Steady As She Goes

While there has been some expectation that the Federal Reserve would have to begin raising interest rates to prevent inflation, the comments today by Ben Bernanke throw some cold water on that idea :

"Though we have begun to see some improvement in economic activity, we still have some way to go before we can be assured that the recovery will be self-sustaining. Also at issue is whether the recovery will be strong enough to create the large number of jobs that will be needed to materially bring down the unemployment rate. Economic forecasts are subject to great uncertainty, but my best guess at this point is that we will continue to see modest economic growth next year--sufficient to bring down the unemployment rate, but at a pace slower than we would like.

A number of factors support the view that the recovery will continue next year. Importantly, financial conditions continue to improve: Corporations are having relatively little difficulty raising funds in the bond and stock markets, stock prices and other asset values have recovered significantly from their lows, and a variety of indicators suggest that fears of systemic collapse have receded substantially. Monetary and fiscal policies are supportive. And I have already mentioned what appear to be improving conditions in housing, consumer expenditure, business investment, and global economic activity.

On the other hand, the economy confronts some formidable headwinds that seem likely to keep the pace of expansion moderate. Despite the general improvement in financial conditions, credit remains tight for many borrowers, particularly bank-dependent borrowers such as households and small businesses. And the job market, though no longer contracting at the pace we saw in 2008 and earlier this year, remains weak. Household spending is unlikely to grow rapidly when people remain worried about job security and have limited access to credit. " Ben S. Bernanke, December 7, 2009.

Several weeks ago the Federal Open Market Committee issued the following 3rd quarter statement :

"Investor sentiment toward the banking sector appeared to deteriorate over the intermeeting period. Bank share prices fell, with equity prices for large banks declining more than those for regional and smaller banks. Credit default swap spreads for large bank holding companies were about flat, but they widened for regional and smaller banking organizations. Market participants reportedly remained concerned about the earnings prospects for banks in an environment of weak economic activity and rising loan losses.

Debt of the private domestic nonfinancial sector appeared to have declined again in the third quarter, as estimates suggested that household debt edged down and nonfinancial business debt decreased. Consumer credit contracted for the seventh consecutive month in August, reflecting declines in both revolving and nonrevolving credit; issuance of consumer credit asset-backed securities also fell."

"The recovery appeared to be continuing and was expected to gradually strengthen over time. Still, most members projected that over the next couple of years, the unemployment rate would remain quite elevated and the level of inflation would remain below rates consistent over the longer run with the Federal Reserve's objectives. Based on this outlook, members decided to maintain the federal funds target range at 0 to 1/4 percent and to continue to state their expectation that economic conditions were likely to warrant exceptionally low rates for an extended period. Low levels of resource utilization, subdued inflation trends, and stable inflation expectations were among the important factors underlying their expectation for monetary policy, and members agreed that policy communications would be enhanced by citing these conditions in the policy statement. Members noted the possibility that some negative side effects might result from the maintenance of very low short-term interest rates for an extended period, including the possibility that such a policy stance could lead to excessive risk-taking in financial markets or an unanchoring of inflation expectations. While members currently saw the likelihood of such effects as relatively low, they would remain alert to these risks."

"The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels of the federal funds rate for an extended period." FOMC Minutes, November 3-4, 2009.

The information presented by the Fed seems to be that (1) interest rates will remain low for the foreseeable future, (2) despite the addition of significant amounts of cash (stimulus money) into the banking system, banks are still reluctant to loan the money, and (3) there is an "underutilization" of available financial resources. I believe the Fed is well aware of the danger to the banking system that is posed by these conditions.

Money is a tool of commerce, and like any other tool, is also a commodity. It is necessary to provide a conduit for exchange of goods and services. The value of those goods and services are subject to relative supply and demand. Rapid communications, enhanced transportation facilities, and better education have opened the way for competition in US domestic markets for goods and services produced in developing countries. Workers in those countries are likely to have lower demands for wages and benefits, and production in the marketplace shifts toward lowest cost and highest profit.

Consumption of goods and services in the US has changed. Prior to the financial market collapse, most American economic activity was undergirded by credit extended, to a large degree, on real estate, in markets which had been overdeveloped. The housing supply in the United States still exceeds demand; this is the reason for the decline in real estate prices and the large numbers of vacant dwellings that can be found in every major American city. To give an example, Census 1990 tables show that Summit County, OH had a 1990 population of about 515,000 with 211,500 housing units. The 2006-2008 projection tables indicate a population of 543,600 (up 5.6%) with 242,700 housing units (up 14.8%). Housing unit growth outstripped population growth in the county by nearly 3:1 over a decade and a half. When the smoke cleared, there were 8% fewer people per house in 2006-2008 than in 1990. Despite the increase in supply, predominant prices had risen from $60-75K to $100-150K in that time period. While this appears to fly in the face of the law of supply and demand, the underlying cause of the anomaly was the availability of easy credit and lax underwriting guidelines, coupled with a change in behavior whereby homeowners borrowed against anticipated future increases in home value in order to subsidize lifestyles that were beyond the means of their ordinary incomes.

Mr. Bernanke's concern about underutilization of the available financial resources is valid. It needs to be recognized, though, that no matter how one might want to demonize the bankers for not making credit more readily available to consumers when the rates are so low and the cash is so plentiful, they are being prudent. In fact, considering the current excessive overcompensation of American workers (by developing world standards), they are also being prudent in not lending to commercial enterprises to stimulate production, since the market for overpriced American goods is shrinking (and this despite the contraction in our balance of payments ratios).

The Fed's concern with respect to their policy possibly leading to "excessive risk-taking in financial markets" is valid. Supply and demand drives lending as well as buying (alas, how many times people have been warned that when they mortgage their home, they are selling it to the lender for the term of the mortgage!) and a shortage of mortgage funds in the conventional market always seems to bring out the unconventional lenders with a correspondingly higher interest rate to compensate for the increased risk. While the "official" interest rates promulgated by the Fed may be low, desperate borrowers may be willing to pay a premium for the use of money provided by unconventional lenders willing to gamble, a situation which could lead to an even more serious economic, or possibly even social, collapse further down the road.

Another serious consequence has to do with the nature of the banking business itself. Banks do not make money on deposits, they make money on loans. The wild profitability of banks during the period 2001-2005 was related to their profligate lending practices. If they do not lend money, they make no profit, and investors shun unproductive assets. The banks themselves may raise interest rates -- this is seen already in the credit card industry -- and once again expose themselves to inordinate risk-taking. Or, they may be replaced by other institutions. I would be willing to guess that in some parts of the country Islamic banks are starting to take up the slack. When reinforced by the power of money, Sharia Law puts on a very attractive face. But be aware; the situation in Dubai is instructive. There is a reason why slavery and debtors' prisons still exist in lands that utilize that type of economic structure.