Economic Recovery - Treat the Disease, Not the Symptom By Robert M. Pardes

Online, October 29, 2010 (Newswire.com) - By now it has become all too apparent that the patchwork of monetary, fiscal and regulatory band aids administered in pursuit of revitalizing the economy are likely to be ineffective in achieving that objective and restoring domestic and international confidence. The term "patchwork" is intended to be pejorative, in that the steps that have been taken do not necessarily work in tandem, and to some extent are counterproductive.

For the typical working or middle class household, the debate regarding if, when and the severity of any recession carries little meaning and is often cast aside as an intellectual exercise for the wealthy. Reliance on the technical definition of a recession (two consecutive quarters of negative growth) grossly understates the severity of the current economic downturn, in that it relies on national averages and does not fairly gauge the economic well being of the average American household. It's a recession if you are reading about it. It's a depression if you are living under the twin evils of reduced household income and double digit inflation for the core basket of household necessities (food, gas, healthcare, utilities, college tuition, etc...).

The stated objective of the monetary and fiscal actions that have been taken so far is to provide stimulus to consumer spending - a primary driver of economic growth. Just as flawed blueprints ultimately cause delay and added expense to the construction of a new building, a misguided objective in treating the ills impacting the economy will similarly add delay and expense, while still proving ineffective in the end.

In the current economic downturn, the actual and projected decline in consumer spending is merely a symptom of the much greater disease - the collapse of the U.S housing and related capital markets. Absent this crisis and the spillover to other asset classes, declines in consumer spending would not be on the front burner. Uncoordinated and offsetting dosages of tax rebates, interest rate cuts and unsettling regulatory proposals are being administered on pure speculation that discretionary resources will be created and immediately elevate consumer spending levels. It is not surprising the market response is less than enthusiastic, as evidenced by widening spreads, continuing illiquidity, and increasing inflationary pressures.

There are no easy or perfect remedies. However, a fair assessment of the factors that continue to plague the housing sector and the dim prospects of a quick economic recovery suggest a cohesive prescription can be fashioned. This plan can support the improved promise of curing the patient without squandering taxpayer dollars and unnecessarily prolonging a painful process that is unavoidable given the proverbial hole we are already in. The basic tenets of this prescription are fourfold:

Focus on liquidity, not interest rates
Support the demographics that comprised core housing demand prior to the real estate bubble
Utilize HUD and the existing distribution system for housing finance to disburse needed remedial resources, as they will prove to be far more cost effective than the alternatives
Allow the unavoidable and inevitable pain to run its course as quickly as possible.
With these guiding principles in mind, consider the following:

I. The Impact of Interest Rate Cuts
The actions of the Federal Reserve in cutting short term rates have done little to provide relief to deteriorating economic conditions. To the contrary, the 300 basis points of rate cuts over the last six months have been counterproductive in addressing the disease infecting the economy.

The proof in the pudding is that the rate for fixed rate mortgages is higher today than at the beginning of the year, and slightly higher than one year ago. Thus, the Fed's actions have not assisted in increasing the purchasing power of potential homebuyers or reducing the carrying costs of existing homeowners through mortgage refinancing. One exception is any cost savings realized by homeowners with extended home equity lines of credit.

Any perception that significant rate cuts could mitigate future defaults relating to adjustable rate non-prime loans and negative amortization ARMs (often referred to as option ARMs) is clearly misguided. For the most part, rate adjustments relating to the toxic sub-prime and Alt A mortgages dominating the headlines are tied to the London Interbank Offered Rate (LIBOR), an index that the Fed has little direct influence over. Option ARMS are tied to the moving 12 month average of the 1 year treasury, a lagging index that considerably dilutes the near term benefits of rate cuts. Here again, the Fed's actions are virtually impotent in addressing a key concern weighing heavily on the prospects of an expedient economic recovery.

On the other hand, the Fed's actions relative to rate cuts have spawned inflationary pressures evident in the considerable increases in oil prices, food and other commodities. Has there been a fundamental shift in our dependence on foreign investment in our debt instruments (which includes the considerable financing needs of Fannie Mae and Freddie Mac)? Of course not.

With the Federal Reserve telegraphing a willingness to accommodate sizeable future rate cuts while most other central banks have stated intentions to stand pat or increase rates, the risk of continuing devaluation of the dollar against other currencies is considerable. It's no wonder foreign investors require a premium to cover the anticipated slide in the currency to maintain the level of demand for dollar denominated debt. The same holds true for goods purchased with dollars, driving up the cost of imports, most significantly, oil.

Finally, a considerable demographic component of the consumer spending equation is retirees and seniors dependent on fixed incomes. While least accountable for the excesses of the recent past, the spending power of these consumers are being hit hard in terms of higher costs for their necessities, and lower rates on their savings.

In short, any potential benefits of pronounced cuts in short term rates have been largely diluted or eliminated by offsetting reductions in consumer spending power.