Maybe another rate cut will cure everything. Markets, spooked by sub prime losses hidden throughout the banking system, rose yesterday, encouraged by signals the Fed will cut another 50 basis points (on top of the 75bp cut last week). Lower borrowing rates allow banks to rebuild balance sheets shredded by imprudent lending.
This medicine has worked before. Back in the late 80s, after a previous round of imprudent lending, with bank balance sheets in tatters, Alan Greenspan drove down short term interest rates, while allowing long term yields to stay high. Just by borrowing short and buying Treasury bonds (as safe a strategy as possible) banks captured a huge spread and cured what ailed them. A bank could borrow at the Fed’s discount window at 3% and turn around and use that money to buy a long-term bond from the Fed earning 8%. In effect, the US taxpayer bailed out the banks. We are about to do it again.
The cause of the current crisis, as we all now know, is the bad debt hidden throughout the world financial system due to the securitization of sub prime mortgage loans. The rash of NINJA loans to people with No Income, No Job or Assets can be blamed securitization, on the inevitable moral hazard when the man who writes the loan doesn’t expect to own it for more than a week or two before he bundles it off and sells it to yield hungry investors, but more than anything, NINJA loans can be blamed on booming house prices and the conviction so many of us had that prices could never go down.
And what made house prices skyrocket? More than anything else, it was incredibly low interest rates. Back in 2000, when the Internet bubble popped, Alan Greenspan, fearing that a declining stock market would infect the rest of the economy cut rates to the lowest they had been in 40 years. Fearing the dissolution of one asset bubble (in stocks) he fomented another (in homes).
So low interest rates, the cure for our current crisis, happens to also be its fundamental cause. The cliché everybody knows about central banks, that they take away the punch bowl just as the party gets going, that is to say they raise rates when growth threatens to become inflationary, is out of date. Now, it seems, their purpose is to bring the punch bowl out whenever financial markets get nervous.
Businessmen and financiers love to talk about the free market when times are good, when profits are rising, but whenever they are in trouble, they shamelessly squeal for help, taking more taxpayer money than all the welfare mothers put together. The government and the Fed have bailed out the financial sector over and over, in 1982 during the Latin American debt crisis, in the mid 80s with the Savings and Loans, in the late 80s with the collapse of junk bonds, in 1994 with the Tequila crisis, in 1998 with Long Term Capital Management.
In the 90s, financiers and traders talked about the "Greenspan Put", the belief that if the stock market declined, Alan Greenspan would ignore his Ayn Randist ideals, and cut rates to bail them out. Confidence that Greenspan, like a stock option to sell at a fixed price, put a floor under their possible losses, naturally (moral hazard once again) encouraged more risk taking. The job of the Fed today seems more to provide a safety net for financiers than inflation fighting.
It used to be, back in the Golden Age of economic growth, the years the French call La Trente Glorieuse, the thirty years of prosperity after World War II, the years of unsurpassed economic growth, the period 1945-1973 when the nation’s wealth flowed towards the middle class and the poor, not the top 1%, our central bankers, men who had lived through the Great Depression, saw maintaining full employment as their primary responsibility. The real economy of goods and services, the economy of wages that most of us live in was the main concern of our economic policy makers.
That changed in the 70s. The 70s marked the end of the thirty glorious years. Economic growth stagnated. Inflation rose. The 70s were terrible years for the holders of wealth. If they put their money into the bank, the interest they earned was less than inflation. The stock market lost 3/4 of its inflation-adjusted value from 1966 to 1982. In real terms, saving money was a losing proposition.
Workers however didn’t do so badly. Wage inflation exceeded price inflation so the working stiff continued to prosper. During the Golden Age, the rich got richer, so they didn’t mind that the poor did too. In the 70s, with growth stalling, the economy began to seem like a zero sum game. Paul Volker, the Fed chairman, a blunt and honest man, said that curing the economy required a decline in the living standards of ordinary Americans.
The 80s, Volker/Reagan, was the counter attack of capital. Paul Volker, perhaps the most influential Fed Chairman ever, raised interest rates until the economy screamed. To wipe out inflation he engineered the most brutal recession since the 1930s. Unemployment skyrocketed, as did bankruptcies. Volker didn’t flinch. Workers fearing for their jobs don’t ask for higher wages. Inflation, driven mostly by wage pressure, finally came down. When Volker finally cut rates in 1982 (not to help bankrupt businesses or unemployed workers, but to bail out the banks and their Latin America debts) the stock market began its long boom.
Even our best years of growth, in the 90s under Clinton, do not match the record of the Golden Age 1945-1973. And while back then, for every 1% productivity growth wages went up 1.2%, today productivity growth raises the income of only the richest among us. Median male real wages are lower today than they were in 1973. In the Golden Age, average Americans doubled their income in a generation. Today, it takes two incomes to maintain a middle class lifestyle that back then required only a man working 9 to 5. Most of us work harder and harder while the only the rich get richer.
This, I would suggest, explains our economy’s addiction to cheap credit. Any businessman knows it is demand that fuels growth. Making stuff is easy, selling it is the hard part. Growth in the Golden Age was a byproduct of increasing prosperity. As wages rose, so did demand, creating a virtuous circle.
Today, with wages stagnating, the world economy needs Americans to go into debt to keep demand high. We live in a world of private sector Keynesianism. While John Maynard Keynes saw government spending, for infrastructure, for safety nets for the poor, as the cure for the Great Depression, today our economic policy makers need us all to go deeper in debt to keep the economy growing. Who prospers? The banks. In the Golden Age interest payments were less than 1% of GDP. Today they total 16%.
Will rate cuts work again, as they did in 2000, when Greenspan feared that the end of irrational exuberance for dot.com shares would plunge the real economy into a deflationary spiral? Perhaps, although rising commodity prices indicate the low inflation era may be coming to an end. Also, low US interest rates will push the dollar lower,possibly reducing foreign desire to keep lending us money to fund our consumption. By cutting rates every time markets get nervous, central bankers have been like plungers at Monte Carlo, doubling their bets when they are down. So far they have been lucky. Let us all hope they are lucky again.
But maybe, progressives should remember what worked in the Golden Age. Back then, higher wages made prosperity trickle up. The trickle down economy post Reagan has not made the average American wealther, or made our country stronger. Debt fueled consumption is not a long-range strategy for prosperity. Higher wages, perhaps backed with stronger unions may well be.