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Low Interest Rates Are the Problem – Not the Solution

While politicians on both sides of the aisle go on cable news and try to deny their involvement in the current financial crisis and pretend that over the last eight years there was nothing that they could have done to prevent the circumstances that created the largest structural meltdown since the Great Depression. The reality of the situation is clear to those on the outside looking in. The current situation is a tragic combination of mismanagement and bad economic theory.

For the second time we have seen the theory of top down economics fail miserably. The value of the dollar has been gutted over the last eight years. Our international spending power has been cut in half. American assets are being bought by foreign companies and governments. The national debt has skyrocketed. All this with the party claiming to be “financially conservative” leading the way. Allowing financial institutions to attempt to self regulate has lead to a structural problem requiring the government (aka the American people) bail out the unstable banking institutions. For historic reference look back to the S&L crisis of the late 1980’s. Functionally this alone would have been enough to create a crippling recession.

This time we have had a much more disastrous scenario that hasn’t been seen since right before the crash of 1929, system wide use of excessive leverage. The underlying cause is different this time the result is well on the way to being the same.

As a reaction to the bursting of the tech bubble and the terrorist attacks on 9/11 the Federal Reserve lowered interest rates to stimulate the economy. Rates kept dropping, in a series of rate cuts they took the fed funds rate down to 1%. Hello real estate bubble! Fueled by low rates real estate became white hot. The low rates are good for those selling homes they are bad for the organizations carrying the mortgages. To provide their investors with returns lenders had to increase the volume of transactions. This means increasing leverage. With “normal” interest rates an investor could receive an acceptable rate of return lending money to homebuyers with out taking excessive risk. To achieve the same rate of return and keep investors happy loan terms were made “creative” and qualification standards were lowered and in some cases non-existent. Smart lenders turned around packaged the loans as “CDO’s” Collateralized Debt Obligations and sold to other investors. The return for buying CDO’s was low but it was significantly higher than traditional bonds and notes.

The low CDO returns led the Investment Banks that bought the CDO’s to use excessive leverage. Again this is to make their investors happy. Bear Sterns the first to fail was reportedly leveraged at 40 to 1. That means for every $1 that Bear Sterns had in cash they controlled $40 worth of financial instruments. When the market is going in your favor you look brilliant. A 2.5% move in your favor results in 100% return on your money. The flip side of the coin is 2.5% against equals a 100%, total and complete loss. That is exactly what we have seen. These investment banks that lead the S&P 500 rally on the way up are now crashing down.

When real estate peaked in 2006 and the creative adjustable rate loans started to reset in large numbers the only solution from the fed was start cutting rates again. The Bernanke fed was listening to Wall Street and the pundits to further kept rates low in a failed attempt to slow the bursting bubble. Looking towards the financial horizon rates are still extremely low prohibiting acceptable returns with out taking substantial risks.

The current financial crisis will take a long time to clear through the pipes. In the current election cycle one thing we will not hear from the candidates is a realistic fix because it is not politically viable. The necessary actions to solve the crisis make bad sound bites and the general public would never vote for. Not doing anything to stop foreclosures. Raise government revenues aka more taxes and drastically cutting government spending. Forgetting the phrase “too big to fail” and letting companies that made bad decisions go bankrupt, including AIG. Stopping the idea that less regulation is always better. Permanently ending excessively low interest rates by establishing a fed funds rate band of 6-9%. Stopping all attempts to micro manage the economy, stopping emergency fed rate cuts and having the Federal Open Market Committee (FOMC) meet only 2 or 4 times a year. Creating a strong dollar by slowing down the flood of new dollars coming out of the Federal Reserve. Permanently ending deficit spending even if that means taking a back seat to the UN or NATO in international intervention and abandoning the policy of preemptive war.

No easy politically motivated sound bites will fix the problems. As individuals we can vote for change and return to the days of personal financial responsibility. Bring personal financial education into the school system. Learn about debt and the responsible use of credit. Teach the ramifications of living outside your means.

All these steps will slow the massive but unsustainable economic growth the current system is built on. At the same time it will moderate the violent swings that we have seen in recent economic cycles. There will still be bull markets and bear markets how ever it will reduce the likely hood of another economic crisis of this scale.