The Hindu Business Line : US economy in real trouble?

The problem arising from defaults in home loans in the US is assuming global proportions. Simply put, these loans were mostly given to poorer people and hence placed in ‘sub-prime’ category. These borrowers are unable to make repayments due to declining incomes. This has led to huge losses for banks and they are reducing their exposures including that to the Indian stocks to some extent.

The question is whether this problem in the US is likely to be temporary or one of longer term? The argument in favour of the former is that it is limited in scope to sub-prime loans that account for a small fraction of the portfolio of the banks.

Wharton’s Prof Jeremy Siegel is optimistic. He says in an interview to Knowledge@Wharton: “It’s a mess for those people who invested in mortgages, but it will not be horrible news for other credit instruments. But there is no question that this cools down the economy, because we already see a cancellation of buyouts; borrowing is getting tougher”.

Not convincing

This is not convincing. “Cooling of the economy” is but an understatement for a wider crisis. Further, the underlying cause for people not being able to meet payments must be appreciated. The underlying cause of loan defaults is the declining income of borrowers coupled with the rise in interest rates. This smacks of a ‘stagflation’. Government spending, inflation and interest rates rise, but do not translate into higher incomes for the people. Thus, even if loan defaults are small presently, the underlying causes are much deeper and will surely play out in time to come.

The above discussion also nails Standard and Poor’s argument that low unemployment rates at 4-5 per cent point to the strength of the US economy. In her testimony before the Senate Banking Committee, Ms Susan Barnes, Managing Director of Standard & Poor’s Ratings Services, said: “As long as interest rates and unemployment remain at historical lows, and income growth continues to be positive, there is sufficient protection for the majority of investment grade bonds. As of April 12, 2007, only 0.3 per cent of the outstanding ratings in the sub-prime area have been downgraded or placed on CreditWatch.”

This line of argument fails to answer why people are finding it difficult to meet their payment obligations. It seems that high employment prevails along with low incomes. Perhaps wages and real incomes are declining. Imports are more costly due to a decline in the dollar value, leading to lower real income of the borrowers. The US media is full of stories of how borrowers are cutting down on their food and other necessities to meet their loan repayments. High employment can, therefore, prevail along with lower incomes which is a precursor to a wider economic crisis.

Fed hand

But how do we explain low unemployment rates? Truly, the US economy had entered a crisis after the dot.com bubble burst in 2002. But this was not manifest because the Federal Reserve Board upped interest rates on US Treasury Bills while lowering them on housing loans.

As a result, global capital flowed into the US economy, was lent to housing sector and led to increased demand for cement, steel, furniture and labour. This employment was created artificially by resorting to external borrowings. It is like the Government of India borrowing from the IMF to run Employment Guarantee Scheme.

Such stratagems are effective only in the short term until the debt collector comes calling and loans are to be repaid. We may, therefore, expect unemployment rates to rise soon.

Another argument is that US economic growth rate remains strong. Wharton Prof. Siegel says, “I think that stocks stand on their own feet — earnings are coming in, at or above expectations, and the economy is still growing. We had a 3.4 per cent GDP growth last quarter; expectations are 2.5 per cent for the current quarter. The economy is not falling apart, despite the sub-prime crisis.”

But these data do not indicate the strength of the economy. These may be the harbinger of the unravelling of the long-term decline which had been artificially halted till recently. The US economy has been cruising along since 2002 just as a car continues to move a few hundred meters in neutral gear even after the engine has been switched off.

Fallacious argument

Yet another argument is that high growth rate and infrastructure development in emerging markets is creating export opportunities for the US companies. The problem is that this same construction boom affects other US companies — more coal plants in China can reduce demand for nuclear power companies, more airports in India leads to less demand for buses and highways.

Fundamentally high growth in the emerging markets challenges American economic supremacy. US T-Bills will no longer serve as a safe haven for global investors and that will cause severe problems for the US economy. The US economy may be poised for a long-term downturn that actually started with the bursting of the dotcom bubble in 2002. Only a huge technological innovation, say a personal helicopter, can save the US from such a fate.

(The author, a freelance writer, can be contacted at bharatj@sancharnet.in)