As the stock markets predicted on Tuesday (with a huge bounce) the Federal Reserve is on a mission. The US central bank slashed its base interest rate to 1% last night.
That sounds low, but actually it’s not that long since US rates were at 1%. The last time they were at this level was only back in 2004. In fact, chronically low interest rates in the US are one of the main reasons that we’re in the current mess.
So you’d be forgiven for asking, how are they supposed to help now?
Let’s find out…
This recession will be worse than the one in the ’90s
British pundits are still trying to make out that this recession won’t be as bad as the one in the 1990s. This is clearly nonsense – the housing market pile-up alone is already worse than it was then, down 14.6% on the year, reported Nationwide this morning. It’s more a sign that we’ve reached a bit of a lull in the storm. People’s expectations have fallen a bit, we’ll adjust to that plateau, and then they’ll have to fall again.
Over in the US, however, they’re a lot gloomier – after all, they’ve had longer to get used to the idea of a massive slump. On Channel 4’s Dispatches programme the other night, hedge fund manager Hugh Hendry interviewed a number of economists who readily tossed in comparisons with the Depression as if it was perfectly obvious that times were the worst in nearly 80 years.
Of course, it won’t be as bad as it was then, they say. Federal Reserve chief Ben Bernanke has studied the Depression, they say. He knows what to do.
Cobblers. Bernanke might have studied the Depression for most of his academic life, but it looks to me like he was studying the wrong half of the Depression.
Put it this way, I wouldn’t want to put Bernanke in charge of road safety. His idea of efficient traffic management would be to impose ever-increasing minimum speed limits and then employ lots of extra morgue attendants and road sweepers in the hope that the carnage from multiple pile-ups could be cleaned up more quickly and so avoid traffic jams.
The point is, you have to tackle a bubble before it bursts. The longer you leave it, the worse the fall-out will be. And this bubble was left unmolested until it exploded all of its own accord. Anyone who thinks that lower interest rates are going to save us now will be sorely disappointed.
Why dropping interest-rates doesn’t work
One of the reasons that John Maynard Keynes recommended direct government intervention in the economy is that sometimes you reached a point where cutting interest rates was like “pushing on a string.” And we’re already past that point.
In normal times, cutting interest rates encourages extra borrowing because it allows people to borrow more money. But that assumes that people want to borrow. Now that the housing bubble has popped, demand for loans has slumped. Not only are people unwilling to borrow money to buy a depreciating asset, but those who own a house are stuck with the uncomfortable realisation that the ‘wealth’ they thought they had stored in their house is declining by the day. That doesn’t put you in the mood to spend.
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So regardless of how low you drop rates, people don’t want to borrow more. They want to pay back their debts. Meanwhile, lower rates also punish savers, making them feel insecure about their net worth, which encourages them to hang onto their cash rather than spending it.
If you don’t believe this, then just look at Japan. How successful was the zero interest-rate policy and massive government spending there? If 19 years of economic stagnation is your idea of fun, then yes, it worked very well. But most people would rather avoid that outcome.
The government will try to print its way out of debt
The reality is we borrowed lots of money – arguably too much – and now we have to pay it back, regardless of what the world’s governments and central banks would like us to do. It’s not that hard to understand. Lots of people don’t seem to like the idea, because it sounds moralistic. But it’s no more moralistic than pointing out that if you throw an apple into the air, at some point it will fall back down again.
So what do you do if you have big debts? You either repay them, which means you have to accept that your present-day consumption is going to fall as you pay for the consumption you borrowed from the future. Or you don’t pay them back at all, which results in a loss of status and assets, and usually means you’ll have a tough time getting more loans in the future.
Of course, there is one other option. You could print counterfeit money in your back garden and pay your creditors back with that. As an individual, if you do that, you’ll be arrested. But as a government, you can print away to your little heart’s content. And the bigger the player you are, the more likely you are to get away with it.
That’s clearly the Fed’s desired outcome. And if there’s any world government that can do it, it’s America’s. That’s why oil and other commodities bounced yesterday.
It’s early days yet, and deflation is likely to set in before we see anything else. But if the Fed has its way, inflation could make a comeback sooner than anyone expects.
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