There is an old Wall Street joke about a man who jumped off the Empire State Building; when asked at the 40th floor how he was doing, he replied, “So far, so good.” Something similar might be said about our economy. Everything is looking good: Growth is satisfactory, unemployment is close to a record post-World War II low, inflation is decelerating. But it has major underlying weaknesses, and if they’re not addressed in a forceful and timely manner, our
economy could have its day of reckoning. The most immediate weakness is to be found in our financial system. Thanks to the Federal Reserve’s aggressive 5¼ percentage point interest-rate hike over the past two years to contain inflation, the value of our banking system’s bond portfolio has plummeted. As of September 2023, the banks had mark-to-market losses on their bond and loan portfolios of a staggering $1.5 trillion, according to calculations by my
American Enterprise Institute colleague Paul Kupiec. Adding to the banks’ troubles is a commercial real-estate crisis as a result of soaring vacancies in a world where people increasingly work from home and shop online. Office prices are estimated to fall by at least 40% from their 2022 peak. That together with high interest rates will make it well-nigh impossible for property developers to roll over the $930 billion in maturing property loans this year without a major debt restructuring. A wave of commercial-property defaults at a time of already-stressed balance sheets will be particularly problematic for the regional banks, which have close to 20% of their loan portfolio tied up in commercial-property lending. A recent National Bureau of Economic Research study estimates commercial-loan problems could lead to the failure of nearly 400 banks. That in turn could cause a credit crunch for small and medium-sized businesses and tip the economy into recession. Stay up on the very latest with Evening Update. Please provide a valid email address. By clicking above you agree to the Terms of Use and Privacy Policy . Never miss a story. An even more serious economic weakness is the abysmal state of our public finances. With cyclical economic strength, when our budget should at least be balanced, we are running a budget deficit of 6% of gross domestic product. Worse yet, per the nonpartisan Congressional Budget Office, on present policies we will continue to run 6%-of-GDP deficits for as far as the eye can see. Budget deficits of this order of magnitude are clearly not sustainable; our public-debt level is already close to 100% of GDP. Based on our budget outlook, by 2030 our public debt will exceed the record set at World War II’s end, and by 2050 it will exceed 150%. Meanwhile, interest payments on the debt are on course to become the largest budget spending item. Little wonder the credit-rating agencies are starting to downgrade our rating. We are fortunate in that, unlike in other countries, our government borrows in dollars and not in foreign currencies; this means it is highly improbable that we will ever default on our debt since the Federal Reserve could always print the dollars to repay the debt. But such money printing could set us on a path to ever-higher inflation. That would invite the return of the bond vigilantes and precipitate a dollar crisis. The way to avoid a day of reckoning is a return to more responsible budget policy on both sides of the political aisle. With tax reform and public-spending cuts, the public debt could be placed on a more sustainable path. At the same time, by reducing overall demand pressure, room could be made for the Fed to cut interest rates without unleashing inflation. Lower interest rates in turn would reduce the current strains on the banking system and help relieve the commercial real-estate crisis. A good place to start in setting our economic house in order would be a serious discussion of these issues during this
election cycle. However, judging by Messrs. Biden’s and Trump’s pronouncements on the election trail, I am not holding my breath for this to happen. American Enterprise Institute senior fellow Desmond Lachman 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 .