Commentary: Please, Mr. Greenspan...We Need Some More

By Rich Miller

So, would you believe the ailing economy may soon perk up? To hear Federal Reserve policymakers tell it, the central bank's monetary medicine is beginning to work its magic. Commercial banks have slashed prime lending rates by 1 1/2 percentage points this year, in tandem with Fed easing. Money-supply growth has taken off. The broad M2 measure, which includes currency in circulation and savings deposits, rocketed ahead at an 11% annual clip over the past three months. And the corporate-bond market is booming, racking up a record $150 billion in new issues in the first quarter.

It won't be too long, Fed policymakers believe, before all that money sloshing around translates into stepped-up consumer and corporate spending and faster economic growth. "We can negotiate the present rocky economic passage successfully and enjoy stronger growth in the second half of the year or possibly even earlier," said Richmond Fed President J. Alfred Broaddus Jr. in a Mar. 28 speech.

WALL OF DEBT. The Fed's upbeat chatter notwithstanding, arresting the economy's wrenching slide may prove far tougher than Alan Greenspan & Co. are banking on. To get the economy going again, they may have to open up the monetary taps even wider and pump a lot more liquidity into the financial system. The reason? A huge wall of debt that consumers and companies built up in the go-go years of the late 1990s. The International Monetary Fund reckons that America's private-sector financial deficit--the difference between private investment and the savings built up by consumers and companies--is alarmingly high, at more than 5% of gross domestic product.

When the economy was booming and the stock market was soaring, that ratio wasn't of much concern. But now that the economy has tanked, the debt overhang acts as a barrier to growth by soaking up the liquidity the Fed is pumping into the financial system. Because they're so much in the hole, consumers and companies are more apt to use the extra money to pay down debt, instead of putting it toward financing a fresh spending spree. While that's good for the economy in the long run, it's a hindrance to getting growth going again now.

Signs of cash piling up are everywhere. Much of the surge in M2 has been due to a big increase in cash stashed in money-market mutual funds by individual investors. Such funds have ballooned by a seasonally adjusted $40 billion this year, according to Fed estimates. In earlier years, such transfers might have been a prelude to a big splash of consumer spending. But now, investors are just looking to shelter assets from the stock market storm.

Corporations, too, are turning more wary. Sure, they issued a raft of new bonds last quarter. But that's not because they're poised to ramp up spending on new plants and equipment. Much of the money raised was used to pay off short-term debt. Since the start of the year, U.S. companies have reduced the amount of commercial-paper they have outstanding by more than $50 billion. Many have no choice: An increasing number of outfits are finding themselves all but shut out of the commercial-paper market. That's because the main buyers of the paper, the money-market mutual funds, can't hold more than 5% of their assets in lower-rated securities under government regulations. With more and more corporate debt being downgraded as the economy stumbles, companies must look elsewhere for funds.

Banks are also pulling in their horns. Plagued by an increase in bad loans issued during the boom, banks are turning more cautious. And that's robbing the economy of some of the punch the Fed would normally expect from lower interest rates. More than 50% of bankers tightened credit standards in the first quarter, despite pleas by Greenspan that they not curtail credit too much.

So does all this mean that the Fed's rate cuts are largely ineffective; in economists' parlance, that the central bank is pushing on a string? Far from it. What it does mean, though, is that the Fed is going to have to work harder at juicing up the economy with bolder and bigger interest rate cuts. To do otherwise could consign the country to a protracted period of malaise. No amount of sunny prognostications by the Fed will change that.

Miller covers the Federal Reserve from Washington.

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