from the hip

The real interest rate in the US after the last rate cuts by the Fed – the interest rate adjusted for inflation – is negative. Is that good or bad? Seems to me, reading about this in New York Times, that both Obama and Clinton hold much to narrow views on the crisis, and think it is mostly a financial crisis that can be solved by stimulating the economy and regulating the credit market.

Every time the rate has been cut in the last six months, the stock market has reacted positively. And the Fed has been looked upon as an institution that actually does something to reverse the current crisis in the American economy. The rate cuts have been said to stimulate the economy, and so on.

And, yeah, guess what, lower interest rates are great for the stock market. Always have been, always will be. Simply because lower rates means that on the average, and everything being equal (ceteris paribus, it’s often called), and all of that, stocks become more attractive as investment instruments compared to other instruments.

So, if the crisis facing the US had been a financial crisis, that would have shored up things neatly. But the current crisis is not financial – it only has some financial aspects. The crisis in 2008 is structural (I’ve discussed this a bit in previous post, and will get back to it as well in later posts).

Structurally, for the real economy, negative interest rates may be bad news, even if they are good for the stock market and for financial institutions in trouble.

If you think about if, you will quickly realize that negative interest rates simply mean that almost any investment that have a yield equal to the rate of inflation becomes a profitable investment. So, the lower the interest rate, the stupider the investments, so to speak.

And low interest rates were one of the main causes of the current housing crisis (quote from Bonfire of the Builders, Business Week):

A diverse cast of characters combined to launch the once-in-a-lifetime housing boom of the past five years. Traditional mortgage companies and banks unleashed a barrage of loans, many to borrowers with iffy credit histories who didn’t bother to read the fine print about upwardly mobile interest rates. Wall Street egged on the often-reckless underwriting by buying vast quantities of home loans for repackaging as securities. Now that the boom has fizzled and foreclosure rates are rising, the important role of large homebuilders as lenders is also coming into sharper focus.

In addition to spitting out subdivisions, many of which now stand half-empty, builders jumped into the mortgage business to a degree they never had. Wall Street provided the same encouragement it offered other lenders. Even as the housing supply began to exceed demand last year, builders kept sales brisk by pushing adjustable-rate, interest-only, and other risky loans. In some cases they attracted clientele who couldn’t afford conventional mortgages.

So now, with low interest rates, there is the risk of fueling the same speculative building spree again. And also, to make investors spend precious capital on low-yield projects that look good today, but will surely be bad once interest rates come up again.

In my opinion, and I’ll say more about this later, the American economy currently need high interest rates (something like a real interest rate of +3-4%) to ascertain that capital is spent on smart projects and to reduce non-productive speculative investments.