Economics matters

First that and now this. First the Federal Reserve and now the federal government are taking steps that make it clear that they will not allow the housing market and the U.S. economy to correct itself. Unfortunately, with each row of bricks that raises the dam of the U.S. economy higher bankers and the government increase the economic pain that all will feel when the dam does break.

First, the Federal Reserve Bank sees that the housing market is correcting itself and responds by lowering its interest rate. Yes, it re-assures financial markets but it also sends a subtle but unambiguous message to every American. Borrow all you can because when the time comes to pay the money back the Fed may change the rules. It is no wonder that Americans have a negative savings rate.

Let's think about why Americans choose to borrow rather than save. Lowering the interest rate has two effects. First, lowering the interest rate encourages borrowing and discourages saving. Who wants to save his money at 1 or 2% interest? Much better to borrow at 5 or 6%.

Also, in today's economy lowering the interest rate will increase the rate of inflation. Inflation, of course, is the great adversary of savings. It is bad enough to only receive 1 or 2% on your savings; it is doubly bad when inflation is higher than the interest rate that you are receiving. If we want to raise the amount of savings in the United States, we should encourage savings and discourage borrowing.

The recent move by the Federal Reserve Board and the discussion by the federal government are steps in the opposite direction. By lowering the interest rate, the Fed has just said that it is more important to bail-out borrowers than safeguard savers. The banks will get their money either way. But what about those who have saved for years rather than upgrade to that new and bigger house? What about those who are planning to retire in the next few years rather than those who just got a "great rate" (that is scheduled to increase in the next year) on a new house?

Between the Federal Reserve Board injecting money into the economy and the federal government planning to help homeowners avoid foreclosure, the idea seems to be that Americans should not have to face the consequences of their acts if the consequences would be too painful. Every person who signed a mortgage to buy a home was a legal adult who was aware of the consequences

The real story is the incredible reversal of common sense. To me common sense says that borrowers who over-reached and took out loans that they cannot pay off should face the consequences even if it means moving in with friends or relatives. Savers who socked away money for a rainy day rather than upgrade to a McMansion should be entitled to not worrying. Instead the government is talking about taking taxpayer money and giving it to people who took a risk and lost.

Thinking in terms of real people, we should imagine two imaginary couples. Both couples are within ten years of retirement. As their children leave the house, marry, and move away, both couples consider what their financial goals should be. One couple decides to sell their home, downside to a smaller home, and use the profit to pay down their mortgage so that they can pay their home off by retirement. They also use the smaller mortgage payment to save for retirement.

The other couple decide to upgrade to a newer house in a better neighborhood and take out an ARM with a really low teaser rate. They can just afford the payments but figure that they will continue to get raises and interest rates will stay low. They convince themselves that they will always be able to refinance and if things get really bad they can sell the newer house and downgrade. After all, the loan officer tells them, home prices always rise.

Now think about both these two couples and their respective situation now. The couple that saved has fewer worries; in fact, they are poised for retirement. They have sacrificed their present enjoyment of a bigger and more prestigious house for their future enjoyment of a secure retirement. The second couple, on the other hand, is now in a desperate situation. They face a larger mortgage payment as their ARM is reset. Further, they find that they cannot sell their house at any price. They do not want the bank to foreclose on their house, but they do not have the financial resources to pay the higher payment. They sacrificed their future retirement for the temporary enjoyment of a nicer home.

Now the Federal Reserve is lowering interest rates and the government is talking about bailing out overstretched borrowers. If both these things happen, the couple that saved will see their hard-earned tax dollars going to pay for a home that they did not purchase and will not get to enjoy. The couple that saved will see their savings for future retirement diminished in buying power by the ravages of inflation.

What powerful lesson will this teach to the people of my generation? "Don't save, spend! Spend it all and borrow some more!" And some people wonder why the United States is not mentioned in prophecy ...