Wrong Economic Prescriptions for 2009

By Dr. K. Brad Stamm
January 22, 2009

The outgoing Bush White House and the incoming Obama administration appear to be only forward-looking regarding the financial crisis and not honestly evaluating the central reason we are having this economic catastrophe unparalleled in severity since the Great Depression. They are quite naively avoiding placing blame on government and financial leaders for past mistakes and, by doing so, are repeating the very policy decision that incited this collapse: unprecedented non-market interest rates that do not sufficiently reflect the risks inherent in the economy and assets to which they are tied.

Federal Reserve Chairman Ben Bernanke’s current policies should boost the economy and the markets in the short run. The Fed’s target rate for banks to loan to each other their excess reserves is close to zero, and the discount rate, the rate charged by the Federal Reserve for banks to borrow directly from it, is a mere 0.5 percent. These low rates have, and will, continue to generate massive refinancing of homes for those in relatively good financial standing who able to tap into the newly accessible credit. This expansionary monetary stimulus has the effect of increasing the disposable income of thousands of families and allowing businesses to pursue investments otherwise not financially viable.

However, a look back over the almost 16 years of uninterrupted economic expansion beginning in the 1990s should make it clear that what put us in our economic predicament were excessively low interest rates igniting over-borrowing by consumers, aggressive selling of loans by mortgage brokers and bankers, and increased speculation by “investors” brought on by the cheerleading of overzealous self-interested stock brokers. Artificially low interest rates are not a long run solution to this recession. There will be some relief in the form of increased purchases of new homes, more disposable income to spend on retail items, and a moderate improvement in the stock market, but low interest rates are not a panacea for our ailing economy. Giving a patient the same prescription that slowly poisoned her, resulting in a highly overblown real estate market, is economic policy malpractice.

There are two countervailing forces to the Fed’s low interest rates. First, the $7.8 trillion government spending package consisting of a combination of loans, direct investments and guarantees, plus the additional Barack Obama initiative of at least another $700 billion in infrastructure spending, will push the federal debt up to more than $12 trillion and possibly $13 trillion. This very large national debt will result in the classic case of what economists call “crowding out” in which the government is competing for the same dollars that corporations and the public are trying to borrow, causing interest rates to rise. Thus, the intended effects of the current manipulated lowering of interest rates to induce spending and growth will be dampened by higher rates caused by inordinate amounts of government borrowing and potentially exacerbated by the reluctance or inability of foreign nations to continue loaning to us due to the global nature of the slowdown. The other force potentially working against the lower interest rate and easy credit policies of the Federal Reserve is that the result of this quantitative easing could cause inflation, essentially outweighing or neutralizing the impact of the low target rates.

We must willingly endure the necessary pain to pay for the largely fabricated growth of the past 16 years in order to restore financial health to the U.S. and this process will likely take three to four years. The economy needs a slowly improving stock market of 4 to 6 percent growth annually based on corporate value directly tied to profitability and not speculation. Housing prices need a gradual increase in value reflecting market supply and demand, and not driven by expectations of rising prices, thus avoiding those fleeting and dysfunctional feelings of irrational exuberance. Lastly, the employment picture should be allowed to “heal itself” through adjustments in wages, movements toward more modern and sustainable business models, geographic shifts of labor, and structural shifts in the way we train and educate labor.

Thus, there needs to be a slow and somewhat painful recovery in these three areas: employment, the stock market and housing; the very same markets that the Federal Reserve, White House, and Treasury Department are trying to inflate through low interest rates and fiscal spending. This is the wrong remedy. These quick and expensive fixes, both present and future, will bring temporarily relief. But we need slow, steady growth, based on improvements in productivity and not a return to unrealistic consumer spending nor to numerous government works projects that will only directly benefit one or two industries.

Looking back at our mistakes is essential so that we can learn from them. In the Old Testament, Lot’s wife looked back at the cities of Sodom and Gomorrah and became a pillar of salt, possibly because she desired a self-centered lifestyle that is both unproductive and potentially destructive, and was not willing to be a team player with her family. However, looking back to learn from our mistakes while not revisiting them, whether individually, as a firm, or as an entire nation, makes good sense so that we can avoid those errors the next time we are challenged economically or morally.

Dr. K. Brad Stamm, Ph.D. is a professor of economics at Cornerstone University in Grand Rapids, Mich. He can be reached at [email protected].