Aug 14 2001

Forget the Fed, save yourself

Confidence in Alan Greenspan has led consumers and businesses to rack up unsustainable levels of debt. But he can't hold off a major downturn forever

by Wynn Quon

There's a good chance that, regardless of what Alan Greenspan does, a major downturn in the economy will come.

Investor confidence in Mr. Greenspan rests on a string of Federal Reserve successes. Rate cuts brought us safe landings after the 1987 crash, and again during the Asian crisis in 1998. But it's Mr. Greenspan's very success that is to blame for today's difficulties. Believing in the omnipotence of the Fed, consumers and businesses have imprudently racked up unsustainable levels of debt.

Why would Fed interest rate cuts not work when debt levels are high? The accompanying table gives part of the answer. Many key interest rates are beyond the direct control of the Federal Reserve. In a period of a year, the Federal Reserve rate has fallen from 6.5% to 3.75% -- a drop of almost half. But notice how the interest rate on credit card debt, at over 15%, has barely budged. The United States has US$650-billion of outstanding consumer credit, and that debt burden is not noticeably lighter. The interest rate on margin loans (loans for buying stocks) has fallen, but only by a fifth. That isn't much relief for the holders of the US$100-billion in margin debt. On the other hand, banks have been quick to slash the interest they pay to those with cash in the bank. Those who rely on short-term interest income are likely to be hit with a 30% decline in interest income. The only bright spot is the fall in mortgage rates. But even here the gains have not kept up with the pace of Fed cuts. Worse, consumers have taken to refinancing their mortgages and using the cash for more deficit spending.

In the business world, the same dynamic holds. Lower Fed interest rates mean that some companies' debt costs will fall. But for many companies, those costs will actually rise. Let's take the example of 360networks, which filed for Chapter 11 bankruptcy protection in late June with over US$2-billion of long-term debt. The Fed's rate cuts were no help for the company. 360networks' long-term debt obligations carried an interest rate of 12-13%. When investors are worried that they're not going to get their bond payments, they charge higher interest.

It is companies like 360networks -- debt-heavy and cash-flow-poor -- that pose risks for the economy at large. How many of these ticking time bombs are out there? One indicator is the ratio of corporate bond upgrades to downgrades. According to John Lonski, chief economist at Moody's Investors Service, this indicator stands at the worst level since 1989, the year just before the last recession.

The shape of government finances isn't encouraging either. In the United States, receipts from corporate income tax fell 26% from last year. Government coffers were also pumped up last year by capital gains from the stock market. Needless to say, this isn't something that's expected to happen again this year. Add it all up and the United States' much-vaunted budget surplus looks like it will vanish soon. The situation is similarly precarious in Canada. The federal government has barely begun working down the debt incurred during the early '90s. A drop in economic activity would quickly put the numbers back into the red.

The bottom line: Mr. Greenspan's effort to stimulate the economy will be like trying to kick a whale down a beach.

Students of economic history will know we've been here before -- namely Japan in the past decade and the United States in the 1930s. In Japan, stock prices are down 65% from their 1989 peak, even though interest rates have been cut to nearly zero. In the Dirty Thirties, interest rates fell from 6% to 1.5%, but it was not enough to prevent stocks from delivering their worst performance in history. Both crises had this in common: They happened in the aftermath of heavy speculative bingeing, massive buildup of public and private debt and steep declines in personal savings.

The trouble with being in debt is that it's easier to stay out than to get out. If consumers, businesses and governments simultaneously cut back, we'll be in for a rough ride. We're caught in what game theorists call a "prisoner's dilemma": what appears to be the rational course of action for each individual results in a negative outcome for the group -- in this case, a downward deflationary spiral in the economy. In the post-bubble economy, there are dilemmas galore. Last week, Nortel announced it is taking on a billion dollars of new debt. The company is knocking US$75-million off the bottom line, annually, to pay the interest. Meanwhile, sales have been falling steeply.

What should investors and businesses do?

Mindless, brutal cutbacks aren't the answer. It is worthwhile to note that, in the classic prisoner's dilemma, a strategy of co-operation pays off better than one of beggar-thy-neighbour. The way forward is a tricky balance of writing off the badly damaged while salvaging those who are merely bruised. Expect the best, but prepare for the worst. The unspoken danger that most people miss in relying too much on Mr. Greenspan is this: If he is unable to work his magic and pull the economy out of its slump, the blow to confidence will be severe. It is far better to leave off the Fed-watching and, as Voltaire said, to "tend one's own garden." Investors and businesses alike should think hard about contingency plans for a recession. Mr. Greenspan will do his best, but his best probably won't be good enough.

Home