The Federal Reserve and Treasury need
to prod the private banks to reform
lending practices and compensation
structures, and to encourage to bond
rating agencies to return to
investor-financed ratings.
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
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