Thursday, November 1, 2007

America On Sale

Today the Board of Governors of the Federal Reserve cut the federal funds target rate – the rate that banks borrow reserves from each other – by .25%, from 4.75% to 4.5%. The commentary was furious, with supporters and distracters arguing for and against. “It’s a bail out for Wall Street” and “Helicopter Ben to the rescue” on the one side. “It’s the right thing to do to dampen the impact of the housing downturn” on the other. I believe it was not the right thing to do, but rather than use platitudes and sound bites I think I found a straight forward way to show why I am uncomfortable with this FED action. (Please keep in mind that I am working with simple numbers and simple concepts, while those making these decisions have exponentially more data and brainpower than I.)

In theory, a reduction in the interest rate will spur consumers and businesses to borrow and spend, which in turn adds fuel to the economy. Here are the Household Debt Service Payments and Financial Obligations as a Percent of Disposable Personal Income numbers from the fed:

1980 Q1 = 15.90%
1990 Q1 = 17.28%
2000 Q1 = 17.67%
2007 Q1 = 19.28%
Average of quarterly data since 1980 Q1 = 17.30%
These numbers are from here:

The ratio of debt service and financial obligations to our personal incomes appears to be at an historic high since 1980, as far back as this report goes. Our debt service and financial obligations ratio is now over 11% higher than the average of the past 26 years, and 21.3% higher than in 1980. Keep in mind that this ratio has expanded considerably during a period of very low interest rates. Should rates go up, this burden can get even worse. This cannot continue forever. At some point we need to de-leverage. If we keep putting it off, it will only be more painful when it ultimately occurs because it will take us longer to get back to a manageable debt service ratio.

Add to the debt service burden on consumers the high cost of energy and food and the declining value of homes and the picture looks pretty bleak. The last thing we need right now is higher prices added to our debt service burden.

Many pundits are claiming that the expanding global economy will save us from a recession, especially with the weak dollar spurring exports. The problem with this argument is that a falling dollar only adds to the inflation problem, as does strong global demand. Is this a time we should be lowering interest rates?

I believe we are paying for the delay of the inevitable recession through a loss of purchasing power and incremental debt service burden that will only make it worse when the correction comes. It does not seem this is the time to be encouraging more borrowing. In the interim, our assets are now dirt cheap in relation to many other currencies. America is ON SALE.

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