When all you have is a hammer, every problem looks like a nail

The Federal Reserve can only fiddle with interest rates, but that manipulation may have little effect on the fundamentals of the current economic slowdown.

Without doing much analysis (I’m a doctor, Jim, not a rocket scientist), it seems there are at least two major drivers for the current economic problems. Inflation does not seem to be driven by a surplus of capital for spending – the type of condition that can be addressed by raising interest rates. Instead, it seems pretty clear that inflation is coming at the low end, as the CPI spikes due to the high cost of goods affected by the cost of transportation and farming inputs (driven by the high price for oil). A way to address this rise in prices is to help lower the cost of oil, or to have the government capture some of the oil profit (taxes on excessive profit, increased exploration royalties) and use that for capital/infrastructure investment. One way to damp the wild speculation in oil prices would be to increase the margin requirements for commodities traders; with margin requirements at 5% – 7%, they are betting on prices and trading oil with other people’s money. Increasing the margin requirement to 50% – 75% means having more capital in the game, and will likely damp the amount of churn in the market. It will hopefully shake out a lot of the speculators while allowing producers and end consumers to hedge prices properly.

The other major economic driver seems to be a huge drop in consumer confidence as the subprime mortgage fiasco unfolds. People caught in loans they can’t pay are forced to walk away from their homes or to cut spending back drastically to pay their mortgage. Other homeowners worry that a large number of houses coming on the market for sale will create downward pressure on their own home values and erode their own equity, perhaps even forcing them underwater. And of course whatever spending was fueled by home refinancing or equity loans will likely dry up, as fewer homeowners are willing to use their equity to finance shorter term expenditures. It seems the best way to shore up consumer confidence will be to allow courts and judges to reset or annul mortgages, refinances, and equity loans which were obtained with fraudulent information, where it can be demonstrated that the fraud was perpetrated by the broker or loan originator, not the applicant. To the extent that applicants participated in fraud to obtain loans or commissions, they should be punished. Profits and commissions obtained through fraud should be clawed back by their organizations to pay for the write-offs; or, if particular organizations are unable to withstand such losses, they should be allowed to go out of business and not be bailed out.

How will it help to have financial institutions bear the brunt of the mortgage meltdown? After all, won’t that dry up capital available for credit? Yes – but when the Fed talks about raising interest rates, they’re trying to effect the same thing anyway. And squeezing fraud, speculation, and unnecessary risk out of the system can only help shore up confidence in the system and convince borrowers that when they enter into a debt obligation, both sides believe it can be reasonably paid off.