What You Should Think About Economic Churn

December 11, 2007

“So now, as an infallible way of making little ease great ease, I began to contract a quantity of debt.”

–from Great Expectations by Charles Dickens

Wall Street’s elite and television news anchors seem largely of one mind when it comes to the recent decision to cut interest rates again. None of them seem to have a problem with the ongoing trend. To the contrary, their complaint is that the latest cut was relatively modest when continuing turmoil in the world of high finance is thought to constitute a demand for bold cuts to continue. Chronically drunk on loose credit, they find mere moderation of the trend cause to for vocal complaint.

The underlying thinking is simple enough. Lower interest rates mean that consumers and businesses may borrow more easily. All else being equal, this also means that consumers will make more large purchases and businesses will undertake more aggressive expansion. It also lowers the hurdles aspirant entrepreneurs must overcome to launch a new venture. So far, so good, right?

The problem with this nice neat simple thinking of this sort is that we do not actually live in a nice neat simple world. After all, if great economic success was automatically the result of lowering interest rates, why not slash them to the practical minimum with all possible haste? The answer lies in the fact that not all economic activity is actually a good thing. Sometimes new ventures actually are a bad idea, destined to waste resources then fold for lack of revenue. Sometimes existing businesses are not actually better off at a larger size. Sometimes consumers are not best served by another big ticket purchase.

One major influence on present economic conditions is proof enough that this is true. The ongoing problems with mortgage-related financial instruments in the United States have much to do with a mismatch between real estate acquisitions and suitable lifestyle choices. This goes beyond low interest rates and a shamelessly underegulated mortgage industry enticing homeowners to bite off more than they could possibly chew. The rise of media promoting lavish home improvement aspirations, even idealizing fairy tale rarities in which amateurs “flip” properties they have no intention of inhabiting, fueled a wave of cultural pressure to go big with real estate.

No doubt there are many Americans with the resources to live in large houses or even own multiple homes. However, there are also many Americans who attempt to do this in spite of lacking the resources to make it a sound decision. There was a definite sense of schadenfreude in the early 1990s when Japanese investors, coming from a crowded island nation, took tremendous losses on commercial real estate in the U.S. The idea that an office tower in a major city might actually be less valuable from one year to the next simply did not compute among analysts willing to be literally crammed inside trains for their morning commute.

When excessive capacity ran up against sagging U.S. demand for that urban office space, even world famous landmarks had difficulty holding their value. Somehow that experience, well-covered in financial media of the time, seems to have been forgotten by figures framing American real estate policies and practices this century. Year after year of steady growth in the sector was thought to be part of a perpetual boom. It seems to me anyone claiming to be an expert in economics and/or personal finance ought know better than to ever endorse the notion of a perpetual boom.

Yet what has happened to American housing lately is not all that divergent from what has been happening to American business lately. For years and years “more more more” has been the battle cry of pundits and policymakers alike. Yet more activity does not necessarily generate more real value. One healthy aspect of the business cycle is that downturns weed out marginal operations that are not thriving on their own merits.

An ideal economy has very little churn — makework activity or meaningless transactions that serve no useful purpose. The more churn involved in an economy, the more demands will be placed on working citizens without any compensatory increases in quality of life. To a simpleton spellbound by Gross Domestic Product and unemployment figures, there is no difference between churn and meaningful productive endeavors. Yet to the people actually doing the work, there are huge consequences for morale. Perhaps more importantly, to everyone participating in the economy, there are huge consequences for the quality of goods and services obtained by a given unit of purchasing power.

Replacing a lifelong pharmaceutical therapy or an expensive surgery with a simple remedy for a common medical condition is seen as bad for the economy by prevailing metrics. Yet who among us would prefer to live in a world where a $500/month treatment is widely promoted in spite of being no better than a $150 treatment that provides at least as much health benefit? A pro-churn paradigm has our nation favoring the perpetual prescription or the sophisticated surgery over simpler approaches. While the market ultimately promotes smart choices when they become available, it also discourages the development and popularization of smart choices when there are huge profits to be made from continued dependence on costlier alternatives.

The most recent announced decline in interest rates, as with all others, is thought by its proponents to spur new ideas and new investments that will advance the cause of American prosperity. Yet this method of growing the economy is more like blowing up a balloon than building up a structure. Absolute emphasis on quantity, with no regard at all for quality, drives greater levels of economic activity without driving any greater satisfaction of human needs or desires (save the desire to prop up specific economic indicators.) In the long term, it actually undermines prosperity by amplifying the extent of future losses when an inevitable reckoning comes to pass.

This is not to say that there is no place for manipulation of interest rates as a means to stimulate or fortify a national economy. In fact, the prospect of surging foreclosure rates in response to rising interest rates is precisely the sort of scenario in which a bold cut could accomplish some useful purpose. Unfortunately, this purpose — encouraging stability in the face of troubling fundamental conditions — is best accomplished when the bold cut stands out as a sharp contrast to historical changes. When national policy has long been “cut, cut, and then cut some more,” no practical cut will be bold enough to send the right signals, and anything less than continued sharp cuts only compounds the influence of troubling fundamentals.

If managing a national economy were like running a horse race, we would find America’s productive elements so heavily whipped that no further action is likely to bring about a more energetic effort. Had the implement been used more sparingly, then it would have much more potential to motivate a surge at this point in time, when there is a clear imperative for stimulating intervention. In this way it becomes possible to provide effective support as it is needed. Realism, sensitivity, and selectivity all have crucial roles to play in these decisions.

Alas, along with just about every other issue that has some political dimension, most discussions of interest rate policy have been dumbed down beneath the point of usefulness. “When rates go down it is good, when rates go up it is bad,” is just a slightly more nuanced perspective than Frankenstein’s monster’s thoughts on fire. Yet widely respected financial analysts seem unable to do better in their assessments of Federal Reserve actions. This mindset is a wonderful thing for promoting even more economic churn, but when it comes to promoting real productivity and building real value in the American economy, it is anything but wonderful.