US Cut Interest Rates and Start Sending Tax Rebates

Bill Bonner - Thu 01 May, 2008

Two extraordinary things happened yesterday, the Fed cut rates 25 bps and the government started sending “tax rebates”.

Writing from Ouzilly:

It is May Day in Europe. It is a holiday for almost everyone. But here at the Daily Reckoning’s mobile headquarters, we keep reckoning day in and day out.

And what we reckon today is that two extraordinary things happened yesterday – related to one another and equally absurd.

Yesterday, the Fed did what it was widely expected to do – it lowered rates by 25 bps, bringing the key Fed lending rate down to 2%, or about half the rate of consumer price inflation. And that is where we begin to wonder. What kind of a bank would lend money for less than the inflation rate? Isn’t it sure to lose money?

Yes, of course…but it’s a long, long story…

The other extraordinary thing that happened was that the US federal government began sending people “tax rebates.” Of course, they are not tax rebates at all. Everyone who filed a tax return will get $300, whether he owed any taxes or not. A taxpayer will get another $300. Plus, children and dependents will get $300 each.

Alas, today’s news tells us that much of the presumed benefit from the giveaway program will be lost because of higher fuel and food prices.

(And here we offer some helpful advice: We’ve heard that SUVs aren’t selling very well anymore. Maybe the feds should give every family an SUV -- one made in America, of course. That would be good for the auto industry – and then people could take the money they save from not having to buy a new car themselves and use it to buy gasoline and groceries.)

The US government is already $9.3 trillion in debt (not to mention the other $40 trillion ‘financing gap’). It is giving out money it doesn’t really have -- $106 billion worth. But it is doing so for good reason – or so it believes. The president of all the Americans – George W. Bush – said that the handouts will be “good for the consumer economy.”

Lending money below the inflation rate…giving out money you don’t have, when you are already so deep in debt you will never get out - how could any of this be good for the real economy? But by this time we are so far into Never, Never Land that we will never find our way back.

A consumer economy may benefit from consumer spending – but only if consumers have money to spend. If giving away phoney money, which you don’t really have, could make things better – why stop at $300 a head? Why not give away $1,000 a person…or $5,000?

Likewise, if it’s a good idea to lend money at 2% below the inflation rate…why not lend it at 10% below the inflation rate?

The really extraordinary thing is that the brightest minds in the nation think they can control the economy in these extraordinary ways. But they would think so, wouldn’t they? The guy who believes drinking doesn’t affect his driving is always the guy with the whiskey bottle.

Meanwhile, there was some ordinary news yesterday too. The Dow eased off 11 points. The euro stayed at $1.55. And gold lost another $11 – dropping to $866. Wouldn’t it be nice if the price would fall below $800! Maybe it will; maybe it won’t. But Dear Readers are urged not to lose heart. This bull market in gold isn’t over yet. The real excitement is still ahead.

*** Jeremy Grantham, writing in the Financial Times, says the Fed needs a smarter, tougher man at the helm – someone like Paul Volcker.

He explains why:

“Efficient Market Hypothesis assumes man acts rationally and efficiently in economic matters in ways that can be caught in elegant mathematical models. Ben Bernanke, chairman of the Federal Reserve, shares this view completely, and Alan Greenspan, his predecessor, when it suits him. In such a convenient world, there can be no bubbles and no crashes. A related belief is that sensible, disciplined control of money supply will drive away all ills, including the madness of crowds, and, therefore, a sensible central banker is all powerful.

“Unfortunately, both concepts are complete illusions. First, we live in a behavioural jungle where markets can crash 23 per cent in a day without any defining event, price/earnings ratios in Japan can rise to 65 times and the value of land under the Emperor’s palace really can equal California’s. Second, central bankers do not always do the right thing, often because that would involve great career risk. Being slapped by a Senate subcommittee for saying “irrational exuberance” is bad enough. Taking away punch bowls and risking being seen as holding the pin when the bubble pops is even more dangerous stuff.

“The world seems to think the Fed has substantial power to influence the real economy. Its tools, though, are not nearly as effective as believed. It controls short rates that influence banking profits and perhaps a little increase or decrease in debt. But long-term growth depends on education, supply of workers, capital spending, and technology, over none of which the Fed has any control.

“Both Mr Bernanke and Mr Greenspan have trouble seeing bubbles. When Mr Bernanke describes an 80-year US housing bubble as “merely reflecting a strong US economy”, we might wonder about his statisticians or his competence. But, really, it is about belief. He is not looking for bubbles to exist in his theoretical world.

“Not believing in bubbles and/or being unwilling to risk unpopularity by moving against them leaves the two Fed bosses with no alternative but to give free rein to speculators on the upside and focus on the downside. But, even on the downside, did they have to be so generous?

“It created an extreme form of moral hazard: it allowed risk takers to win too big and too easily; it helped spawn a huge hedge fund industry; and, worse still, it helped turn formerly discreet bankers into speculators. If you even partially bail out Bear Stearns – leveraged at 40 to 1 – next time someone will try 50 to 1.

“The Fed must show some backbone. If you always take the friendly way out, no bubbles will ever be pricked and we shall always be reacting to crises in an increasingly speculative world. Paul Volcker, the Fed chairman before Mr Greenspan, had the character to do tough, unpleasant things where necessary. His two successors have not.”

*** Brazil is booming. Its bonds were upgraded yesterday. Now, they’re considered investment quality. The Brazilian currency is rising against the dollar. Exports tripled in the last five years. The country is now a net creditor with the rest of the world – with $171 billion in reserves. And its stock market is the best-performing major market in the world this year.

Ah yes…the world turns. Now, the banana republics get rich, while the rich go bananas.