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Until the Fed Feeds Us More Salad and Fewer Twinkies, Speculative Bubbles Will Remain a Risk

By Peter D. Schiff
Guest Columnist

Although the U.S. Federal Reserve still believes that a recession is unlikely to occur, central bank Chairman Ben S. Bernanke & Co. last Wednesday cut interest rates by an additional half a percentage point, following up on the prior week's emergency rate reduction of three quarters of a percentage point.

Not to be outdone by the Fed's generosity, the U.S. House of Representatives and the Bush Administration slapped together a $150 billion "stimulus package, which can only be delayed by the Senate's desire to join in the bead throwing.  On Wall Street, these actions were cheered as heroic, with praise and accolades for all [What could be more politically courageous than handing out free money in an election year…]. Indeed, according to a recent poll, fully 78% of economists thought these policies were appropriate, while 18% thought that they were not aggressive enough.

Insanity is commonly defined as the act of repeating the same activity while expecting a different result. Bernanke is now repeating the same mistakes made by his predecessor, former Federal Reserve Chairman Alan Greenspan, yet he and almost everyone on Wall Street expect a different result.  The stock market bubble of the 1990s resulted from interest rates being too low, which sent false signals to business, causing them to over-invest in information technology, in telecommunications capabilities, and even in dot-com-related technologies and companies.

When that high-tech bubble burst – rather than permitting the corrective recession to run its course – the Fed responded by slashing interest rates.  The result was an even-larger bubble in housing and real estate. The result: Consumers borrowed far too much money and spent it on expensive "move-up homes, on vacation homes, on "investment properties, and on the furnishings that accompany each of these.

And now that the housing bubble has burst, the Fed is once again slashing interest rates to postpone the pain.

But here's the reality: In order to correct for years of extravagant borrowing and spending, the United States is in desperate need of a period of saving and economizing. But the lower interest rates – by rewarding debtors and punishing savers – actually encourage precisely the opposite behavior.

Given how much harm this strategy has already done in the past, why should we assume it will work any better now?

Consider a real world example.  You've got a spendthrift neighbor, who's maxed out on credit-card and home-equity debt, and who has no savings in the bank. In short, he's struggling to make ends meet, and is one paycheck away from foreclosure and personal bankruptcy. That neighbor comes to you for financial advice, asking what he should do with the $1,200 he received in the "Federal Stimulus Lottery.

Would your advice be: "Go out and buy yourself a brand-new Plasma TV?

My guess is you would suggest he use the cash windfall to pay down his debts. Indeed, if you were a really good friend, you might even help him devise a budget to put his financial house back in order.  Such a plan might include trading in his Mercedes SUV for a more fuel-efficient Honda, eschewing expensive downtown restaurants in favor of brown bag lunches, the destruction of department store charge plates, the cancellation of expensive family vacations, and cutting back on premium cable channels, among other acts aimed at economizing.

In short: When you are neck deep in debt, the solution is to economize, ratchet back on your lifestyle, and repair your personal balance sheet. In other words, you undergo your own personal recession.

Would your advice be any different if it was not just one neighbor seeking help, but 300 million?  If it's wrong for a deeply debt-ridden individual to blow a windfall, it's just as wrong if millions of us do it collectively.  If our economy is already staggering under too heavy a debt load, consider how much worse off we will be if we each blow through those rebate checks.

Think of it this way: Imagine an obese individual showing up at a Weight Watchers meeting, only to have his counselors hand him a box of Twinkies. How much weight do you think would be lost on the "Twinkie Diet?

American consumers have basically stuffed themselves almost to the point of explosion.  What is needed is a healthy salad, not more Twinkies.

Ironically, by blowing up both the stock market bubble in the 1990s and the real estate bubble that followed, Greenspan actually repeated the same mistakes that Fed Chairman Benjamin Strong Jr. made in the 1920s and that Fed Chairman William McChesney Martin made in the 1960s, respectively.

It seems sanity is a major disqualification for central bankers.

[Editor's Note: Money Morning Guest Columnist Peter D. Schiff is the president of Euro Pacific Capital Inc., a Darien, Conn.-based broker/dealer known for its foreign-markets expertise. A well-known financial author and commentator, Schiff is a regular Money Morning contributor, and has most recently written about Wall Street's lost dominance and soaring gold prices. In mid-August, when analysts were touting beaten-down financial shares, Schiff said the stocks were "toxic," were destined "to get hit hard," and advised investors to "stay away." Investors who heeded that advice, and avoided such shares as Merrill Lynch, also avoided some stressful, subprime-induced losses. Schiff's first book, "Crash Proof: How to Profit from the Coming Economic Collapse," was published by Wiley & Sons in February 2007. To order the book, please click here].

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