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FOOL ON THE HILL
It's the Fed's Fault?
Did the Fed blow it when it raised rates? Many individual investors seem to think so, pointing to
a smoldering ruin that used to be the Nasdaq stock market as evidence. But Bill Mann has a
different view: The Fed had no choice but to raise rates in 1999 and 2000 as both consumer and
corporate debt threatened to spin out of control.
By Bill Mann (TMF Otter)
February 21, 2001
One year ago, individual investors were canonizing
Alan Greenspan. Now they're vilifying him. What
happened?
Our beloved tech stocks collapsed, that's what.
Those companies that were the highest-flying,
most-popular investments suddenly dropped to
valuation levels that those buying "great
companies" did not think it possible for them to go.
Where just nine months ago we were in danger of
inflationary overheating, now the American economy
is coming to a grinding halt.
How could Greenspan, the man who managed the
economy with such a deft touch for 14 years, have
screwed up so badly? Why is it that those who
believed deeply in his oracle-like powers when he
maneuvered us through crises in 1987, 1990, 1994,
and 1997 suddenly believe the Chairman of the
Federal Open Market Committee is a washed-up old
coot?
It's because people are angry. Angry and scared. More than $2 trillion of market
value has evaporated from the Nasdaq market alone over the past year. If people
truly vote their pocketbooks, then as $20,000 per every household went up in
smoke those pocketbooks seemingly turned their owners not just against Clinton
and Gore but any remaining symbols of the time of prosperity.
Now Greenspan is the last of the brain trust that personified U.S. fiscal policy over
the last eight years, still in office, surrounded by a bunch of new blood who aren't
so sure it was so great and weren't there anyway. Now that the soft landing seems
improbable, the roses previously thrown at Greenspan's feet have been replaced by
brickbats.
This bellyaching came to a crescendo this past week when John Chambers, CEO of
Cisco Systems, (Nasdaq: CSCO) said the Federal Reserve acted too slowly in
lowering rates and now must aggressively cut rates even lower than the
already-shaved 100 basis points in order to keep from imploding the global
economy. Chambers also called for President Bush's tax cut, aimed at juicing the
economy and getting things going again. Great logic -- except for the fact that it is
just plain wrong.
Interest rates matter most to companies that want to fund growth through
leverage, a.k.a. debt. As the economy had grown over the last eight years,
companies and individuals alike spent and borrowed wildly, convinced that the good
times would not end. The Fed actually encouraged this by making the cost of debt
exceedingly cheap, flooding the market with dollars looking to be put to use.
Companies built and built with the expectation that the growth they were
experiencing would not stop.
It was a logic that was fine in the middle, but made little sense at the margins.
Competitive local exchange carriers, for example, undertook billions in debt in
order to build out networks that would not be profitable -- or even generate
positive cash flow -- for decades. Cisco, Nortel (NYSE: NT), Lucent (NYSE: LU), and
others were willing to give these same companies credit terms far in excess of their
ability to repay them. Consumers market-led fortunes, meanwhile, caused them
not only to spend more, but to go deeper into debt (as a portion of net income)
than at any time since the Great Depression.
There are two things to recall here. First, the economy is in really good shape. It's
not growing very fast, and consumer confidence is down, but the most recent
unemployment numbers for Northern Virginia, for example, are 1.7%. Nationally, it
is 4.2%. Compare that to the miserable times at the end of the Carter years when
it was north of 11%. Unemployment is rising, but the economy is not really
crumbling, much as it feels that way. Unfortunately, with the overhang of inventory
and capital investment, lowering interest rates will not help it. This has very little to
do with the increases of last year, and everything to do with our own collective
spending habits of the boom years.
Applied Materials (Nasdaq: AMAT), as powerful a durable manufacturer as there is,
warned of slowing growth due to inventory buildup among its customers. Bank One
(NYSE: ONE), a large consumer and commercial lender, had to increase its loan
loss reserve by $1 billion in the fourth quarter of 2000 to ensure sufficient funds on
hand for its deteriorating loan book. Everywhere we look, there are issues of
overcapacity. Overcapacity was caused by overinvestment. Overinvestment was, in
its turn, caused by companies having too much access to cheap capital.
With so much non-performing asset base in the pipeline, one then has to ask:
Even if the Fed continues to lower rates, to whom will this credit go? If companies
are already in debt up to their gills, with underutilized facilities and warehouses full
of inventory, then how is it that enticements to increase capital spending are
supposed to help them?
It won't, unfortunately. Although Greenspan and company may not have
anticipated just how fast the psychology of the American consumer would
deteriorate, he was warning long ago that too-high growth rates could lead to a
crash. During the late '90s there was a general feeling that technology-induced
increases in productivity were responsible for growth rates exceeding what
economists previously believed healthy. For all of our desires to the contrary,
Greenspan is not clairvoyant. For all of his tinkering, he could not predict nor
protect us from the OPEC-led 200% rise in oil prices, nor could he magically create
new electricity sources in California. That was a local domain, and one that was
bungled badly.
We are feeling the pain of a stock market that has let us down. The economy is
feeling the pain of a decade of capital expenditures, a higher and higher portion of
which were made using debt. Until that debt load goes down, banks will not open
up the taps and loan again. And until the liquidity of added spending hits the
economy, the service on that debt will grow more painful.
That leaves the tax cut as the next event to prime the spending pump. Just like
interest rates, however, it's not like a tax cut has an immediate effect. Most
peoples' paychecks would grow by a few bucks a week, hardly the stuff of a heady
windfall. It will help -- but in a Chinese water torture kind of way.
In the end, I don't believe that either rate cuts or tax cuts are going to speed the
economy back up. The Fed did not have much choice in raising rates last year; the
credit quality of the biggest lending institutions was deteriorating too fast. And now
the Fed is caught in the ultimate squeeze play.
It can lower rates, but the banks aren't willing to take the same risks they did
before and there is a paucity of really good borrowers; many companies overbuilt
in the late 1990's anyway. Until inventory levels work their way through the
channels and existing capacity is being utilized, borrowing levels will remain low,
regardless of what the Fed does.
It's like the irrational exuberance that Greenspan warned of in late 1996 happened
to be true. Though we did not end up suffering from the inflation he was so worried
about, we are having a severe hangover nonetheless. |
