William Dunkelberg

Professor of Economics at Temple University, formerly Dean of the Fox School of Business

Notes on the Economy

December 11, 2007

1. Fearing something like our sub-prime mess, China's government has ordered a freeze on lending to slow down spending in their economy. China's high savings rate provides more money for investment than can be properly deployed domestically. They are building stuff they can't use yet.

Part of that huge pool of saving is being invested abroad as well. Last year, the Chinese bought enough treasury bonds to fund the federal deficit. And they invested in the Blackstone IPT. There will be much more to come as they diversify their investments.

Oil producers are being buried in dollars as well, as oil prices touched $100 a barrel. This is due in large part to rising oil demand from China and India and other developing countries. The U.S. still consumes twice as much oil as China, so the pressure on oil and other natural resource prices will continue as other countries move along their growth paths to higher prosperity. Keep this in mind as you think about the diversification of your investment portfolio.

2. The Fed has lowered its forecast for 2008 growth as have many other prognosticators based on the troubles large financial institutions are having with their fancy sub-prime mortgage investments. These institutions made a lot of money during the years that the Fed kept rates historically low and they can afford the losses. Recent Fed rate cuts have even helped them out, although not so for the thousands of other commercial banks that make normal loans.

The Fed now anticipates real GDP growth in the 1.8 to 2.5 percent range, well below the 4 percent growth we had in the third quarter. The Fed's inflation forecast is benign, 1.8 to 2.1 percent. This however will result from the decline in rents resulting from the overbuilding of homes and condos. Those of us buying gas, heating our homes and eating corn will not have such a delightful experience.

The small business optimism index from the national federation of independent business also suggests growth at the low end of the Fed range, although owners were much more optimistic before the Fed scared them with rate cuts and warnings. My view - inflation will be worse and growth will be stronger than the pessimists think. For most, it's business as usual.

3. The government has decided to intervene in the housing market to reduce the trauma associated with the current sub-prime problems. This will change mortgage markets for years in the future. The proposed freezing of terms on about a third of the sub-prime mortgages for 5 years will cost savers a bundle, since savers provide all the money lent to home buyers. This will be piled on top of the reduction in money market fund rates by three-fourths of a point, perhaps more if the fed cuts further. All this to help big banks and borrowers, most of whom made informed decisions about the mortgages they signed up for. There was some fraud in the housing bubble, and it is sad that this wasn't caught by due diligence by mortgage investors.

Deciding who gets help and who doesn't will be a complicated and unfair process. This is a bad ideal all around. There may be changes in mortgage lending regulations that make sense going forward, but trying to change history is not a good idea.

4. One third of all foreclosures in the housing market are in Florida and California. 96 percent of all mortgages are being paid on time. 30% of American home owners have no mortgage. Delinquency rates were higher in the 1980s than they are today. Only 2 percent of all mortgages are in foreclosure, and a bunch of these were speculative investments, not homes that were ordered by real home owners. Indeed, most of the mortgage problems are confined to Southern California, Las Vegas and Florida where speculative building was rampant. Problems in the mid-West are due more to the weak economy there, not overbuilding.

So, should the government get involved? My 40 years of experience tells me that when the government gets involved, the cure is always more expensive for the economy than the disease. Consumers and markets have always managed the economy better than government. Just ask the Russians about how well government solutions works, their per capita income was below Mexico's. But, politicians feel compelled to do something, especially with an election so close. So, grab on to your wallets and hope.