Opinion
Published
March 26, 2024, 6:44 p.m. ET
The New York Stock Exchange on Thursday, March 21, 2024.
ZUM`RESS.com
There's an old Wall Street joke about a man who jumped off the Empire State Building; When asked on the 40th floor how he was doing, he replied: “So far, so good.”
Something similar could be said about our economy.
Everything looks good: growth is satisfactory, unemployment is close to its record low since World War II, and inflation is slowing.
However, it has significant fundamental weaknesses and if these are not addressed vigorously and in a timely manner, our economy could face a day of reckoning.
The most immediate vulnerability lies in our financial system.
Thanks to the Federal Reserve's aggressive 5¼ percentage point interest rate hikes over the past two years to curb inflation, the value of our banking system's bond portfolio has plummeted.
According to calculations by my colleague Paul Kupiec at the American Enterprise Institute, banks had mark-to-market losses on their bond and loan portfolios of a staggering $1.5 trillion as of September 2023.
Adding to the banks' woes is a commercial real estate crisis caused by rising vacancies in a world where people are increasingly working from home and shopping online.
Office prices are estimated to fall at least 40% from their peak in 2022.
Combined with high interest rates, it will be nearly impossible for real estate developers to roll over the $930 billion in real estate loans due this year without a major debt restructuring.
A wave of commercial real estate defaults at a time of already strained balance sheets will be particularly problematic for regional banks, which have nearly 20% of their loan portfolio tied up in commercial real estate loans.
A recent study by the National Bureau of Economic Research says commercial lending problems could cause nearly 400 banks to fail.
This, in turn, could lead to a credit crunch for small and medium-sized businesses and plunge the economy into recession.
An even more serious economic weakness is the miserable state of our public finances.
When the economy is strong, when our budget is at least balanced, we have a budget deficit of 6% of gross domestic product.
Worse, according to the nonpartisan Congressional Budget Office, under current policies we will continue to run a 6% of GDP deficit as far as the eye can see.
Budget deficits of this magnitude are clearly unsustainable; Our national debt is already close to 100% of GDP.
According to our fiscal outlook, our national debt will exceed the record level set at the end of the Second World War by 2030 and will exceed 150% by 2050.
Interest payments on debt are now well on their way to becoming the largest household expense.
No wonder the rating agencies are starting to downgrade our rating.
We are fortunate that, unlike other countries, our government borrows in dollars rather than foreign currencies; This means that it is extremely unlikely that we will ever default on our debts because the Federal Reserve could always print the dollars to repay the debts.
But such money printing could put us on the path to ever higher inflation.
This would result in the return of the bond guards and trigger a dollar crisis.
To avoid a day of reckoning, we must return to more responsible fiscal policies on both sides of the political spectrum.
Tax reform and cuts in government spending could put national debt on a more sustainable path.
At the same time, reducing overall demand pressures could create scope for the Fed to cut interest rates without triggering inflation.
Lower interest rates would, in turn, ease the current burden on the banking system and help alleviate the commercial real estate crisis.
A good start to getting our economic house in order would be a serious discussion of these issues during this election cycle.
However, judging by what Messrs. Biden and Trump said during the campaign, I'm not holding my breath for this to happen.
Desmond Lachman, a senior fellow at the American Enterprise Institute, was deputy director in the International Monetary Fund's Policy Development and Review Division and chief emerging market strategist at Salomon Smith Barney.
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