How to save the US economy – ban saving

The Federal Reserve well and truly lost its nerve yesterday.

Just a week before a scheduled interest-rate meeting, Ben Bernanke and team decided, against a backdrop of plummeting global stock markets, that they couldn’t wait to cut interest rates any longer.

Rates were slashed by three-quarters of a point, to 3.5%. That’s the biggest cut in 23 years, and from a much lower base than rates were then. And it’s far from being the end of the cuts. Plenty of commentators now expect US rates to fall to 2.5% by April, which would put real interest rates firmly in negative territory (in other words, below inflation, thus penalising savers).

The move arrested the decline in markets somewhat. The FTSE 100 bounced back, and the Dow Jones had a much less brutal day than expected, falling ‘just’ 128 points at 11,971, compared to an early collapse of 465 points.

But can the rate cuts save the economy from recession? I don’t think so – here’s why…

In the era of Alan Greenspan, the ‘Maestro’ who got us into all this trouble in the first place, the power of interest rate intervention acquired an almost mystical air.

Any crisis that came along seemed to be soluble simply by Mr Greenspan waving his magic wand and lopping off a quarter point here, a half point there. Tech bubble? Rate cuts. Terror attack? Rate cuts. Bond crisis? Rate cuts.

But let’s go back to basics here for a moment. Why is the Federal Reserve cutting interest rates?

Well, the USeconomy is very dependent on consumer spending. Therefore, to keep that economy out of recession, the Fed needs to boost consumer spending. So they’re trying to make credit cheaper, so that more people are able to borrow more money to keep spending. They’re so keen to do this, that they are willing to cut interest rates to below inflation. Let’s make this very clear – when real interest rates are negative, that means that your savings are being destroyed by inflation for every minute that they remain in the bank. That’s a big incentive to spend – negative real interest rates are one good reason that so many Chinese have been willing to gamble all their savings in the stock market, because there’s no point on keeping them in the bank.

Meanwhile, the USgovernment is also planning on giving consumers tax rebates – free money, in other words – in the hope that they’ll spend that too.

So all the interventions are basically aimed at one thing – get those shoppers out there spending.

In the era of Alan Greenspan, the ‘Maestro’ who got us into all this trouble in the first place, the power of interest rate intervention acquired an almost mystical air.

Any crisis that came along seemed to be soluble simply by Mr Greenspan waving his magic wand and lopping off a quarter point here, a half point there. Tech bubble? Rate cuts. Terror attack? Rate cuts. Bond crisis? Rate cuts.

But let’s go back to basics here for a moment. Why is the Federal Reserve cutting interest rates?

Well, the USeconomy is very dependent on consumer spending. Therefore, to keep that economy out of recession, the Fed needs to boost consumer spending. So they’re trying to make credit cheaper, so that more people are able to borrow more money to keep spending. They’re so keen to do this, that they are willing to cut interest rates to below inflation. Let’s make this very clear – when real interest rates are negative, that means that your savings are being destroyed by inflation for every minute that they remain in the bank. That’s a big incentive to spend – negative real interest rates are one good reason that so many Chinese have been willing to gamble all their savings in the stock market, because there’s no point on keeping them in the bank.

Meanwhile, the USgovernment is also planning on giving consumers tax rebates – free money, in other words – in the hope that they’ll spend that too.

So all the interventions are basically aimed at one thing – get those shoppers out there spending.

More stupid ways to get people spending

Well, here’s a suggestion. Why doesn’t the USgovernment set up a government-funded Department of Retail? It could hire professional shoppers, and then give them a big bag of money that they’d have to spend in the nation’s malls every week. If they missed their spending targets, they’d be fired. It’d be a tough job, but I’m sure they could find someone to do it.

These crack consumption troops would be there, ready to strike when the nation’s lazy unpatriotic consumers decided they’d spent a bit too much and just didn’t want any more flat-screen TVs or new cars.

Or why not just make saving illegal? Thriftiness has been seen as more of a vice than a virtue for nigh-on decades now, so it wouldn’t take much effort to re-brand ‘saving’ as ‘hoarding’. That’d get spending up.

These of course, are all stupid ideas. But then, so is the idea that slashing interest rates can somehow make your economy better in a painless, consequence-free manner.

I know I keep coming back to this, but no one else seems to be saying it. If you spend more than you earn yesterday, then that means you have to spend less today. If you go on a rampant decade-long spending binge fuelled by cheap credit, then that means you have to spend less for rather longer than just one day.

Once again. If the world’s central banks had wanted to prevent the hangover we’re facing, then they shouldn’t have happily been adding jet fuel to the punch bowl all the way through the boom. It’s too late now to do anything to stop the crash, and the fact that the Fed is panicking and the government is clutching at straws just proves that.

Bank of Englandlooks set to cut rates too

As for the UK– well, we’re pretty much in the same boat. Mervyn King warned yesterday that he may have to write another letter, maybe more than one, to the Chancellor later in the year. He clearly believes that inflation could be a problem.

But it’s also clear that he’s simply covering his back so that when inflation does go above target, he can say, “well, I did warn you.” And the reason he’s covering his back is because regardless of what happens to inflation, the Bank of England is going to cut interest rates. We’re all herd animals at heart – and just as with ordinary retail investors, when one central banker panics and runs, the rest of them get the urge to run right alongside him. Even if all he’s racing towards is the edge of a cliff.

There isn’t going to be a soft landing. That’s for sure.

So what does all this mean for one of MoneyWeek’s favourite investments, gold? You can find out from our commodities expert Dominic Frisby, on the MoneyWeek website here: What the US rate cuts mean for gold

Turning to the wider markets…

Stocks pull back losses following Fed cut

After opening with a sharp 239-point fall, London stocks were given an afternoon boost by the Fed’s emergency rate cut and went on to close up 161 points overall, at 5,740. The broader indices were also higher. For a full market report, see: London market close.

On the Continent, the Paris CAC-40 added 298 points to end the day at 4,842. However, the German DAX-30 fell 20 points to end the day at 6,769, although the index was much recovered from earlier lows.

Across the Atlantic, the Dow Jones pulled back from an opening slump of 465 points to end the day down 128 points, at 11,971, its fifth consecutive close in the red. Elsewhere, the tech-rich Nasdaq was down 47 points, at 2,292. And the S&P 500 was 14 points lower, at 1,310.

In Asia, stocks had bounced back from yesterday’s sell-off today. The Japanese Nikkei had added 256 points to close at 12,829. And the Hang Seng was up 2,332 points, at 24,090.

Gold rebounds on rate cuts

Cured oil was little-changed at $89.25 this morning, and Brent spot was at $88.41 in London.

After rebounding to $894.30 from a low of $849.50 yesterday following the Fed’s decision, gold had fallen back to $888.75 this morning. And silver was at $16.01.

In the currency markets, the pound was at 1.9606 against the dollar and 1.3416 against the euro, whilst the dollar was at 0.6842 against the euro and 106.19 against the Japanese yen.

And in Londonthis morning, commercial property developer Great Portland Estates plc. announced that the value of its assets fell 4.1% in the third quarter as the credit squeeze affected investors’ appetite for commercial property.

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