Brought low by a decade of mistakes
By Doron Tsur
Withdrawal pangs. That's the only way to7 describe what the U.S. economy and credit market are going through. The entire global marketplace, investors worldwide, have their eyes on the daily fluctuations of stocks and bonds, and on headlines about investment funds around the world desperately scrabbling for credit. They're all trying to forecast what the U.S. Federal Reserve will do: Will chairman Ben Bernanke lower U.S. interest rates, or won't he? That's the million-dollar question.
But the frenetic press coverage fixates on the moment and misses the big picture. The really important question isn't a quarter-percent tweak in interest rates here or there, it's the condition of the U.S. economy - still the biggest in the world - after the smoke clears.
The crisis in America's subprime mortgage market was caused by homebuyers of dubious quality defaulting on their loans, and it turned into a liquidity crisis. That's how most papers have been describing the events of recent weeks. To ease the crunch, central banks pumped cash into the banks, at low interest rates, and the Fed lowered its discount rate at which it lends to banks.
The liquidity crunch naturally led to expectations - accompanied by strident calls - on the Fed to lower interest rates across the board, and soon. The expectations created a broad feeling that somebody is handling the problem, and that an interest rate cut would solve all the ills.
That feeling could be illusory. Doctors distinguish between treating the disease and alleviating the symptom, and dear reader, the liquidity squeeze is just the symptom. Treating it won't make the patient well, only more comfortable for a time. (The patient is the financial markets).
So what is the origin of the liquidity crisis and why is it just the symptom? Its origin is that U.S. lenders carelessly lavished loans on too many borrowers who couldn't afford to repay them, and in recent months it became glaringly clear that much of that credit couldn't be collected. The collateral backing the loans, mainly private homes, couldn't be sold either. That is the disease.
In the months to come, interest on loans already granted is likely to rise. That is because the bankers lent the money at low rates, which were to be revised upward over time anyway. But the result will be even more borrowers defaulting on their debts.
In short, nobody knows just how bad the problem is going to get.
Meanwhile, through derivatives, debt was packaged and repackaged. Among other things, investment funds bought weird and wild derivatives based on mortgages, including these subprime mortgages, and the risk became dispersed. But it didn't disappear.
The fear that major investment funds and investment banks own all too much of this doubtful debt has made regular banks leery of lending to them in recent weeks. So the banks cut off the credit that had routinely financed these funds.
The fear swamped the capital markets too. A lot of companies routinely obtain short-term financing by issuing securities to institutional investors. But now the fear stopped the institutionals from buying these securities, creating a liquidity crunch at the companies. They were reduced to borrowing from banks instead, which put more pressure on the banks. They just didn't have enough money to go around and found themselves in a liquidity crunch, so the central banks stepped in and lent them cash at low interest rates.
But make no mistake, the liquidity crisis is a symptom, and the disease is bad credit given to people who shouldn't have received it. The liquidity squeeze is not the cause of the crisis, so resolving it isn't the solution.
True, an interest rate cut could relieve the cash crunch and lift share prices, but it does nothing to resolve the issue of mounting bad debt. A rate cut can't help a bankrupt borrower to repay his loans.
In the last decade, interest rate cuts were how America attacked every financial problem that cropped up, and with every sign of a slowdown. In 1998 that's how it handled the crisis in the emerging markets, and when Long-Term Capital Management folded and sent shock waves throughout the global marketplace, that's what America did - it cut interest rates. It did so again in 2001 when the dot-com bubble burst, and yet again after September 11. And now it's probably going to respond the same way to the subprime meltdown.
But the medicine of rate cuts has side effects. One is rising inflationary pressure. Low interest rates lift demand, which in turn lifts prices.
Also, rate cuts are addictive. Consumers and manufacturers become accustomed to obtaining credit at a snap of the fingers. But like any addictive substance, the longer you take it, the more you need to get your high.
Moreover, economic considerations become skewed because in an environment of low interest rates, almost any investment looks good.
Those are the shaky legs on which an economic boom develops, and is destined to end in tears.
In an environment of low interest there is high probability that bubbles will form - in stocks, commodities, property, and speculators run rampant too.
Bernanke knows all this. To continue our medical metaphor, central bankers are like doctors contending with patients who demand morphine, even if that doesn't cure their disease and just has serious side effects. The central banker has difficulty refusing the pleas from investors and business leaders alike, not to mention the media and politicians.
But remember that U.S. interest rates aren't high. The Fed funds rate is just 5.25 percent and yields on 10-year treasuries are just 4.7 percent. That isn't an environment that creates recession: These are neutral interest rates that support economic activity, not contraction. The problem is that for too many years the American economy has relied on cheap credit. It's addicted and it's hard to restabilize it at "normal" interest rates.
Every time interest rates have started to creep up in the last decade, three or four times, the economy goes into withdrawal and screams for low interest rates. That inhibits the Fed from using interest rates as a monetary tool. The question is whether Bernanke has the grit to stand strong against the entire financial and political world and say, "Thus far, and no more."
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