What You Should Think About Interest Rate Cuts

October 28, 2007

“Start with the idea that you cannot repeal the laws of economics, even if they are inconvenient.”

–Larry Summers

Conventional wisdom in some circles holds that lowering interest rates is good for business. This week policymakers with the Federal Reserve will meet to discuss the prospect of a fresh cut. Though this only involves the rates charged to banks borrowing money within the system, it is true that lower rates there translate quickly into greater availability of credit for businesses and homeowners. It also translates into greater availability of credit for speculative investors, though some would call me an economic heretic for suggesting loose credit has any downside.

Yet promoting unsound speculation is not the only downside it possesses. Another is not so much controversial as it is ignored. When credit is loosened by lowering key Federal Reserve rates, supporting the American national debt becomes less rewarding. The long term consequences of cut after cut after cut include lower foreign faith in the traditional reliability of the American dollar’s value along with less willingness to support the ever-growing national debt.

Recently that debt surpassed $9 trillion. To put it another way, our federal government owes individuals, foreign governments and other institutions nine thousand thousand thousand thousand dollars. To put it still another way, the U.S. Treasury is on the brink of being $30,000 in debt for every person living within our borders. It is true that the sitting President inherited most of this debt. It is also true that the archetypical “compassionate conservative” conserved the nation into and beyond a 50% increase in the size of that debt.

So our government needs much more support to remain solvent, yet again and again the investment environment is shifted to lower returns on the most stable varieties of long term investments. Of course, this is precisely what the groupmind on Wall Street desires. The same warped thinking that raises stock values when a company becomes smaller by severing ties with human assets and often lowers corporate valuations in response to expansion of American operations also holds that interest rate cuts are always a good thing.

To get to the heart of this, I’d like to look to the words of John Bogle, founder of The Vanguard Group. In an appearance last month on Bill Moyer’s Journal, the mutual find pioneer explained, “in the first 15 years I was in this business, the average mutual fund held the average stock for seven years. Call that long term investing. Now, the average mutual fund holds the average stock for one year. That’s short term speculation.” Keep in mind, mutual funds are generally considered a slow and steady component of capital markets. A proliferation of online activity and day traders creates much more churn.

Why is it bad that more and more stock transactions take place with an eye toward immediate gains? This kind of behavior takes the focus off of business practices and management initiatives likely to produce sustainable growth. Among other things, the present situation means that architects of “pump and dump” schemes can more easily degrade the integrity of capital markets. Yet it also means that stock exchanges suffer from a general loss of integrity as their useful purpose — to enable investors to profit while supporting the expansion of successful businesses — gives way to a casino mentality that marginalizes shareholder oversight of business operations.

After so many delays, the day of reckoning brought on by rising spending coupled with falling federal interest rates seems to be moving from inevitable to imminent. The longer deliberately optimistic estimates (and in some cases deliberately distorted official reports on present conditions) delay recognition of real inflationary pressures, the stronger those pressures become. Not many Americans understand how much Pollyanna economics induces fundamental weakness. Yet almost all Americans have a sense something huge has happened when told that our greenbacks are no longer as valuable as that funny money Canada prints.

I believe macroeconomic stewardship is a lot like being an old man’s private physician. The human body is full of complex interdependent systems. Attentive diligence is required to get a sense of current trouble spots and determine the correct treatments for maximum health. It is as much an art as a science. Sometimes, it really is best not to meddle at all. Sometimes a very small change can produce a major result. Then sometimes, a condition emerges that requires bold, even drastic, action. Obsession with a single approach tends to be counterproductive in such efforts, as it is no substitute for cultivating awareness of crucial specifics that vary from case to case.

I would not go so far as to predict that drastic action is required right this moment. Unwarranted economic alarmism probably devastates short term growth just as unwarranted economic optimism may devastate long term growth. I suspect few economists would dispute that the key to real long term growth involves sustainability in business practices.

Wall Street and other capital markets lose some of their usefulness if they become insensitive to quarterly profit statements and other short term considerations. Yet Wall Street has lost more than a little of its usefulness by becoming exclusively sensitive to those variables. In the process, the institution has become insensitive to the quality of long term planning, investments in human capital, cultivation of consumer trust, and many other important factors that should influence the value of a business.

Failure to think of growth in sustainable terms also leads to a mismatch of huge national debt and loose domestic credit that only supports the exodus of American wealth. Remember, businesses exploiting access to cheap credit are under no obligation to expand their operations inside the United States. This approach to stimulus may enable the rich to become richer, but whatever wealth actually trickles down from this tends to wind up putting food on tables far from American shores. I have nothing against gainfully employed foreigners. However, I think we all should be unhappy with “job creation” strategies that channel American resources without regard for where new jobs are actually created.

Again this all comes back to sustainability. In the present international climate, further bold expansion of the national debt seems unwise, to say the least. Already our currency has shown a measure of weakness unlike anything most living Americans have ever experienced. This week it is likely the Federal Reserve will cut interest rates out of fear that doing anything else would weaken the performance of capital markets.

Given that the performance of capital markets is actually weakening the broader national economy, is it really wise to act again on this fear? Didn’t this habit of loosening credit as a means to increase growth contribute to some of the problems already at issue? Will the need to promote sustainable economic growth ever be given priority over the need to placate speculative investors? As I see it, there is only one way to prevent harsh realities from forcing our hand. That way demands taking stock of the bigger picture, and responding to what we see before economic myopia sends our nation strolling right off a fiscal cliff.