The Fed May Be Making Things Worse

08/16/2010 11:52 am EST


Terry Savage

Author, The Savage Truth on Money

“You can lead a horse to water, but you can’t make him drink.”

How true that old saying is. And here’s another one along those lines:

“You can stuff the banks with money, but you can’t make them lend. . .And you can lower interest rates to zero, but you can’t give people and businesses the confidence to borrow.”

The market has it figured out—even if the Federal Reserve and Congress don’t.

All the stimulus Congress can create—including an additional $3 billion of funds from the Troubled Asset Relief Program (TARP) to struggling homeowners and billions to save schoolteachers’ jobs—won’t get consumers past the fear zone.  

All the money the Fed can create won’t get business going again without the critical ingredient called confidence. If banks don’t have confidence, the money will sit on their books, invested in safe Treasuries, not in lending to business and consumers.

Sadly, confidence is just what the Fed undermined with its latest promise to keep creating new credit in the banking system and keep interest rates near zero—all in an attempt to “stimulate” the economy. 

There’s actually plenty of money around, including $2 trillion on corporate balance sheets.

But banks would rather pay savers close to zero interest and then redeposit the cash in risk-free ten-year Treasuries earning 2.5% than risk lending to businesses that need money.

And businesses that have cash balances don’t want to invest their money in new plants or stores or products—or even in new employees—given economic uncertainties. 

The fact that health care and financial services reform bills are layering new and uncertain costs on business is just one more reason for companies that have cash to hoard it.

Consumers are the most scared about the future. Even potential home buyers who have a down payment and good credit are scared to buy, because they don’t know if they’ll have jobs in the future or if their current home will sell. And they figure real estate prices will go lower, or stay low longer.

So, the economy is grinding to a halt—or at least to very slow growth. 

But does the Fed have the right remedy—or is it just making things worse?

Consider this possibility: Low interest rates may actually be slowing the economy down!

Seniors who have lived on the interest they earn on their savings have had to cut back their life-styles—cutting into consumer spending.

Unemployed people, especially the growing army of the long-term jobless, are throwing every penny into eating and paying the rent.

People who have jobs and want to get out of debt realize they have to spend less and save more, slowing the economy.

Pension funds must project lower returns, so the trustees of state and business pension funds have to contribute more—diverting resources from economic growth and expansion.

About the only “winner” in this game is the US Treasury. It gets to borrow money to fund its deficits at the lowest rates in history. With two-year Treasuries yielding only about 0.5% and ten-year Treasuries yielding 2.75%, the government saves a fortune on interest—for the time being.

In fact, if rates were only at the “normal” low levels of three years ago, according to economist Brian Wesbury, the Fed would have to spend an additional $230 billion this year to borrow—adding to the deficit.

While these low rates aren’t sparking consumer or business borrowing, they are serving as an incentive for the government to keep spending and borrowing. 

Consumers and businesses have learned the lessons of frugality in uncertain times all too well.  What a shame the government hasn’t even begun to learn that lesson. We’ll all pay for its mistakes.

Comments? Please join the conversation and have your say.

Related Articles on MARKETS