Low interest rates are the problem, not the solution

While politicians on both sides of the aisle go on cable news and try to deny their involvement in the current financial crisis and pretend that for the past eight years they could have done nothing to prevent the circumstances that created the biggest structural collapse since the great Depression. The reality of the situation is clear to those looking on from the outside. The current situation is a tragic combination of bad management and bad economic theory.

For the second time we have seen the top-down theory of economics fail miserably. The value of the dollar has been eviscerated in the last eight years. Our international purchasing power has been cut in half. US assets are being bought up by foreign companies and governments. The national debt has skyrocketed. All this with the party that claims to be “financially conservative” at the helm. Allowing financial institutions to try to self-regulate has led to a structural problem that requires the government (aka the American people) to bail out shaky banking institutions. For historical reference, look back to the S&L crisis of the late 1980s. Functionally, this alone would have been enough to create a crippling recession.

This time we have had a much more disastrous scenario than has been seen since just before the 1929 crash, the use of excessive leverage throughout the system. The underlying cause is different this time, the result is on track to be the same.

In reaction to the bursting of the tech bubble and the terrorist attacks of September 11, the Federal Reserve lowered interest rates to stimulate the economy. Rates kept falling, in a series of rate cuts, lowering the fed funds rate to 1%. Hello housing bubble! Fueled by low rates, real estate became hot. Low rates are good for home sellers and bad for organizations that carry mortgages. To provide returns to their investors, lenders had to increase the volume of transactions. This means increasing leverage. With “normal” interest rates, an investor could receive an acceptable rate of return lending money to homebuyers without taking excessive risk. To achieve the same rate of return and keep investors happy, loan terms were made “creative” and qualification standards were lowered and, in some cases, non-existent. Savvy lenders packaged the loans as “CDO” Collateralized Debt Obligations and sold them to other investors. The yield on the purchase of CDOs was low, but significantly higher than that of traditional bonds and notes.

The low returns on CDOs led investment banks that purchased the CDOs to use excessive leverage. Again, this is to make your investors happy. Bear Sterns, the first to fail, was reportedly leveraged 40 to 1. That means for every $1 Bear Sterns had in cash, they controlled $40 worth of financial instruments. When the market is going in your favor, you look brilliant. A 2.5% move in your favor results in a 100% return on your money. The other side of the coin is 2.5% vs. equal to 100%, total and complete loss. That is exactly what we have seen. These investment banks that led the S&P 500 rally are now collapsing.

When real estate peaked in 2006 and creative adjustable-rate loans began to rebound in large numbers, the Fed’s only solution was to start cutting rates again. Bernanke’s Fed was listening to Wall Street and pundits to keep rates lower in a failed attempt to stop the bubble from bursting. Looking out over the financial horizon, rates remain extremely low, making it impossible to earn acceptable returns without taking substantial risk.

The current financial crisis will take a long time to clear up. In the current election cycle, one thing we won’t hear from candidates is a realistic solution because it’s not politically viable. The actions necessary to solve the crisis make bad sentences and the general public would never vote for them. Do nothing to stop foreclosures. Increase government revenue, that is, more taxes and drastically reduce public spending. Forget the phrase “too big to fail” and let companies that made bad decisions go bankrupt, including AIG. Do away with the idea that less regulation is always better. Permanently end excessively low interest rates by establishing a 6-9% federal funds rate band. Stop all attempts to micromanage the economy, stop emergency federal rate cuts, and have the Federal Open Market Committee (FOMC) meet only 2-4 times a year. Create a strong dollar by stemming the flood of new dollars coming out of the Federal Reserve. Permanently end deficit spending, even if it means taking a backseat to the UN or NATO in international intervention and abandoning the policy of preventive war.

There are no easy politically motivated snippets that fix the problems. As individuals we can vote for change and return to the days of personal financial responsibility. Bring personal financial education to the school system. Learn about debt and the responsible use of credit. Teach the ramifications of living outside of your means.

All of these steps will curb the massive but unsustainable economic growth on which the current system is based. At the same time, it will moderate the violent swings we have seen in recent business cycles. There will still be bull and bear markets, however it will reduce the possibility of another economic crisis of this scale.