The Fed's Rate Cut

Posted by: Michael Mandel on January 22

The Fed cutting rates this morning by 0.75 percentage points will help some things but not others. The central bank should be able to pump enough liquidity into the financial markets to avoid a general systemic collapse. That’s the main function of the central bank, and they have sufficient resources to do it.

However, the Fed cannot stop the consumer crunch, which is the result of lenders finally realizing that American households have overspent their means. Nor can the Fed stop the coming realization that the underlying U.S. growth rate has been overstated.

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Reader Comments

j. ellis

January 22, 2008 12:16 PM

What does this mean in terms of rates specifically. We are we now..4.5? or 4%

Sean Olender

January 22, 2008 12:31 PM

Today's conundrum is that this crisis was caused by excessive credit used for consumption as opposed to investment. There is a lot of bad debt in the system and the pain of writing it down is going to be intense. As as been said countless times, ours is a problem of solvency and not liquidity. Lower rates should not help a person making $50,000 a year keep his $800,000 mortgage.

The American savings rate has slowly dropped from just above 8% to just below 0 over about 20 years. During this time consumer credit including mortgages, car loans and credit card debt has increased to levels that anyone with a calculator would have trouble believing.

The problem is that built into asset prices, stock prices and the entire global economy is a rate of increase in consumer spending in the United States. That rate of increase assumes that savings rates can be pressed down and credit consumption can be levered up in the future at the same rate as during the past 20 years. Clearly this is impossible.

So while US government officials will say, "we need to encourage Americans to save more" they will do everything in their power to discourage this. It is no accident that when consumer spending doesn't grow fast enough (mind you, it didn't fall, it just isn't growing fast enough), the federal reserve slashes rates by 1.75% in just a couple of months to make it seem stupid to save. The goal is to always keep interest rates below the rate of inflation so that the average person has a tremendous disincentive to save.

It's not that the Fed, Treasury, and other authorities wouldn't like Americans to save, it's that to accomplish even an anemic 2% savings rate, Americans would have to take consumer spending 2% lower meaning it would be flat. That would cause a global catastrophe with oil prices plummeting (unless a war with Iran is engineered to support prices) and Chinese factories running idle and threatening the government with 300 million rural Chinese who just showed up in urban areas for work.

The whole world is relying on Americans to spend more than they make, so we can expect every possible lever to be pulled in an effort to keep Americans borrowing and spending right into the apocalypse.

The truly terrifying architecture of the present global system is that at the point at which consumer spending can no longer rise, it must collapse. It cannot remain flat.

During the Japanese deflation that lasted more than fifteen years, Japanese had substantial savings and structures in place that limited the social problems that are normally associated with that sort of protracted downturn. The US consumer has no savings. Perhaps 80% of Americans may face catastrophic consequences if their income source was cut off because there is no savings. This lack of savings means that layoffs translate immediately into debt defaults on cars, houses and cards. The lack of savings renders the whole system highly unstable.

And yet it is this lack of savings that allowed economic growth above Japanese and European rates for almost three decades. This is the conundrum. To keep familiar rates of growth that justify current stock prices, you need most Americans to spend more than they make.

We may now be approaching a substantial shift in expectations because even Americans cannot indefinitely spend more than they make. If Americans start to save just a little, the entire system will have to be repriced to reflect this new reality and its long term consequences. And not merely the United States' economy, but also our partners in China, Japan, EU and elsewhere.

The profligate American is the linchpin of the entire global order and he is increasingly looking like the dead man in 'Weekend at Bernie's' - propped up and made to look like he's able to continue.

Joe Cushing

January 22, 2008 11:02 PM

Excellently written comment by Sean. I'm not sure that it is that simple though. If people saved money, they'd have more to spend. They would also be providing capital in the form of debt and equity for companies and consumers alike. This would not take long to affect productivity which I believe is the primary reason for our economic growth. I don't think the wealth effect of savings takes too long either. The wealth effect could show up in measurable ways in about a year. That's about how long it would take for a person to save enough money to have visible interest/dividends.

All of peoples' income is eventually spent. If we saved more, more of our income would be spent on goods, and less would be spent on interest. I'd guess the economic growth disadvantages of saving vs spending are very short term-- probably less than 18 months. If our savings rate was higher over the last 20 years, the world would be better off today.

Brandon W

January 23, 2008 12:49 PM

Sean, you're right. But if I were you, I would be watching out for black Suburbans with tinted windows.

Angela Jackson

January 29, 2008 11:23 AM

HELP ME!!!

Everywhere I read "Write Down". What is a write down????? Is it the same as a "Write off"?

My mom owed $18,000. to a bank 'named' TUBA in 2002, she never paid them. They sold the bad debt to ABC company. They began calling her everyday for a year, then TUBA sold her debt to EFG company. A year later TUBA sold her bad debt to XYZ. Now all three companys are calling her to collect over $25,000.

It seems my moms bad debit is being regained by TUBA by them selling it to several companies.

IS THIS WHAT THEY MEAN BY WRITE DOWN INSTEAD OF WRITE OFF??????

My mom should have her credit affected for ten years from 2002 but now I think it will haunt her forever since TUBA keeps selling the bad debit to different companies to re-coup the monies.

Thank you for your interest. This blog is no longer active.

 

About

Michael Mandel, BW's award-winning chief economist, provides his unique perspective on the hot economic issues of the day. From globalization to the future of work to the ups and downs of the financial markets, Mandel-named 2006 economic journalist of the year by the World Leadership Forum-offers cutting edge analysis and commentary.

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