Losses From the Federal Reserve Interest Rate Cuts

As the stock market continues to shine in the light of the Federal Reserve’s recent interest rate cuts, let’s consider the losers. There were losers. Today’s financial markets allow you to profit from virtually any change in direction of any financial instrument. Some profited from the pain of the subprime mortgage mess. Most prominently, this included investment bank Goldman Sachs, which recently reported a sizeable gain from betting that the mortgage markets were going to belly flop. Who were losers?

Those that held dollar denominated assets. The dollar was sinking before the rate cuts, and sank even more afterwards. Anyone who held dollar denominated assets lost money. Americans, whose native currency is the dollar, are relatively unaffected by the loss, unless they travel overseas or need to buy imported goods from Europe. In order to protect export industries, China largely links its currency to the dollar, and Japan tries to keep its currency from dropping much against the dollar. So the prices of goods from China are not likely to be affected much by the drop in the dollar, and the prices of goods from Japan will probably be affected only to a limited extent.

Foreigners and foreign nations took significant losses. Many apparently are shifting their investments out of the dollar and into other currencies. The oil producing Middle Eastern emirates, who have to invest large pools of cash from their oil profits, are said to be doing this.

Another big loser was China. Because it keeps its currency in rough parity with the dollar, a drop in the dollar means a drop in China’s currency (the yuan). China imports a lot of oil, which is priced in dollars and becomes more expensive when the dollar drops. The Chinese central bank has already announced that it is investing some of its dollar denominated assets in other currencies. That trend can be expected to continue.

Those that bet against inflation. The aggressiveness of the Fed’s interest rate cuts heightened inflationary fears. Those fears are reflected in yields on the 10-year Treasury note and the 30-Treasury bond, which have risen since the Fed rate cuts. Everyone who was holding these longer term Treasury securities before the Fed cuts has taken losses. Losers would include many investment banks and hedge funds, which hold these securities as hedges, investments, and sales inventory, and for other purposes. Many other investors bought them as part of a flight to quality. Now that the Fed has made riskier investments more attractive, quality investments suffer by comparison.

Those that believed the Fed would act slowly. Many believed, during the past summer, that the Fed had signaled it would be reluctant to do anything that might smack of a bailout of investors who made reckless decisions. The derivatives market would have provided ways to place bets on a slow process of accommodation. The Sept. 18, 2007 half-point cuts were a surprise accommodation that was anything but slow. Hedge funds and everyone else who had bet on gradualism got a scrape on the knee.

Many of the losers were diversified or hedged, and would likely have profited from other holdings and positions. But the effects of the rate cut may be muted by the fact that it caused some loss. How bad were these losses? We might get some idea in early October, after the close of the third quarter for commercial banks, and again in early December, after the late November close of the fiscal year for investment banks.

The U.S. economy may be the biggest loser. The Sept. 18 rate cuts took the financial markets a step away from the notion of market risk. They may have provided too much comfort to speculators, and, most importantly, to the banks that financed speculators. These constituencies now expect a bailout whenever they stumble. If the government bails out investors and lenders who make bad decisions, then capital will remain misallocated in favor of those bad decisions. Economic rewards will be based on governmental and political considerations. Markets will play a secondary role. Economic pain will be allocated toward those that lack political power, such as hourly wage workers and small businesses. Holders of capital will choose to invest in businesses that have influence in Washington, while ideas with economic merit remain unfunded.

Even though the Fed’s rate cuts were meant to stimulate the economy, the result might turn out to be . . . Japan, where a central bank policy of accommodation after the 1989 stock and real estate market crashes led to stagnation. The accommodation was made, to a large degree, to protect Japan’s banks from having to write down a plethora of bad real estate loans (does this sound familiar?). The overhang from this debt lasted for about 15 years, while Japan’s banks did little to finance new commerce or industry. Even today, Japan has not recovered the economic vibrancy it had in the 1960s, 70s and 80s.

In Asia, during the years when Japan was crippled by bad loans it refused to confront, a newly capitalist and very hungry China became a manufacturing giant. Today, China, India and other low cost-manufacturing nations endeavor to become wealthy by producing inexpensive goods and services. In America, people try to become wealthy by speculating in asset values and financial derivatives. After the huge run-up in real estate values from 2001 to 2005, there isn’t likely to be much future wealth generation from real estate for a long time (see our previous blog at http://blogger.uncleleosden.com/2007/09/when-will-housing-prices-recover.html). However, in spite of all of the Fed’s public commentary, there seems to be little doubt in the financial markets that the Fed will prop up stocks and financial instruments derived from real estate values.

The wealth of nations doesn’t come from government subsidies, nor does it come from making speculators and their financiers welfare queens. As hedge funds hire the cream of the business schools’ graduates, one wonders whether America’s intellectual capital is being misallocated. The tech sector didn’t get a government bail out after the 2000 crash. Many idiotically conceived dot com companies collapsed and lots of mostly young people lost their jobs. Today, America’s tech sector is vibrant and unemployment rates remain low notwithstanding one month’s disappointing data. We learn more from our losses than our successes. Will the Fed’s policies impede Wall Street’s move up the learning curve?

Crime News: Man admits stealing 1500 girls' shoes. http://www.wtop.com/?nid=456&sid=1257596. Did you ever think that Imelda could be surpassed?