Wednesday, August 10, 2011

Low interest rates

The Fed has announced, or specifically Ben Bernanke has announced, that the Fed will keep interest rates low through at least 2013. Though the current crisis has spurred an increase in savings, this foolish move will keep savings below what we need to rebuild our capital stocks to get our economy moving again.

We had historically low interest rates though the housing bubble. Because the borrowing was being funneled through the housing market, whose prices are not reflected in the inflation measures. Since inflation appeared low when in fact it was higher, the Fed assumed the target rate was correct. A similar occurrence took place during the tech bubble when stock prices were soaring and the inflation there was not reflected in inflation measures.

The low savings rate caused by low interest rates caused a huge problem. People did not have savings to use to purchase homes. The solution was to "encourage" banks to loan to people with low down payments. This was done in several ways.

Fannie Mae and Freddie Mac were created to purchased home loans from banks thus freeing up new funds to create new loans. Since Fannie and Freddie were government created entities, it was assumed they would have the backing of government funds if anything went sour. They lacked the incentives to verify that the loans they purchased were good investments and the banks knew that.

Under the old system, in order to purchase a home you needed to have a sufficient down payment to give you a vested interest in the home as well as a reliable income to show that you will be able to make the payments. Unfortunately this meant many blacks and other minorities could not own home. Some interests groups attempted to pressure banks to make more loans to minorities to try to fix the inequities. Of course these loans did not fix the underlying cause of these inequities, poverty, and lead these people to inevitable foreclosure.

With the Feds announcement that they intend to continue the practice that encourages bubbles and recession, where are we headed next? Recently gold prices have been increasing due to the fears of inflation. Is gold the next asset bubble or will there be something different? And after the next crash caused by artificially low interest rates, will the Federal Reserve learn its lesson or will the continue the insanity of doing the same thing over and over and expecting different results?

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