FED Up!
Written by Ed Szamborski Friday, 05 November 2010 19:00
This week marked the launch of the QE2, no, not the lovely ocean liner, but the Quantitative Easing v.2 from the Federal Reserve Bank under Mr. Bernanke. This time, the fed has decided to purchase 600 billion dollars worth of Treasury bonds. Why they think this is a clever idea down at the Fed is beyond me as I, and many others, thought Keynes was dead (the long run did finally catch up with him!) But his bad ideas linger like a virus in both Europe and America.
The Fed has several ostensible weapons in its’ anti-recessionary arsenal. One is control of interest rates on the short term thru overnight rate used to lend money to banks. When the economy is weak, the Fed tends to lower rates in the hopes of stimulating economic production by making it easier for borrowers to get money for business expansion. They have already let loose every round in this gun, lowering short term rates to an effective zero level.
Another is to flood the market with additional liquidity, allowing banks and other financial institutions to borrow more funds temporarily from the Fed "window". This tries to ensure that banks have enough ready cash to meet any excess demands from depositors looking to withdraw funds, as well as having additional monies to lend to businesses in need. This torpedo has left the launch tube and has already run its course.
Finally, they can do what they are trying now, flooding the markets with cash by buying bonds back from bond holders. The goal of this is to both give businesses and investors more cash in their pockets, as well as interest rates on bonds, which could lower the price of borrowing for things like mortgages.
This kind of thinking is all very well and good when sitting around the table at the college pub with a beer and your freshman economics professor. But, in this real world economy these moves have unintended and predictable negative effects that our friends at the Fed have discounted in favor of their alleged advantages. They ignore the real human reactions to these economic moves that fly in the face of the Fed's conclusions bred of intellectual naval gazing.
Low interest rates have several negative effects that we are now seeing. First and foremost, low rates punish people for being frugal and responsible. Individuals, like investors and retirees, are burdened with lowered incomes, which have a huge effect on consumer spending. The retiree with much of his money in CDs is feeling very poor right now, and is forced to live off his hard earned capital instead of the interest generated by his accounts. Successful businesses who have managed to earn profits and accumulate them are cut off from savings income. Interventionists think this very clever, causing businesses to deploy capital and spend it, stimulating the economy. They ignore the psychological impact of lower incomes. Business people are rattled by the lowered value of their cash, and their instinct is not to spend it, but to hold onto it ever more tightly, resulting in less spending and investment.
Low interest rates weaken the dollar. Investors, both domestic and foreign, seek a reasonable return on their cash and will not settle for a zero rate of return, or from lower long term rates caused by QE2. They will move cash assets to other currencies, especially the euro. The Fed thinks this is a great idea, because a cheap dollar could American imports are cheaper and therefore more competitive. That is a longer term and more indirect effect, as consumers and businesses around the world do not suddenly switch to American goods if they get a 5 or 10% currency discount. But what does happen is that imports to America become more expensive today. The American consumer does not change his buying habits overnight, switching from Swiss cheese to domestic cheddar because of a 10% price increase, but is hit with an inflationary reduction of his disposable income today! This just serves to further depress the American consumer economy. The Europeans have tried several of these devaluation skirmishes in the past and they always weaken the economy that launches the devaluations.
Low rates and high liquidity are a political sop to banks. Banks and other financial institutions are some of the most important businesses in an advanced economy, providing a safe haven for saver and business cash, and providing various financial products that allow us to conduct many consumer and business transactions with ease and safety. The Fed appears to want two things, bank profits and finances to stabilize, and banks to lend more to increase bank client economic activity.
Yes, banks are rolling in profits right now, but that is mostly due to those low short term rates. Banks kept, and even raised, the cost of borrowing to consumers and ruthlessly cut the amount of consumer credit available by decreasing credit limits on client loans and credit cards. Banks were spooked by the previous over-extension of credit, and have swung their lending criteria so far to the strict side, that much lending has ground to a halt. A small real estate developer friend of mine used to be able to borrow up to the full amount of the value of a property, renovate or rebuild, then sell or rent. Now, banks will either not lend at all, or they demand a 40% down payment from the developer. The traditional down payment on commercial real estate loans was around 20%, so the zero down scenario may have been too low, but the new 40% down demand has absolutely killed small scale development, killing untold jobs in construction while the housing stock slowly decays. Low rates do not enhance lending, they stifle it by allowing banks to take advantage of free money to lend to only sure bets.
Low interest rates are creating an asset bubble. When rates are low individuals, savers, investors and retirees, feel under tremendous pressure regarding their incomes. These people are very financially conservative, and feel poorer because of lower incomes from low rates on CDs, money market accounts and savings accounts and start to consider more risky investments. One example is gold, which has seen a steady rise since the beginning of this recession. This could end badly when interest rates rise again as zero rates are just not the norm.
The other disaster in the making for investors is the bond bubble. Bond investors chase rates, and feel that bonds somehow connote safety. But, the opposite is true. Soon bond rates will rise from their current historic lows, and buyers of bond funds, or of bonds that they will not hold to maturity will be badly burned. They are also pouring tons of money into municipal and state bonds at a time when these local finances are at their most precarious, opening the door to the possibility of investor loss thru default.
The Keynesian view of economics reminds me of those old caricatures of businessmen and investors showing them yelling into candlestick phones yelling, "BUY" "SELL". They see investors, consumers and businessmen in a kind of a cartoonish way, and think that by pushing and pulling monetary and fiscal levers that whatever they have concluded in a meeting will happen in the real world. What they don't have is a grasp of actual human fears and aspirations and how they make people behave in ways that are not 100% logical, but often tainted by emotion and personal experience. Economics is as much about psychology as anything else. How about a contrarian solution to counter the current conventional wisdom of monetary looseness? Now is the time to create a positive, forward looking mood in consumers, savers, investors and businesses. Raise rates NOW. Signal a slow but steady increase in Fed interest rates up to 2 or 3%. Make it clear that the American economy is coming out of recession and that the Fed and Treasury are showing confidence in the nascent recovery and the American people. This will have several positive effects.
First, it will increase incomes to savers which will make them relax their iron grip on their wallets and lead to an increased consumer spending. Second, it will strengthen the dollar, leading to an immediate lessening of consumer and producer price pressure, and free up more consumer discretionary income. Third, it will help deflate the current asset bubbles in commodities and bonds, allowing investors to make more reasonable and less risky investment choices, especially for retirees who are now suffering from disastrously low returns on savings and higher exposure to risky investments. Fourth, banks will start reverting to a standard lending model to make money, and not rely on zero rates from the Fed to artificially boost their bottom lines. This will free up capital to sound and deserving businesses that are currently locked out of the credit market. Let the recovery begin.