Last week's edition of This American Life (finally) did an article on the credit crunch. And among a lot of CDO-funny-mortgage talk, there was a very nice nugget that I took away. Why exactly does a low Fed rate lead to the current set of problems? If you think it's because "mortgages were cheap", that's only part of the story.
You usually hear financial magazines talk about the Fed rate in purely "growth vs. inflation protection" terms, but the point in the This American Life piece is that it's important to see the downstream effect on Treasury rates and what this does to "cash as an investment".
When you create a situation where money and credit are cheap, you also make cash a bad place to invest. (That's the nugget.)
When cash is a bad place to invest (because it doesn't keep pace with inflation), you make people take more risk in order to receive a return on their cash. In so many ways, you've compounded the problem: people can do more risky things with other people's money because credit is cheap. And the people who have the job description "keep cash safe" also have to take more risk to do that job.
The Fed is in a very difficult position right now, and bursting the credit bubble is no fun for anyone. Among other things, if you raise the overnight rate, ARMs reset to higher rates and more people lose their homes, creating the expected avalanche of problems. (Of course, there is some room for the Fed to move because the mortgage market has priced in some of these long-term effects already.)
I think the important idea is that cash is an investment. People will hold more of it either when they're (a) terrified, as in a flight to safety, even holding it at a loss, or (b) it has a good return under normal circumstances. Otherwise this cash will move to other places.
I do hope we can return to a healthy balance, where all this cash can be used to drive real investment, rather than the speculation of the last few years.
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