Of Interest Rates and Debt
As I write, the media is celebrating the Feds dramatic cut of 0.5% in the federal funds interest rate (the rate for lending by the Federal Reserve to banks). The comment is uniformly positive: the cut will boost the stock market, restore sagging corporate profits and maybe get consumers spending a little more.
This pseudo analysis is about as far as our media is prepared to go. We are not told why lower interest rates have this effect. Perhaps it is assumed that the average reader knows the connection but this is surely not the case. Such an analysis could not avoid exposing the vast underbelly of debt that sustains and jeopardizes our economy.
For the simple truth is that lower interest rates make it easier for individuals and businesses to borrow and to carry existing debt. If our society were not so deeply in debt, interest rates wouldnt matter very much. Because we are so heavily indebted, they matter a great deal. The long expansion of the last 20 years interrupted in 199092 has been possible only because of an enormous increase in debt by individuals, businesses and governments. The most dynamic economy that of the U.S. is the most indebted. Since the privatization of money creation in the 1970s, the credit needed for economic growth must come from borrowing. Prosperity can only continue if enough people are able and willing to borrow more. It is all well and good for governments to pay down the debt, but they can only do so if individuals and businesses incur ever more debt. In the end it is all a confidence game that can go on only as long as borrowers are willing to put up collateral, and banks are willing to monetize those assets. However, there is every indication that the consumers have reached the limit of their borrowing capacity.
The Wall Street journal (4/01) records an enormous increase in corporate defaults over the past six months. Since debt service is now such a large component of corporate costs, even a small decrease in sales can spell disaster. As companies default on debt, bank capital is eroded. The Bank ofAmerica for example, is on the hook for over $1 billion in loans to California utilities. It is possible for banks to hide their liabilities for a while but there have been repeated warnings that the banks are overextended. For the past year, the banks have responded by raising the bar, i.e., making it more difficult to borrow. That in itself explains much of the current downturn.
While we cannot know the exact state of the banks, we can assume that Alan Greenspan does know, and therein lies the real explanation for his sudden move. It is doubtful that the Fed was motivated by the plight of the consumer, or even by the speculator, but the Fed has always moved quickly to rescue the banking sector. For a serious banking crisis in the U.S. a la Thailand, or Mexico, or Russia or even Japan would plunge us into a serious depression.
The question of the hour, of course, is whether Greenspan and Co. can pull it off again by astute manipulation of the monetary levers. By pull it off I mean avoiding the collapse of the banking system. There can be little doubt that he has successfully finessed a number of financial crises which could have brought the credit pyramid tumbling down as it has elsewhere. Those disasters, ironically, have extended the U.S. credit boom by increasing the flow of funds to the U.S., but a long overdue drop in the U.S. dollar would reverse that trend quickly. The Fed is trying hard to keep a lot of balls in the air simultaneously. How much longer can the confidence game continue?
What is certain is that all the maneuvers do not solve the root problem. The debt continues to rise and with it the cost of the interest payments. A reduction in interest rates may help to keep the game going a little longer, but as long as interest rates exceed the rate of economic growth the debt much increase. How much debt can a society sustain? The Fed has got us past the record set in 1929. How much farther can they go?
--from Economic Reform, February 2001