Sunday, August 5, 2007

Uncle Alan's Legacy at the Federal Reserve

This week, on Tuesday (August 7, 2007), the Federal Reserve Open Market Committee meets to decide where to set the Fed's target for the federal funds interest rate. That is the rate that heavily influences other short term interest rates. The consensus expectation is that the Fed is going to hold the fed funds rate steady at 5.25%, where it's been for a year.

There are some that would like the Fed to lower interest rates. They point to the turmoil in the debt markets, especially the market for mortgage backed securities, and argue that lowering rates would boost investor confidence and give relief to financial institutions that now face significant potential losses. Further, the simple arithmetic of investing dictates that lower interest rates mean that equity investments like stocks will automatically become more valuable. Given the 6% drop in stock prices since the Dow Jones Industrial Average hit its peak a little over two weeks ago on July 19, 2007, and a 281 point drop last Friday (8/3/07), stock investors wouldn't mind a little extra octane in the financial system.

On the other hand, the Fed continues to see inflationary risks. While gasoline prices have eased off a bit in recent weeks, they remain high, as do crude oil prices. And food prices have been rising nastily (check out bread and milk, for example). Moreover, the economy remains steady, and unemployment is comparatively low. Productivity growth has tailed off from the high levels of the 1990's, which means that increases in labor costs are more likely to be covered by increased prices than by more production per employee. The first increment in the federally mandated minimum wage increases became effective on July 24, 2007. This, along with other wage and salary increases, could have inflationary effect.

Most importantly, the American consumer continues to do yeoman's duty at the mall. Surveys of consumer confidence indicate consumers have yet to meet a sale they don't like. Even though gas price increases have reduced spending for some other items, and stagnant or dropping home prices now limit the ability to spend one's home equity on cheese curls and DVDs, Americans on average have a negative savings rate while keeping steaks and shrimp on the dinner table.

Consumer spending constitutes 70% of the U.S. economy. It's the locomotive that pulls the rest of the economy along. If consumer spending stays strong, the Fed won't be strongly inclined to lower interest rates. Even if the Fed has to arrange a bailout of financial institutions as a result of the mortgage market's belly flop, it might keep interest rates steady in order to tamp down any inflationary sparks. If, however, the consumer loses momentum, then the Fed will find the going toughter.

Will the consumer keep spending? The evidence is mixed. Numerous statistical studies indicate that median household income in America has hardly risen in the last 30 years. And, as we mentioned, savings rates have been going negative (which means people are spending their savings, not adding to them). The rich have been getting richer, but even then they can't buy all the . . . well, stuff . . . that retailers have been selling. So where the heck have consumers, with their hardly rising median incomes, been getting the smackeroos for their flat screen TVs, $2,000 grills and $40,000 kitchens?

The answer is two-fold: (a) debt and (b) equity. The debt in this case is credit card and other consumer debt. Consumer debt reaches new record levels with each passing year. This debt is funded to a large degree by the packaging of credit card debt into pools of loans that are sold to investors. This is essentially the same process by which mortgage loans are packaged into CDOs and sold to investors. And investors have been willing to buy credit card debt for the same reasons why they've bought mortgage loans--the availability of easy money and the idea that if it's risky, that's good.

The second source of consumer money--equity--includes equity from stocks and home equity. The equity in stocks came in the late 1990's, with the dot com stock market boom. A lot of people stopped saving then, and went on a spending spree because the increased value of their stocks made them feel wealthy. When the stock market went bust in the early 2000's, this feeling could have gone bust. But it was immediately propped up by the real estate boom that began around 2000, which offered the potential to convert one's home equity into shoes, cars, pizza, football tickets, imported vodka, and a never-ending array of portable electronic devices. The real estate boom, as we now realize, was instigated to a large degree by an array of confusing but eagerly underwritten mortgage loans containing time-delayed fuses that blew up on the borrower two or three years later with unmanageable payment increases. These poorly conceived loans, remarkably, were sought after in the mortgage markets for packaging in CDOs that were avidly bought by hedge funds and institutional investors, often using borrowed money. As we discussed in our earlier blog (, easy credit made all this possible.

Easy credit was the key, and easy credit was the product of Federal Reserve policy. Let's take a look at history. Shortly after Alan Greenspan became Chairman of the Fed, the markets crashed on October 19, 1987, dropping 22.68% in one day. Not an easy introduction to the Chairman's job. Chairman Greenspan made clear that the Fed would supply liquidity to the banking system in order to prevent any financial panics. He eased interest rates, which soothed market fears and instilled confidence that the Fed was on the job. His quick action helped prevent a larger market meltdown, and the market eventually rallied to boom into the 1990's.

Lowering interest rates became a Fed response to adversity. When the economy slid toward recession in the early 1990's, the Fed lowered interest rates. When the stock market bust of 2000 began, the Fed eased interest rates. In the aftermath of the 9/11/2001 terrorist attacks, the Fed lowered interest rates. And, throughout the 1990's and 2000's, the Fed kept interest rates at historically low levels. This willingness to keep the cost of borrowing low and lower helped to prevent financial panics and recession. But it also allowed increasingly large amounts of credit to become available. People grew accustomed to the idea that if bad things happened, the Fed would lower interest rates and bail them out. So they became more reckless. This is the moral hazard problem that we've discussed before.

Chairman Greenspan's success at keeping things on a relatively even keel made him as much of a hero as an economist can become. He was famously ambiguous, expressing three or four thoughts in two sentences or less whenever pressed by Congress on important questions. That way, he left his options open. But he sounded confident, which was all that seemed to matter. Over time, he became an avuncular figure, whose bow-tied social appearances were as likely to be reported in the society pages as his enigmatic ramblings were to be reported in the business pages.

Part of his legacy, however, is the vast pool of easy credit that has roamed throughout the world economy in recent years, creating bubbles in the stock, real estate, debt, commodities and derivatives markets. These bubbles, like all bubbles, have popped. There is no question that Greenspan's intentions were the best--he wanted to prevent economic downturns. And he largely succeeded. By all appearances, he was aware of the risks of too much easy money, and tried to raise rates to reduce the bubbling. The stock market downturn in 2000 was preceding by Fed rate increases, and the real estate and mortgage markets downturns in 2006 and 2007 were preceded by a series of Fed rate increases that Greenspan started in June 2005 (which Chairman Bernanke continued for a few Open Market Committee meetings in the first half of 2006).

But Chairman Greenspan may have misjudged the extent to which Wall Street, government policy makers, investors, and others would come to rely on quick injections of credit to fix economic problems. When things go wrong, there's a tendency now to expect the government to fix problems. Conservative that he is, Greenspan nevertheless fueled this tendency with his adroit interest rate adjustments. In so doing, he created moral hazard that he surely would not endorse.

This is a part of his legacy that now confronts Chairman Bernanke and the other members of the Open Market Committee. One strongly suspects that Chairman Bernanke would like to wean the financial markets off their expectation that the Fed will cure all of their boo-boos. The more the U.S. and the world economies depend on governmental monetary policies to function, the less well they will ultimately function. Wealth--as in the wealth of nations--cannot be built on inflating asset values or financial engineering. The Dutch found this out a few centuries ago in their dalliance with tulip bulbs. Wealth is built on innovation, investment and productivity. Yet, much of the U.S. economy has been propped up in recent years by easy credit and the resulting asset bubbles and the financial engineering that easy credit fosters. While houses don't usually resemble tulip bulbs, exceptions could have been found in the ARM-drenched real estate markets of a few American cities at the height of the recent lunacy.

Easy credit is now becoming a thing of the past. Mortgage borrowers are actually being asked to demonstrate that they have a modicum of creditworthiness. Real estate values have stopped rising and could be dropping, so the home equity gravy train has slowed to a crawl. As investors in the debt markets pull back from all varieties of packaged debt, credit card borrowers may find it harder to get new or higher credit lines. The booze for the consumer party is running low.

Will consumers curtail spending because of the subprime train wreck? Not if they can help it. CDOs and hedge funds are far removed from the daily lives of most people. The losses from the subprime mess have thus far appeared to fall on Cartier's clientele much more than on Wal-Mart's. Bentley dealers in the New York metropolitan area may be concerned, but Toyota dealers probably aren't. In spite of recent stagnation and losses in home values, consumers armed with their debit and credit cards have continued to charge ahead, disregarding the cannon to the right and the cannon to the left.

But if the subprime mess metastasizes into the broader economy, the Fed may be forced by the moral hazard of its own creation to lower interest rates once again, even if doing so fuels inflation or creates more easy credit to bubble around in future years. Only once in the last 30 years has the Fed truly held the line and asked American financial institutions, investors and consumers to act like adults. That was in the early 1980's, when Chairman Paul Volcker and the Fed of that era raised interest rates and triggered a sharp recession that squeezed the nasty inflation of the 1970's out of the economy and laid the foundation for the prosperity of the last 25 years. The American public of the Volcker era still had vivid memories of the Great Depression and World War II, and understood that sacrifice was sometimes required to make the world a better place. That principle hasn't changed, but does today's American public--which has never met a sacrifice it didn't admire someone else for making--understand it?

Crime News: now, you can't even trust the ice cream vendor.

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