May. 29, 2008

On the economy

Strap in, this is going be a rough recovery ride

Steven Pearlstein

Suddenly, it seems, we're getting hit from all directions.

Energy and food prices are soaring. The housing market continues to collapse. Government revenue is falling, and taxes are rising. Airlines are jacking up fares and fees while reducing service. Banks are pulling credit lines. Auto companies are cutting production once again. Even investment bankers are losing their jobs.

The tendency is to see these as separate developments, each with its own causes and dynamic. Fundamentally, however, they are all part of the same story — the story of the global economy purging itself of large and unsustainable imbalances that for a time allowed many Americans to think they were richer than they really were.

Most of us understand that an overabundance of cheap, easy credit created a housing bubble that artificially inflated the price of land and housing, produced too many homes and homeowners, and persuaded too many Americans to dip into their home equity to support a lifestyle their income could not sustain. Now that the bubble has burst, we are coming to accept the reality of lower prices, reduced production, declining homeownership rates and the wisdom that a house is not an ATM or a substitute for a retirement fund.

Put another way, residential real estate is finding a new equilibrium, that magical place in the economist's imagination where supply and demand of houses and mortgages come back into some sort of rough balance at a lower price.

But the thing to remember is that it's not just residential real estate. The same factors that were behind the housing bubble were also at work, to varying degrees, in the auto bubble, the commercial real estate bubble, the travel bubble, the college tuition bubble, the retail bubble, the Web 2.0 bubble and most recently the commodities bubble. Unlike housing, which began losing steam two years ago, these other sectors have just begun the painful process of repricing and finding a new balance between supply and demand.

Take the case of the airline industry, which likes to blame its woes on skyrocketing fuel prices.

While there's an ongoing debate about why the price of oil has doubled over the past year, there is little doubt that the declining dollar is a significant factor. The decline is the result of years of large and growing U.S. trade deficits that should have caused the exchange rate to adjust years ago but didn't because so many of our trading partners in Asia and the Middle East were intent on linking their currencies to the dollar. In the process of maintaining those dollar pegs and reinvesting those surpluses in Treasury bonds and Fannie Mae and Freddie Mac securities, they created a surfeit of cheap credit that spawned all those bubbles.

Now that the process is reversing itself, the overvalued dollar is being repriced. But in the short run, it has played havoc with the cost of commodities, most of which are priced in dollars. Producers have raised their dollar prices to prevent a decline in the global purchasing power from their commodities sales. At the same time, some of the excess credit that financed mortgages and corporate takeovers has been shifted to commodity speculation, turbocharging the swings in prices of everything from corn futures to jet fuel. At some point, that speculative bubble will burst and energy prices will plunge. When things finally settle down, the new equilibrium price is almost certain to be well above where it was last year at this time.

That said, jet fuel is hardly the airlines' only problem. The reality is that for too many years, airlines have sold too many tickets at prices that failed to reflect the real cost of providing the service passengers want and expect. That includes such things as cleaning planes; handling reservations, check-ins and baggage without undue waiting; serving a decent meal when necessary; and treating passengers fairly when flights are canceled. But they also include costs that may be less obvious, like keeping up with preventive maintenance, hedging fuel costs, paying a decent wage to front-line employees, investing in modern air traffic control systems, and paying a price that reflects the true value of scarce air space and landing rights.

Airline executives will say that if they were to charge enough to reflect all these costs, they would have many fewer passengers. That's the point: A sustainable equilibrium will inevitably involve a smaller industry with fewer planes, fewer flights, fewer passengers and fewer employees.

And what about that $199 round-trip fare from Washington to L.A.? Sad to say, it was no less a part of the previous economic mirage than the no-doc subprime loans, Google at $750 a share and takeover deals financed at 80 percent leverage.

What I've described is a double whammy for American households: the slower growth that comes with downsizing a number of key industries that expanded as a result of the credit bubble, along with rising prices for food, energy, health care and almost everything imported. And you can add a third blow, this one from government.

Across the country, state and local governments are already hip-deep into budget crises in response to declining revenue from property assessments and real estate transfers. Here in Washington, a dramatic dropoff in revenue from business profits and capital gains has wiped out any hope of reducing federal operating deficits that, under the likeliest political and economic scenarios, will exceed $500 billion a year for as far as the eye can see.

This is another example of an unsustainable equilibrium that has roots in the trade deficit and the credit bubble. Despite the happy talk you might be hearing from the presidential candidates, it presents Americans with a stark and unpleasant choice.

One option is to raise taxes and leave less money for private spending, which is what many state and local governments have begun to do. The other is to accept lower levels of government service and subsidies, which inevitably will lower the incomes of some households while forcing others to go without services or pay for them privately. Either way, it amounts to a lower standard of living than we thought we had achieved.

Is all this the end of the world? For the richest country on the planet, certainly not. But it does represent the end of a decade or more during which Americans were permitted and even encouraged by the rest of the world — and by their own leaders — to live way beyond their means. As a result, the United States has gone from being the largest creditor nation to the world's largest debtor. For the first time since the early 1980s, Americans will have to endure several years of uncomfortably slow growth and uncomfortably high inflation as the U.S. economy regains its balance and creates a foundation for more solid and sustainable growth.