The word is that the Fed is going to cut overnight interest rates by 100 basis points this week. That’s 1% to you and me. It would lower the rate to 2%. I’m wondering what effect this will have in terms of arresting the current economic crisis.
The fed funds rate (which is explained in Wikipedia) governs the interest rates that banks charge one another on overnight loans. I won’t bother to go into more detail, but suffice it to say that the lower this rate is, the higher the incentive for banks (and thus, everyone else) to borrow money which can then in turn be lent to businesses, consumers, or other banks. The idea is that this borrowing is an engine for economic growth.
The problem right now is not that borrowing money is too expensive, it’s that there aren’t assets out there that people want to buy. That’s what killed Bear Stearns. Bear Stearns, being a bank, borrowed a bunch of money from people and then put that money into investments. Their creditors decided that those investments were so poor that if they didn’t ask for their money right away, they were never going to get it. Not being able to find new suckers to loan them money and being unable to liquidate any of their investments left Bear Stearns in a position to default on a bunch of debt. That precipitated this weekend’s three way deal between Bear Stearns, JP Morgan, and the federal government.
Bear Stearns’ problem is one shared by many people holding investments these days, which is that nobody knows how to value those investments. Investments are valued based on risk. Treasury bonds are low risk, so they pay a low return. Credit card debt is high risk, so it pays a high return. Because the real estate market is in total chaos, nobody knows what the risk level is for mortgage-backed securities, and if you can’t gauge the risk level of an investment, you can’t sell it. Based on the write offs we’re seeing in the banking industry, chances are most banks are holding a lot of investments that are off the charts in terms of risk. They’re going to wind up being worth nothing.
To return to my point, if the problem right now is that nobody sees any investments they trust, will the Fed cutting interest rates do much to jump start economic activity? It seems like the Fed has to do cut the rate, for psychological reasons if nothing else, but is there any reason to expect it to help. I’m no economist and I’m hardly a business person, but I do wonder what’s going on here.