OUTSIDE THE BOX

The high price of easy money

Commentary: U.S. policy makers should let the market guide the way
By Haag Sherman, MarketWatch
Last update: 3:42 p.m. EST Feb. 7, 2008
HOUSTON (MarketWatch) -- Before undertaking yet another dose of fiscal and monetary
stimulus, U.S. policymakers should study the current credit crisis and develop a more rational
market-based solution.
To combat the credit crisis and a potential recession, President George Bush and Congress have
proposed a $150 billion stimulus package. At the same time, the Federal Reserve has been slashing
rates, with more to come. Remarkably, the debate has largely centered on whether the government is
doing enough, rather than the merits of this policy.
The credit and accompanying housing bubble was largely created through excessive monetary
stimulus in the wake of 9/11, as Fed Chairman Alan Greenspan held "real" interest rates (Fed Funds
less inflation) at or below 0% for nearly four years.
At the same time, the U.S. government started running large cash deficits -- $500 billion or more per
annum, requiring the U.S. to borrow heavily from abroad.
Armed with an abundance of cheap money, Americans acted rationally and started borrowing and
spending liberally. Not surprisingly, the U.S.'s trade deficit soared and consumer savings rate
plummeted, and consumer debt increased dramatically.
Worse yet, since short-term rates were artificially low, consumers started
The current
borrowing short-term money (e.g., adjustable rate mortgages) to finance a long-
round of
stimulus will term asset (housing), and could buy ever more expensive houses based on the
likely create same level of income. The housing market soared.
more The party's over
inflationary
pressures, but The party came to an end when the Federal Reserve started raising interest
will not avert rates to more normal levels, and investors started pricing risk more stringently.
continued Logically, this resulted in sharp declines in the housing and credit markets.
declines in the
Banks are now writing down their mortgage portfolios and are not in a position
housing and
credit markets. to extend credit, no matter how low the Federal Reserve lowers interest rates.
Consumers -- seeing their largest asset (housing) fall in value -- are
retrenching.
The housing market was not the only area of inflation during this easy money era. Just about every
asset class inflated -- from U.S. equities to real estate to foreign equities.
America's current fiscal and monetary policies bear a striking resemblance to those of the late 1960s
and 1970s, which resulted in over a decade of stagnant economic growth and inflation. As was the
case during the 1970s, foreign currency markets have taken a dim view of this easy money era. The
U.S. dollar has plummeted by as much as 30%, and gold -- a historical store of value -- has soared.

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The current round of stimulus will likely create more inflationary pressures, but will not avert continued
declines in the housing and credit markets. These assets will decline until supported by economic
fundamentals -- and still have much further to fall. Thus, the rate cuts and fiscal stimulus will be
counterproductive and ultimately damaging to the economy (resulting in inflation, a weakening dollar
and, ironically, higher interest rates over time).
Against this backdrop, the U.S. should focus on a dramatic change in monetary and fiscal policy,
rather than repeating past policy mistakes.
Let the market lead
First, America should abandon central planning and allow the market -- not the Federal Reserve -- to
set short-term rates. While not perfect, the market has been proven more effective over time than
central planning. It makes no more sense for the Federal Reserve to set the price of money -- the most
ubiquitous of all commodities -- than it does for it to set the price of wheat, corn, or any other
commodity.
As with long-term rates, short-term rates should be market-driven. During periods of economic
recovery (e.g., late 2003 through 2005), demand for capital would increase and short term rates would
rise, rather than "real" Fed Funds remaining at or below 0%. During an economic slowdown, the price
of money would decline, creating an incentive to borrow and spurring economic activity.
In short, the Federal Reserve would not have the latitude to create bubbles and inflation due to
excessive easing or to grind the economy into recession through too much tightening, as it has done in
the past.
Second, the U.S. government should account for its finances in accordance with generally accepted
accounting principles, or GAAP, just like corporate America. The current budgetary numbers provide
Americans with a false sense that the deficit is declining, which has been used to justify the $150
billion stimulus package. However, if you compare the stated budget deficit ($162 billion in fiscal 2007)
with the increase in national debt, or cash deficit, of $575 billion, the budget situation is not improving.
The GAAP deficit is even more sobering -- a staggering $4 trillion for 2007 (after taking into account
accruals for future obligations under Medicare and Social Security). These numbers do not support
further fiscal stimulus.
In fact, America's fiscal policy is laying the foundation for another crisis: a run on U.S. Treasurys. This
may seem farfetched. However, Moody's has indicated that unless the U.S. government addresses its
ballooning entitlement programs, the U.S. Treasury may be downgraded from the highest credit rating
of AAA in the next 10 years, thereby jeopardizing the dollar as the world's reserve currency.
In short, market forces and transparency represent the bedrock of this nation's economic system and,
ultimately, prosperity. It is time to apply these same principles to the federal government.
Haag Sherman is co-founder and chief investment officer of Salient Partners, an investment firm with
more than $6 billion in assets and a division of Sanders Morris Harris Group.

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