Hair of the dog?

9/12/07

On the Opinion page of the 9/12/07 Wall Street Journal, Martin Feldstein argues for a reduction of the fed funds rate “…starting on a path from the current 5.25% to 4.25%, and possibly even less” in response to the problems in the credit markets, to falling housing prices, and to the resultant reductions in consumer spending. Dr. Feldstein argues, predictably, that if the Fed doesn’t act now, we could face (Egads! (Emphasis mine)) recession.

Later in his piece, Dr. Feldstein perhaps inadvertently summarizes the problem by writing:

“The decline in house prices and rise in interest rates will shrink the future volume of mortgage equity withdrawals, causing consumer spending to decline. While the resulting rise in the saving rate would clearly be good in the long term, permitting increased investment in plant and equipment and reduced dependence on capital from abroad, a rapid rise in the saving rate could push the economy into recession.”

By making this statement, Dr. Feldstein touches on the ultimate problem here; unfortunately, he does so in the process of prescribing the wrong solution.

The “sub-prime mortgage” problem, which, as I said in my 3/14/07 post, far transcends sub-prime mortgages, is only one of the manifestations of a much larger malady facing our economy and our nation. As unsophisticated and old-fashioned as this might sound, the problem is that we, as a people, have been living well beyond our means for years now. We spend more than we save, counting on the inflation in the value of our portfolios, taken broadly to include (especially) real estate, to compensate for our utter lack of thrift and to reassure ourselves that everything will be okay; after all, household net worth is in great shape. Yes, household net worth is in good shape because easy credit has inflated the value of our assets at a rate faster than the growth rate of our debt. So net worth is in decent shape because asset values are going up, but asset values are increasing only because debt is being piled up to support the prices of those assets. It all sounds very circular because it is.

This shell game disguises, at least for the financial experts, the problem but does not eliminate or deal with it: We spend too much and save too little. What Dr. Feldstein is proposing is a bromide that will enable this profligacy to continue in order to avoid (Horrors!) a recession. Further, he proposes this hair of the dog even though he knows what the problem is. Like any stiff morning-after drink, Dr. Feldstein’s prescription will merely delay the onset of the symptoms of the underlying disease, making the sickness much more virulent when it finally surfaces, as it inevitably will.

As hard as this might sound to the financial Masters of the Universe who helped get us into this mess and who insist that it is only a bump in the road, the reality is that we cannot live beyond our means no matter what the money wunderkinds would have us believe. We have to start saving again. As Dr. Feldstein points out, a reduction in housing values will force us to start saving again. Given the pig-headedness of the American people, this is perhaps the only thing that will get us saving again, and not only for the reason Dr. Feldstein outlines; i.e., a reduction in housing values and consequent inability of spendthrift Americans to borrow against their homes for such necessities as European vacations, luxury cars, weekly spa treatments, extravagant nights out, and look down your nose private schools. (Dr. Feldstein did not come up with that gratuitous list of grotesque extravagances; yours truly did.) A severe recession will not only seal the home equity piggy bank, it will impress upon people one of the primary reasons we must save: times will not always be good, and we have to save for the proverbial rainy day. And having access to a home equity line of credit does not constitute saving.

The Fed can cut rates all it wants, but, given that the nature of the problem lies not in liquidity but in credit quality (See my 8/18/07 and 8/23/07 posts.), injections of liquidity will not solve this problem. The market will just have to be allowed to sort things out. This will in all likelihood involve a recession. It will hurt. So does necessary (as opposed to the cosmetic type so commonly funded with home equity loans) surgery. But it will have to be endured because we can’t go on much longer without excising the tumor of excessive spending. (See my 8/30/07 post.)