Fed Math: 1% Funds Rate – 3% Inflation = 2% Off when you Borrow?

“I don’t think that the boom came from a 1 per cent Fed funds rate or from the Fed’s easing. It came from the collapse of the Berlin Wall,” Mr. Greenspan told his listeners.

The Financial Times reports:

“The former Fed chairman said the collapse of Communism in Eastern Europe and the shift towards more market-based economies in China and other parts of the developing world brought ‘billions of cheap labourers onto the scene.'”

“This, brought disinflation and lowered inflation risk premiums and long-term interest rates, creating a decline in real interest rates and equity-risk premiums. The real market value of assets increased faster than GDP”.

There is undoubtedly some truth to what Greenspan says. But this is one of those occasions for which the word ‘disingenuous’ must have been invented. Yes, global integration probably has reduced inflation expectations, thus permitting lower interest rates and higher asset values. But without the active aiding and abetting of the Fed, which set the Fed Funds rate under 2% – i.e., below inflation – for 35 months, the boom in housing prices would probably never have turned into a bubble. And millions of Americans would still be solvent today. Globalization may have lowered inflation rates…permitting lower interest rates. But globalization didn’t bring with it lending rates below the rate of inflation. Those negative lending rates were not imposed by Mr. Market, but by Mr. Market Manager Greenspan.

A negative lending rate is a marvel. It allows a speculator to borrow, knowing that he can repay less than he was lent. Negative lending is to the financial world what a negative-calorie dessert would be to Sara Lee or a negative-year prison sentence would be to a bank robber. You can imagine, dear reader, what mischief they would cause.

Even at low real rates of interest, a borrower has to be careful. But what kind of care is needed when you are guaranteed to make a profit, merely by borrowing?

The actual effect of the Fed’s sub 2% rate is now history…well, a history that is still being written, one painful page at a time. That it brought about a huge bubble in housing prices is beyond question. It also helped sustain the whole U.S. economy…and, by extension, the economy of the whole world. Goldman Sachs calculates that since 2002, American homeowners have been able to “take out” enough money from their houses to add 2.5% a year to real GDP growth – which was most of it.

And now, it appears that the bubble is deflating. The Fed is no longer giving away money. And the housing market is no longer bestowing big gains on homeowners. The granite countertop business is slowing down…along with the rest of the housing-manufacturing complex.

If Mr. Greenspan were right, investors could expect high asset prices for a long time. Global trade, after all, is not likely to disappear any time soon. Why should house prices go down then? Or stock prices, for that matter?

But now, even the Maestro concedes house prices are going down. Only, he says, it is because houses have become unaffordable. And he guesses that the worst of the housing slump is already behind us.

And who knows? He could be right. But an investor has to play the odds. What are the odds of making serious gains in stocks at today’s record prices? What are the odds of making serious gains in houses? What are the odds that Mr. Greenspan knows better?

We wait to find out.


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