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Collateral Damage



Mr. Greenspan's view is that household balance sheets are "in good shape," and perhaps stronger than ever, because the value of people's homes and stock portfolios have risen faster than their debts.
-- New York Times 3/16/04

And there it is, in black and white, as reported on the front page of the New York Times: the premise for the economic strategy of the Federal Reserve.

This is why real interest rates are zero (or in my opinion negative) and must stay that way. This is why by the St. Louis' Federal Reserve's own calculation the fed funds rate should be 3% when it is currently 1%. This is why commodity prices continue to rise. This is why even a hint of deflation is unacceptable.

The bottom line is that the level of debt in this country must be supported by asset values, because asset values act like collateral. If the value of assets like stocks and home prices were to fall, the current level of debt would be unacceptable.

I once wrote a piece about my experiences at Interfirst Bank of Dallas in the early 1980's. This was a case where the ninth largest bank in the country went bankrupt, which eventually pulled the whole region into depression, because they made loans ultimately based on asset prices.

The bank knew very well that the cash flow to service debt was highly dependent on the price of oil. So the bank insured the loans through liens on oil companies' land and equipment. This made them feel safe, so they just kept on lending. This supported marginal exploration companies, companies that when oil prices dropped, were not financially stable enough to weather the storm. When these companies defaulted on their loans, land and equipment went for sale in droves.

The bank did not figure on a precipitous drop in land and equipment prices that accompanied the drop in the price of oil when the oil embargo ended in 1983. With the cash flow dried up and collateral values at ten cents on the dollar, the bank's capital was eradicated.

The Federal Reserve knows a lot more than Interfirst Bank did back then. They fully understand the importance of asset prices and have geared everything to inflate assets to protect the level of debt. And they fully understand the need to keep rates low to facilitate debt service. They are worried sick about some exogenous event to tip the scales out of control.

The government prefers to present the psychology that debts are not too high because asset prices have risen faster, not the possibility that asset prices have been driven higher to make the level of debt acceptable.

They cannot accept collateral damage.

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