Greenspan's Black Magic

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As we gird our loins for the next FOMC rate setting meeting next week, the old ‘will they: won’t they?’ is beginning anew, with everyone long of the market, or short of a job, clamouring for Sir Al and the other Knights-Errant (as in mistaken, of course) to rescue the flagging economy by cutting another quarter point off the Funds rate and boosting the money supply.

But, if they gallantly acceded to these demands, would this cut finally do some good? There is no reason to assume so.

Suppose we felt our parlour game of Monopoly was proceeding a little too slowly for our tastes, so we ran to our colour photocopier and printed off another $3,028 in notes, increasing the standard set’s u2018base money’ by 20%.

Now, this will clearly change the outcome of the game, since some players will be more indebted, or less cash rich, than others when the new money hits, while the fortunate few will get it ahead of the others, while the smart cookies will realize its likely consequences before the rest.

In other words, the new money may serve to transfer ownership, to alter relative prices, and to rearrange the balance sheets of the players, but it will patently not alter the number of rentable properties, or increase the stock of houses or hotels available to be built upon them — in other words, the money cannot increase the wealth at stake.

Ultimately, it will not boost the income achievable beyond a preset maximum either, since no more than one hotel can be built on any given property under the rules (in other words the capital stock is not infinitely expandable at whim), though it may well artificially depress the yield as participants bid higher to acquire these assets from one another (though not in the effective u2018privatization’ which the initial purchase entails).

So, if it’s bound to fail in the game of Monopoly, what makes anyone think this ploy will work for the Fed — even assuming that lower short term rates will actually lead to an increase in money creation, something which is far from a given?

In fact, the only thing another ease can help do is to alleviate the constraint to income and the threat to creditworthiness imposed by the interest burden being borne by debtors — largely through indirectly rolling up this ongoing obligation into principal, since somebody, somewhere must owe the increase under our present debt money system.

And do you know who that ultimately benefits?

The lenders. Not the debtors, the lenders.

This is because the deadbeat company and the cash-strapped consumer alike can better hope to put off the day of reckoning, through reducing the income drain via refinancing — often at the cost of accepting higher interest rate risk by funding short and usually at the expense of increasing the size of the debt itself.

These shaky borrowers are also more open to being carried by their banks past the due term of any existing loans, since they now seem u2018safe’ prospects for being rolled forward, with a lesser risk of them falling into the non-current category.

Thus, the bankers — while congratulating themselves on their prudent and sensitive approach to the cycle — can seek to avoid the painful necessity of having to make higher provisions, or even, perish the thought, the write-downs, which are so disruptive of both banks’ present earnings hopes and future expansion plans.

If the economy improves, of course, that is just fine and dandy, for the banks will have every chance of having acquired a larger overall body of claims on the wealth producers (remember that business of transferring ownership?), less a little real adjustment for any incidental inflation, perhaps.

But, what is not generally realized is that the banks’ own actions can be detrimental to the chances of this recovery occurring and this danger is the more magnified, the greater was the scale of the initial malinvestment of capital in the boom.

This is because the banks’ proclivity to exploit artificially low, imposed interest rates, in order to avoid facing up to the harsh realities of the needed liquidation and restructuring, is helping keep all this mass of poorly-used capital frozen in place, to no-one’s overall benefit — not even, should this process proceed too far, their own.

In this, they are also hindering the necessary, market-based readjustment of prices — and so the redirection of scarce resources — by allowing those who produce relatively little of value to continue to compete for goods and services on equal terms with those who do add worth, and so they are favouring capital destroyers over the capital builders.

Worse, in this cycle, the banks are focusing most of their efforts of credit expansion either on outright consumption on the part of individuals, or on that most sterile of u2018investments’, that unwieldy, high-maintenance consumer durable, otherwise called a u2018home’.

No matter how many times the mainstream mindlessly intones the mantra that the u201860% of GDP’ cart comes before the horse, consumption without production is a finite exercise in exhaustion, a rake’s progress to ruin.

So, enjoy the next Fed cut if they deliver it next week, and hail Sir Alan when he rides by in his mortgaged panoply on his borrowed destrier.

Just bear in mind, it might not have been a dragon at which he just tilted, but merely a windmill.

Sean Corrigan [send him mail] writes from London on the financial markets, and edits the daily Capital Letter and the Website Capital Insight.

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