Sometimes I think regulators are in over their heads. They aren’t talented enough to run a company, but they think they can control the excesses of financial companies. Then there’s the Fed. They think they can control an entire economy through the weak policy lever of affecting the views of people have for calculating what interest rates they should use to capitalize the values of assets.
Think of assets as a stream of future cash flows. But what are those cash flows worth today, to buy or sell them? The interest rate that makes the price and the cash flows equal is the capitalization rate, or, “cap rate.”
For years, at least in the Greenspan era, lowering the cap rate via Fed funds was the rule when times were weak. He was the anti-Martin, bringing back the punchbowl rapidly when the party was getting a little dull. Because of that, the economy grew more aggressively for a time, but at a price of growing unproductive debts.
You can lower the interest rates as low as you want, but it doesn’t change the underlying productivity of the economy. You might push asset or goods prices higher — it depends whether saving or spending is more important. At present, actions of the Fed push asset prices higher, which doesn’t do much for the economy as a whole. Rising asset prices do not stimulate the economy much. Though it would be dishonest to do it, it would stimulate the economy more if Ben would rev up the “Helicopter of Happiness” and rain dollars from “Heaven.”
The Fed created the housing bubble with their policies 2001-2007. They did that to stimulate the economy. You can only use strong sectors of the economy to transmit monetary policy, because they can absorb more debt.
That’s true when not in a liquidity trap. We are in such a trap now, given the profligate prior Fed policy. They did not let recessions destroy bad debts leading to a reduction in the marginal productivity of capital. That value is so low now, that companies pay higher dividends and buy back shares. Relatively little goes into growth via new investment.
My point is that monetary policy has some potency if central bankers are willing to inflict pain in the bear phase of the credit cycle. With Greenspan and Bernanke, that was absent. As such, we suffer in a liquidity trap, and one that current Fed policy will not remedy. Far better to raise short-term interest rates and let some bad businesses fail, and grow from there.
By David Merkel, CFA of Aleph Blog