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Beware of relying on lower rates to revive economy

THE BALTIMORE SUN

The stock market, apparently buoyed by lower interest rates, has turned up with such sustained strength in recent weeks that many forecasters have done yet another flip-flop on the economy.

Given the market's well-earned reputation in predicting economic turns, these seers note, it would seem that a short, shallow recession is more likely our fate than a prolonged, deeper slump.

These are the same folks, generally, who were telling us a couple weeks ago to batten down the hatches, which was itself a reversal from the outlook a couple of months ago, when we were told to expect only a modest dip in the economy.

Having been a consistent gloom-and-doomer during the current business cycle, my biases are probably showing here. But it would seem that the miraculous restorative powers of lower interest rates are being greatly oversold here.

I can't confess that this stuff is easy to comprehend, but you need to slog through it if you hope to understand the economic issues of the day. Those issues are increasingly tied to interest rates, money and, as is always the case in Washington, to political policies.

The recent conversion of Federal Reserve Board Chairman Alan Greenspan to fiscal liberalism, complete with repeated lend-and-spend urgings, is more than a little troublesome.

Even without the dangerous politicizing of his position that such cheerleading threatens, it is simply risky business for the nation's chief monetary official to be such an aggressive advocate of easier money and eased lending conditions.

The Bush administration's drive for boosting the economy is so aggressive, in fact, that it now reportedly includes major proposals that would permit accounting changes to reduce banks' concerns about poor real estate loans, possibly muzzle tough bank examiners and get on with the fun of lending money.

We're being assured by Treasury Secretary Nicholas F. Brady, among others, that the banking industry is so much healthier and different from the bankrupt savings and loan industry. Yet the administration's proposals are, on the surface, eerily similar to the funny-money accounting changes a decade ago that permitted S&Ls; to self-destruct.

These issues, in turn, can't help but become embroiled in the lengthy congressional debates expected over the administration's major legislative package to reform and modernize the nation's banking system.

In short, interest rates, monetary policy and banking issues will occupy center stage in the domestic economy for some time.

In terms of the recession, the crucial test of the Fed's moves to lower interest rates is the extent to which they stimulate the economy. Because so many loans have variable interest rates, lower rates will reduce the costs of loans already on the books, thus freeing up funds for other purposes. Lower rates are also counted on to stimulate demand for new loans. Both responses are good for the economy, which is why Wall Street's been in a happy mood.

"If the economy looks so bad, why are stock investors in such a good mood," asked Prudential-Bache economist Edward Yardeni in a recent weekly report. "Apparently they believe, as we do, that investors can start to bet that the worst is over for the economy when the Fed acts decisively to revive economic growth.

"We could be wrong about the economy," he added. "The recession could last longer and be deeper. However, so far, our bullish stance on the stock market has been right on the money."

The economic analysis over at Donaldson, Lufkin & Jenrette is so different that one wonders if the two firms were looking at the same economy.

"Substantial upward movements in stock prices are supposed to be an early signal for an upturn in economic activity," a recent DLJ economic commentary said before strongly disagreeing with that view.

"We expect the fundamentally negative constellation in the foreign exchange markets, in the U.S. fiscal condition and the increasingly aggressive easing by the Fed to impact the bond market first and then to reverse the recent price direction in the stock market.

"There are no signs of recovery ineconomic activity to support the level of stock prices," the firm added, "and there is no sign of domestic or international financial stability to underpin the bond market rally."

Whether you side with today's guest Bull or Bear, the key real-world question is whether lower interest rates will revive the economy.

Clearly, they haven't begun to do so, and there is precious little indica

tion of any rise in loan demand. As for loan supply, Chairman Greenspan's repeated urgings of bankers to lend money to good credit risks is alarming testimony to how much concern there is that no one will come to the Fed's credit party.

The DLJ reference to foreign exchange markets is also relevant. Lower U.S. interest rates reduce the appeal of holding dollars, especially when foreign interest rates are actually rising, as is the case today. Inasmuch as most experts feel that the dollar already had fallen far enough to reflect our need for lower trade deficits, its recent slide to new lows is not expected to have many positive benefits but could hurt overseas demand for U.S. investments.

Apparently to help encourage banks to lend money, the administration is preparing some new regulations that would, among other things, allow institutions to value real estate loans not on current market values but as a function of their long-term worth, keyed to the cash flow projections of the funds a property would generate over the life of the loan.

If such an approach seems fair to you, imagine if it were extended to other types of investments. Unhappy with the price that Wall Street puts on your stock? No problem. Just value it based on your projection of the company's earnings flow.

Another proposal would allow lenders to split problem loans into two components -- the part likely to be repaid and the part expected to be written off.

As is well known, a good percentage of currently non-performing loans eventually are repaid, so it makes some sense to allow banks to reflect this reality on their balance sheets. However, it's also clear that such a provision would also be subject to abuse.

After saying it wanted tough banking oversight and no repeat of the S&L; mess, the Bush administration tired of aggressive (and usually dead-on target) regulator L. William Seidman. Now, it appears that it has also tired of other forms of tough regulation as well.

The larger problem here, as with the broader economy, is that the government tends not to deal with fundamental causes of the problem but with whatever incremental change puts off the ultimate day of reckoning.

The value of today's benefit remains paramount; tomorrow's cost remains someone else's problem.

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