Why the Fed and Obama Might Blow Up the Economy
Mar 22, 2009
Posted by Jody Eisenman | Filed under Uncategorized
“The economy continues to contract. Job losses, declining equity and housing wealth, and tight credit conditions have weighed on consumer sentiment and spending. Weaker sales prospects and difficulties in obtaining credit have led businesses to cut back on inventories and fixed investment.”
This is not my opinion. These are the words of the Federal Open Market Committee (FOMC) from their meeting last week. The Federal Reserve, which is the central banking system of the United States, is responsible for maintaining the stability of our financial system, as well as deal with banking crisis’s. This is also known as monetary policy. How do they do this? Basically, by raising or lowering the Fed Funds Rate (the borrowing rate that is offered to the private banking system) and by making money available by acting as a lender of last resort. Since June of 2006, the Fed had dropped the Fed Funds rate from 5.25 all the way down to essentially zero in December of 2008. The Fed does not like to lower rates this far, as it becomes powerless to make changes. You can’t go lower than zero. They have also provided billions by inducing congress to pass the TARP bill, which has injected hundreds of billions into the banking system. Without these bailouts, the banking system would have probably collapsed.
Unfortunately, these measures have not improved the economy. In addition, thanks to all the bailouts, as well as the stimulus package, our national deficit now exceeds 11 trillion dollars. If we think of this number as a percentage of GDP, we are approaching 80%. To put this in perspective, according to the CIA factbook https://www.cia.gov:443/library/publications/the-world-factbook/rankorder/2186rank.html, this would put the US among the the top 15% leveraged countries in the world. What many people fail to appreciate is that sooner or later, that deficit must be repaid. Fortunately for the US, interest rates on our borrowings (via treasury bills) has remained very low. This may change due to the the policy that the Fed announced last week.
All this spending, combined with a sharp reduction in interest rates, has failed to stimulate the economy. In fact, things are getting worse. Real estate prices continue to drop, the credit markets are weak and the unemployment rate continues to rise. Therefore, the Fed has decided to use a very controversial weapon; namely, they will try to stimulate the economy by purchasing long term treasuries. This is a very high risk strategy due to the fact that we are a debtor nation, and by pursuing this policy, we are simply printing money. Lets take China for example. The Chinese have been very large buyers of our treasuries. With the printing presses open, the dollar is getting weaker. Will the Chinese (and other countries) continue to lend money to the US by buying 30 year treasuries when the rate is around 3.6% and the dollar is dropping? I have my doubts. If foreigners decline to buy, the only alternative we have is to raise rates in order to get buyers in. However, by raising rates, we are actually providing a disincentive for US businesses to borrow, thus prolonging the recession. Clearly, this is a desperation move by the Fed. Combined with massive deficits, we could be looking at a highly inflationary environment in the years to come.
