Death by a Thousand Rate Cuts

Let's imagine for a moment that someone who earns close to minimum wage receives a credit card with a $150,000 spending limit. Excited by this newfound buying power and concerned that the credit card company might at any time change its mind, this person goes out and spends the full amount. However, since we all know that credit isn't free, the unlucky individual soon receives a bill for the amount spent. Of course, making minimum wage and having no savings, he or she can't possibly pay off the debt. In fact, this person can't even make the minimum payment. For several months the person tries to pay off as much of the debt as they can with little success.

At this point one of two things can happen. If the individual bought tangible goods that retain their value, such as jewelry or cars, the credit card company will confiscate the products and resell them with little or no loss for itself. In this case the owner of the credit card will be the loser since they will forfeit the money that they had already paid off. In another scenario the cardholder buys items that have no real value for confiscation, such as trips, services, and clothes. In this case, the big loser will be the credit card company that has nothing to confiscate and is unlikely to ever get back its 150K from the card holder.

But wait. Just before the cardholder is ready to default on the payments, he or she gets the same $150,000 credit offer from a different credit card company with an even better interest rate. The cardholder happily transfers the entire balance from the first credit card and disaster is averted. At least for one more month.

The above scenario is currently playing itself out in our nation's credit market. Only instead of credit card debt, mortgage borrowers owe their banks payments they can't make on real estate that isn't worth the amount of the mortgage. In other words, if the borrower defaults, they and the bank both lose big.

In order to prevent a catastrophe, the Federal Reserve has embarked on a strategy of large rate cuts. This week brings yet another round of rate cuts from countries around the world desperate to find a solution. But if easy credit and low rates got us into this quagmire why would anyone think that more of the same is warranted?

Surely, one of the goals behind low interest rates is to get the real estate market moving again. In that case the government would be happy to learn that September's existing home sales rose a more than expected 5.5%. Is that great news or what? Recovery here we come, right? Wrong. The rise in real estate transaction was also accompanied by a 9% drop in median home prices. In other words, panic selling. The volume at the stock exchanges has also been record breaking the last few weeks. But with large declines in value no one would dare call it a good sign.

So the government's plan is to keep the credit flowing for as long as possible, hoping that the real problem, real estate prices, will take care of itself. Of course, we know that this isn't likely to happen. Japan has had a similar real estate market slump for the last 18 years and their interest rates were for many years zero. In fact, their policies led to the creation of something called Zombie Banks - banks whose net values are less than zero but remain in business because of continuing government credit guarantees.

Do you want the government to continue to use your tax dollar to maintain an illusion of stability and to drag this crisis for years to come? I know I don't. I prefer a painful but short recession in which billions or even trillions of dollars in wealth are destroyed so that we can rebuilt with a practical and sound system, as opposed to a decade long decline. Alan Greenspan admitted last week that the traditional models didn't work, yet it seems that we are still going ahead with the old plan. Einstein is quoted as saying “the definition of insanity is doing the same thing over and over again and expecting different results.” He really was a genius.

Comments

[investor88:]

Genady has written an insightful article.

Easy money and low interest rates got us into this mess, yet we are using the more of the same to cure the ailment. Einstein's words of wisdom : insanity is doing the same things over and over again expecting different results. This is an interesting perspective which means that America may become another Japan.

2008 Oct 30 10:46 AM

[Deumlaokeng:]

Greenspan did not only concede that his models did not work, he was forced to confess that his most fundamental beliefs in the nature of mankind have been disproved, or in his own words "“Those of us who have looked to the self-interest of lending institutions to protect shareholders’ equity, myself included, are in a state of shocked disbelief". For an avowed Libertarian and devotee of Ayn Rand as is Greenspan, this confession is akin to the Pope coming out and announcing that there is no Jesus. Yet policy makers in DC are continuing to listen to this man who has clearly lost his way and who no longer has faith, and so as you say, they just keep doing whatever they did before as that is what animists do. Think of Randy Quaid's character in The Last Detail repeating endlessly "Namu Myōhō Renge Kyō".

2008 Oct 30 10:59 AM

[RiskAverseA...:]

What you are proposing is virtually declaring war on the U.K. The overriding objective of all the goofiness we are seeing is defending the greater bulk of OTC derivatives-based credit securities. Most of these originate in unregulated, offshore financial centers operated by Great Britain. The puppeteers there have never been a humble bunch. They will never humbly admit the errors of their ways. In fact, they still keep Edmund Burke in print just to prove what a bunch of stubborn, intellectually imbalanced crew runs the place. I guess one thing shocking is, given U.S. history, we have not already pulled the trigger. A bigger shock, though, is a Congress infested with such jellyfish as wouldn't dare.

2008 Oct 30 11:02 AM

[whidbey:]

It is not just failure to correct the real estate/financial errors, but the adding to the total cost that is the most heinous sin of the Congress. This year the total debt issued by US Treasury is about 4,800bn dollars. When the foreign central banks say "no" to buying more debt, the cost of our public debt must rise, steeply, and it will destroy all possibility of a recovery without a national default. You have missed the ultimate evil of those in cretins in Congress.

2008 Oct 30 12:29 PM

[pearl2k:]

So the point of TARP is defending "OTC derivatives-based credit securities....Great Briatain." Where can I read more about this? You're the first person I've read to posit this. Thanks.

2008 Oct 31 10:51 AM

[OctoberFaith:]

right here.

2008 Oct 31 08:52 PM