Don't Get Excited: The U.S. Economy Is In Bad Shape Below the Surface

There is an old Wall Street joke about a man who jumped off the Empire State Building. When asked how he was doing while passing the fortieth floor, he replied, “So far so good.”

We have to wonder whether a similar story might not be unfolding now in the U.S. economy. While the economic numbers are lending much support to the proponents of a soft economic landing, the country’s underlying conditions have raised concern that the economy could be in for a hard economic landing later this year.

Good News on the U.S. Economy...

Let us start with the good news. Inflation, which peaked in June 2022 at 9.1 percent, is coming down at a faster rate than most economists had initially predicted. Indeed, it now appears well on its way toward the Federal Reserve’s 2 percent inflation target. More encouraging yet, it is doing so at the same time that the economic recovery is continuing at a satisfactory pace and the labor market continues to be strong. Underlining this point were today’s stronger-than-expected jobs numbers. At this late stage in the recovery, the economy continues to add 200,000 jobs per month, and the unemployment rate remains close to a post-war low.

The bad news is that by having raised interest rates at the fastest pace in decades, the Fed could be laying the ground for another and more vicious round of the regional bank crisis than that which we experienced at the start of last year with the failure of Silicon Valley Bank. If that were to occur, the regional banks must be expected to radically curtail credit to the small and medium-sized businesses that constitute almost half of U.S. economic activity and employment. The reason for pessimism about the regional banks is twofold. First, the Fed’s aggressive interest rate policy has caused very large mark-to-market losses in the banks’ Treasury bond portfolio. For the banking sector as a whole, those losses are estimated at around $600 billion. Second, the regional banks have an unhealthily high exposure to the troubled commercial real estate sector.

This year, property companies are going to experience great difficulty rolling over the $500 billion in maturing loans at very much higher interest rates than those at which the loans were originally contracted. They will do so since, in the pandemic’s aftermath, these companies are being hit by record vacancy rates and sharply declining property prices. 

A recent National Bureau of Economic Research Study highlighted the seriousness of the regional banks’ woes. It found that if interest rates remain close to their current levels and if the commercial real estate companies start defaulting on their loans, around 385 regional banks could fail. That, in turn, summons the ghosts of the early 1980s Savings and Loan Crisis. 

The U.S. Economy Has Debt Issues

Another and perhaps even more serious reason for concern is the abysmal state of our public finances. At a time of cyclical economic strength, when we should be running budget surpluses, our budget deficit is over 6 percent of GDP and is expected to remain at that level for as far as the eye can see. With little prospect that a divided Congress will address this issue anytime soon, the non-partisan Congressional Budget Office is warning that by 2030, the national debt in relation to the size of the economy could reach a similar level to that recorded at the end of World War II. 

It has to be of concern that major foreign governments like those in China and Japan are losing their appetite for U.S. Treasury bonds. It is also disturbing that the rating agencies are warning that the U.S. government’s credit rating could be reduced if it does not mend its profligate budget ways. This could be setting us up for a dollar crisis down the road, leading to another inflationary bout. 

It is understandable that the Biden administration and the Federal Reserve are taking much pride in their economic accomplishments to date. However, with substantial downside risks to the economic recovery in plain sight, we have to hope that they resist the temptation to take a victory lap too soon and take their eye off the ball.

About the Author: Desmond Lachman

Desmond Lachman is a senior fellow at the American Enterprise Institute. He was a deputy director in the International Monetary Fund’s Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney. You can email the author: Editor@nationalinterest.org.