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The trouble with easy money... revisited, after 7 years
ALMOST exactly seven years ago, I wrote a column saying that the approach the Fed was adopting then to save its banks by slashing interest rates to zero and printing money would only provide short-term relief. I also said that thinking out of the box might be the correct way forward (eg maybe a rate hike was needed to encourage savings and discourage a reliance on borrowing) though I have to admit that I did not seriously think this advice would ever be heeded. Back then I believed - as I still do - that flooding the market with easy money and pushing up risky assets may offer respite for a while but it cannot be an optimal solution to deep-seated cracks in the system. I thought that problems would surely arise fairly soon - and it certainly looks that way now.
In today's BT and ST, I came across a few articles saying that markets are now leery of central banks' ability to stave off disaster because of the diminishing impact of each rate cut and monetary injection. For example, the Bank of Japan pushed interest rates into negative territory and the yen has shot up, whilst the Nikkei has collapsed more than 7 per cent in two days. European banks have plunged even though Draghi has promised more money pumping and Wall St is rocking on its heels, worried about whether the Fed would have to cut rates just after raising them.
My worry now is that a prediction I made in 2009 may play out - that the inflated blip from easy money fizzles out and is quickly followed by an even worse downturn.
Was I right to be concerned? You be the judge. Here is the commentary "US stimulus plan a repeat of past mistakes'' which was printed on BT's page 2, Wednesday Feb 25, 2009.
Former British prime minister Winston Churchill once famously said: “Those who fail to learn from history are doomed to repeat it.”
In trying to repair the damage wrought on the US economy by the sub-prime crisis, the American authorities may end up doing more long-term damage than good because they seem bent on following the same steps taken by their predecessors in the hope that they can engineer a quick return to how things were before the crisis erupted.
Unfortunately, there is plenty of reason to believe that the present US stimulus package could well turn out to be a disastrous mistake.
Although opinions are divided on how best to mend the US economy, there seems to be general agreement over the need to “fix the financial markets” in order to “get credit flowing”, which will then “kick-start the economy”, as if one follows the other in logical fashion. But should credit drive the economy, or should the economy drive credit?
In a properly functioning system, credit/money should be viewed as any other product of that economy – a commodity that has prices determined by supply and demand.
Those prices, or interest rates, are set by market forces with minimal intervention from central banks. If economic activity is robust, there will be sufficient competition for credit, which should then ensure money is channelled to its best possible uses.
The present crisis was almost a decade in the making and was founded almost entirely on easy, artificial and non-market-determined credit. It started when former Fed chairman Alan Greenspan slashed interest rates 12 times between 2000 and 2002 to near-zero to try and pump-prime America out of the dotcom recession, and it gained unstoppable momentum when the resultant lax lending then inflated a huge debt bubble whose most visible manifestation was in the property market.
This then attracted millions of low-income or sub-prime borrowers who technically did not qualify for loans but were granted them anyway because they either lied about their finances or got their bankers to lie on their behalf in order to speculate in property.
The collapse in sub-prime debt, however, was only the tip of the iceberg. According to the US Federal Reserve, total US consumer debt, which includes credit card and non-credit card debt but not mortgage debt, reached US$2.55 trillion at the end of 2007 (2008’s figures are not available yet).
Savings on the other hand, are poor; in 2006, the average savings rate fell into negative territory for the first time in almost 70 years and although it has now improved slightly, in 2009 is estimated to be no more than 3-5 per cent of income – less than half the 10 per cent level it was in the 1980s.
In short, the American consumer is hugely reliant on debt but has virtually no savings.
Crucially, it is this that is the crux of the problem and arguably not the crashing real estate market; the fall in property prices only precipitated the crisis but it is massive indebtedness with no savings backup that lies at the root of the present US economic mess.
This conclusion is not new. US fund manager Robert Albertson in the Feb 16 issue of US newspaper Barron’s spoke about the need for a savings, not stimulus, plan; economics professor Ravi Batra in his 2005 book, Greenspan’s Fraud, warned about an impending worldwide collapse from America’s over-reliance on debt; while in December 2007, Morgan Stanley’s Stephen Roach said that the Fed needs to rethink its “reckless, bubble-prone policy” and that the only hope of breaking the endless but lethal chain of inflating bubbles is by raising, not lowering, interest rates.
All of these warnings have fallen on deaf ears and instead of addressing the fundamental problem, which is the over-reliance on debt – at the very least by coming up with ways of encouraging people to save and reduce their reliance on borrowed money – the present approach seeks to get people borrowing and spending again, on the assumption that borrowing/lending leads to increased economic activity, when in reality it should be the other way around.
The fundamental problem is that in the hands of officialdom everywhere (not just the US), monetary and fiscal policies are simply euphemisms for debt creation. So when a crisis strikes, the policy responses always follow the same, standard prescription: cut interest rates and keep cutting until they get to zero; print money; slash taxes; get credit flowing; put money in the pockets of the public so as to get the consumer spending again – pretty much what the present US stimulus plan aims for.
Never mind that it hasn’t worked in Japan for many years and never mind that it hasn’t worked yet in the US, because eventually if you throw enough money at the economy, things must surely pick up.
The problem is that even if there is a recovery later this year, it might only be a short-term, artificially inflated blip that could very well taper off quickly to be followed by an even worse downturn.
You’d have to wonder if investors know this and are very worried – Wall Street dived immediately after the stimulus package was announced and is now almost 20 per cent down since the beginning of the year.
We believe that all accepted wisdoms have to be jettisoned in favour of different, out-of-the-box solutions.
It might be that interest rates and corporate taxes have to be raised instead of lowered. Perhaps a vast, long-term plan installed to reduce the multi-trillion-dollar deficits and wean everyone off the over-reliance on credit.
Whatever the case, the US should get back to the idea of the economy driving credit, not the other way around. For the measures as they stand are nothing more than plastering over the cracks – they have been used before and failed to yield results. To continue on the same path dooms the US to fail again.