Economic Cures Are Like Booze for an Alcoholic: Caroline Baum

Commentary by Caroline Baum

Jan. 27 (Bloomberg) -- Someone returning to Earth from a yearlong sojourn in outer space could be excused for feeling disoriented.

After all, when said space traveler departed our fair planet, the U.S. economy was buckling under the weight of the burst housing bubble. The blame game was in full swing, with the villains ranging from Alan Greenspan and his easy money policies to consumers borrowing and spending beyond their means to financial institutions enabling profligate spending to a misallocation of capital to housing.

Fast forward one year, the crisis is still going strong, the villains are still under attack, yet something curious has happened: The policies and actions responsible for the economy’s illness are now being prescribed as cures.

How can that be? It’s not just our space traveler who’s confused.

Let’s start with the Federal Reserve. In the beginning, there was a boom in technology and Internet stocks followed by a predictable bust. Easy money, which had inflated the stock market bubble, came to the rescue, in the process fomenting another bubble of greater magnitude.

Then-Fed Chairman Greenspan let the benchmark overnight interest rate overstay its welcome at 1 percent, raising it so slowly that anyone with or without a good credit rating had time to get in on the housing boom.

Housing’s Role

The bubble burst with a ferocity that surprised even the most ardent bears. The price of overnight credit is now 0 percent to 0.25 percent, and the quantity of credit (the Fed’s balance sheet) has more than doubled in the past year. If removing the monetary stimulus was tough back in 2004, 2005 and 2006, just imagine what it will take this time when the magnitude of the task will necessitate Fed action well before politicians think it’s feasible.

Now let’s move on to housing, an asset whose price had never declined on a nationwide basis since the Great Depression. At least until home prices started to roll over in 2006.

During the height of the condo-flip frenzy, too much capital was being allocated to housing, a tax-advantaged, unproductive asset. And it was housing, the mortgages used to finance their purchase and the intertwined web of securitized loans that sent the economy into a tailspin.

Starting Over

Now that we’re here, with more homes for sale than buyers at the current price, what’s the government’s solution? Why, make it easier -- and cheaper -- to buy homes. The Fed has embarked on a program to buy $500 billion of mortgage bonds in the first half of 2009 in an attempt to lower actual mortgage lending rates, which fell to an all-time low of 5 percent earlier this month.

Rather than let the market “clear” -- or let prices seek their own level -- policy makers are stimulating artificial demand for housing to prevent prices from falling.

Welcome back to square one.

Then there’s the over-indebted consumer. From 1952 to 1998, the U.S. household sector was a net supplier of funds to the rest of the economy, acquiring more financial assets than debt, according to Paul Kasriel, chief economist at the Northern Trust Corp. in Chicago.

That changed in 1999, when the household sector’s “net acquisition of financial assets,” as it’s called in the Fed’s Flow of Funds Report, turned negative. Households were “net demanders of funds” until 2008, at which point the gap turned positive again, Kasriel says. “It wasn’t because they were acquiring more assets. It was because they couldn’t acquire as much debt.”

More Leverage

Banks, burned by their former excesses, have shut the spigots so even good credits are having trouble getting loans.

The government wants to ensure that consumers, whose spending accounts for about 70 percent of gross domestic product, can borrow and spend. This makes as little sense as using easy money and housing incentives to cure the effects of easy money and over-investment in housing.

“What policy makers on both sides of the Atlantic desire is to sustain household leverage and consumption at any price, when the only exit from the credit crisis involves a return to thrift by the overleveraged,” writes David Roche, president of Independent Strategy, a London consulting firm, in a Jan. 22 Wall Street Journal op-ed. “That cannot be achieved painlessly.”

And yet the federal government is seeking ways to make mortgage and other credit cheaper and more readily available, going further into debt in the process. Institutions deemed too big to fail, such as mortgage-finance giants Fannie Mae and Freddie Mac, were recruited in that effort. (That was after they were told to curb the growth of their portfolios and before they became wards of the state.)

Trade-Offs

These are short-sighted, short-term solutions being orchestrated at the expense of the economy’s long-term health, and I suspect most economists know it. (Politicians are a different story. Their knowledge of economics is generally confined to the area of trade: providing favors in return for campaign contributions.)

President Barack Obama’s crack economics team, including Larry Summers and Christina Romer, and Fed officials from Ben Bernanke on down have to understand that the problem of too much leverage can’t be fixed with more borrowing; that a misallocation of capital to housing can’t be cured with incentives to buy more homes; that consumers (and the nation) can’t spend their way to prosperity.

At least I hope they do.