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When the Fed cut rates to 1% a few years back, I believed they were borrowing growth from the future to mitigate the recession at the time, and that we would have to pay in the future, most likely with sub-par growth but possibly with a recession.

We may be paying for that policy now.

The Bubble that occurred in the late 1990s was not solely the fault of the Fed. In fact, it may not have been primarily the fault of the Fed, though certainly the Fed played a role. However, during the period 1996-1999, the forces which created a prototypical financial bubble as described by Charles Kindleberger were certainly evident, in particular the advent of new technologies and easy money. Easy money is prevalent in virtually all bubbles, but the role technology plays in the creation of financial bubbles is less clear.

As Marc Faber explains, new technologies have the effect of creating the illusion of limitless opportunities and, perhaps more importantly, of indefinite higher returns. The practical application of new technology is to lower cost curves of suppliers of goods and services. When costs are lowered, economic rent initially accrues to investors, i.e. returns on capital are higher than the cost of capital. In the attempt to capture the excess profits that accrues to investors, capital flows into the industry. That capital is used to build supply. Inevitably, as competition increases, prices fall, excess profits are competed away and the value generated by the new technology shifts from the investor to the consumer in the form of lower prices.

In a nice sanitized world, capital would flow into the industry until the marginal cost of equals the marginal return on capital. This, being a world inhabited by human beings, often does not occur. Instead, swept up by greed and over-estimating both the opportunities and their own abilities, people invest too much and create excess supply, which can lead to deflation.

This describes the world in 2001 and 2002, especially relating to the technology industry, which was in the midst of a true economic depression.

The wise and learned men and women of the Federal Reserve System were acutely aware of the havoc over-investment and deflation can wreak upon an economy, witnessed by the economic morass in Japan, which has yet to fully exit nearly two decades later. As a policy response, the learned and wise men and women opted that they would do whatever they could in their power to avoid a Japanese-style deflationary spiral, and cut the Fed funds rate to 1%, a rate not seen in many decades.

The policy worked, at least as a targeted response to avoid a deep, deflationary recession the Fed was so desperate to avoid. As the economy began to grow again, politicians and central bankers gladly patted themselves on the back over deftly avoiding Japan 2.0.

However, as we all learn in our formative years - especially those of us who are male and partook in the self-gratifying, hedonistic activities of college - actions often have unintended consequences. And today, we are awakening from the long party the night before, where we continued drinking in hopes of avoiding a hangover. Now, we are wondering where the heck are we, how did we arrive here, who is that, and please God, I hope nothing happened?!

The decision we currently are facing is whether or not to sober up or to reach for the bottle once again.

The major unintended consequence of the Fed's floor-level interest rate policy was to inflate a housing bubble, one economists, central bankers, investment analysts and homebuilder executives went out of their way to rationalize the causes as fundamental. Excessive global savings, the fall of the Berlin Wall, immigration, financial engineering, aging Baby Boomers, and everything other than the creation of excess monetary balances were reasons given.

As is characteristic of every other financial bubble - think "pro-forma earnings" and Talking Sock Puppet companies bleeding mountains of cash c2000 - excesses were over-looked and explained away during the housing bubble, with the conventional wisdom offering that No Doc, Liar Loans would not be a problem because "housing prices never go down," and homes could be sold for a profit if borrowers ran into financial difficulty.

So, today the financial system is sitting on perhaps a trillion dollars worth of mortgages that are worth less than par, secured on homes that are falling in price by as much as 30% in places like Ft. Myers FL. Financial stocks are getting pounded as the market comes to realize the problems will not be resolved in a quarter or two, and that there is a giant hole on the balance sheets of many financial institutions, some of which will not survive.

The solution? After two decades of being trained to respond as such, the Pavlovian response from Wall Street is to scream for the Fed to interest cut rates. And why not? It has worked before. Never mind the consequences later, deal with the problems now.

Cutting rates is not necessarily the incorrect response. Despite the latest better-than-expected GDP release (pdf) from the BEA - which stated that inflation was at a 44-year low as oil approached $100 - the economy is slowing. But with cheaper money, the issue of unintended consequences is arising again. On Wednesday, the market fell on news that China may not be so eager to hold our currency any longer, a perfectly rational response despite the ego-centric perma-bulls who decry in disbelief the notion that others may not wish to hold a plummeting asset.

Now, as market commentators plead for more rate cuts and admonish the Fed for not cutting further on Hallowe'en, as the earnest and highly respectable Ron Insana did so on Bubblevision Wednesday afternoon, we find ourselves in a box. If we continue to cut interest rates, we risk further dollar weakness, which could lead to accelerated selling of American financial assets by foreigners, or at least not purchasing our paper at the rate they have done so in the past. If we don't cut rates, we risk a recession and stress, perhaps extreme stress, in the financial system.

However, like the unwinding of the technology bubble, cutting rates will not solve the problems in the housing market nor the mortgage market. It may alleviate stress on the financial system somewhat by allowing financial companies to re-liquefy their balance sheets. But the most likely benefactors of continued rate cuts will be assets already hot, such as commodities, Chinese stocks and the Googles of the world.

Cutting rates will be the chosen course of action, I believe. And once again, if the policy works - a big "if" - we will be dealing with even bigger unintended consequences four, five, six years hence, though central bankers and politicians will continue to pat themselves on their backs whilst laying blame on the problems of the future on others.

In the mean time, I am net short.

Source: The Fed Rate Cuts: Do They Really Help the Economy?