08 October 2008

Another Rate Cut, Another Failure

At last! The Federal Reserve, along with many other central banks around the world, have cut interest rates. This is what the markets have been waiting for, everything will be fine now. After all, the previous rate cuts over the last year have done so well that its obvious that a globally coordinated rate reduction will do wonders.

This is clearly poppycock. Interest rates are already at historic lows but that hasn't helped the economy. Lowering the cost of borrowing further won't do anything to encourage people to borrow more, or prevent a further decline in the value of assets. Japan has been trying to almost GIVE money away for nearly 20 years and that didn't re-ignite their economy, and there is no reason to suppose this recent rate cut is going to help anyone either.

Interestingly, rate cuts are one of the best sell signals an investor can find. Stocks almost always head lower in the weeks, and months, following a rate cut. This only makes sense, of course, since rate cuts are always made when central banks are concerned about the health of the economy. Ironically, the time to buy is when central banks start raising rates.

Actually, raising rates isn't as crazy as it sounds. Low interest rates themselves are a significant contributor to the economic crisis. It is difficult for anyone to make money lending at such ridiculously low rates. Why even bother making a loan at 5% when there is barely enough income to cover your costs, let alone compensate for the risk of default (which is greater today than at any time in the last couple decades)? I vote for a co-ordinated global strategy of raising rates, and ceasing mortgage subsidies (i.e. Fannie, Freddie, FHA, etc).

Such a policy of higher interest rates would absolutely hurt the economy in the short term, but it would help restore health to the financial system by making it profitable to lend once again. Unfortunately, no policy makers seem to be willing to accept any short-term pain, even it it will help reduce the depth of our coming depression.

Oh, and let us not forget that it was abnormally low interest rates which were a major cause of the economic mess we are already in. Central banks did indeed prevent a severe recession in the 2002 by lowering interest rates to historic lows, but wound up contributing to the blowing of asset bubbles all over the place with a crack-up credit boom. Alas, there are no more bubbles left to blow, and there is no one left with a clean enough balance sheet to take on more debt.

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