WHAT GREENSPAN IS DOING WRONG.
Spoon Fed
by James J. Cramer

Post date 09.04.01 | Issue date 09.10.01

Although the Federal Reserve cut interest rates last week--for the seventh time in nine months--the economy continues to sputter. Which has led to a lot of throat-clearing about whether the Fed still has the power to break recessions. "Investors are now complaining that Alan Greenspan ... is `pushing on a string,'" The New York Times reported this week. "The Fed can cut rates, but it cannot force companies to buy new equipment or consumers to spend more, the pessimists point out." Or, as Washington Post columnist David Ignatius put it, "[Greenspan] can lead investors to water, but he can't make them drink."

Nonsense. The Fed still has more than enough power to rescue the economy. It's just not using it. Instead of dropping matches on cold coals--that is, reducing short-term interest rates 25 basis points at a time--the Fed ought to pour on a little lighter fluid and cut rates by 100 basis points. A drastic step? Sure. And it will work.

Such a big cut would help, first, by reinvigorating the stock market. Right now investors are spooked by the hit they have taken these past 18 months. They'd rather keep their money on the sidelines--say, by putting it in bank certificates of deposit (CDs), which yield steady, if moderate, interest payments. As a result, even companies performing reasonably well can't get the money they need to finance expansion and pay down the massive debt incurred during the last boom. Remember, the stock market is supposed to be a vehicle for financing business expansion.

The way to fix this situation is to make "safe" investments like CDs less attractive, relatively speaking. And since banks base their interest payments to depositors on the Fed's short-term rates, the easiest way to do this is to keep cutting those rates until private equities start to look enticing again. For example, when you take the short rates to 2.5 percent, a stock like Philip Morris, which reliably yields an annual return of close to 5 percent, will spring up dramatically. So will other high-yielders like DuPont, Dow, and even Ford.

Cutting short-term rates deeply will also allow the banks to make more money themselves, which is equally essential for growth. When banks take money from depositors, they can invest it overnight in two-year Treasury bills; the "spread" between the interest they pay depositors (based on the federal funds rate) and the interest they get from the T-bills is profit. But right now the fed funds rate is almost equal to the yield on two-year T-bills, so banks can't make money this way. Not until the fed funds rate drops to 2.5 percent will banks take depositors' money, lever it up, and lock in a good rate of return by buying two-year bills. This trade, which helped save Citigroup (then Citicorp) and a host of other banks from bankruptcy in the early '90s, generates a massive amount of liquidity for banks. More liquidity means more loans, and more loans mean a growing economy.

Finally, lowering short-term rates would weaken the dollar. All year long, currency speculators have been going long on dollars--that is, buying them up, then holding onto them--because high interest rates make the dollar an attractive longer-term investment. The lower the Fed takes interest rates, the less attractive holding onto dollars will seem. Speculators will then start moving over to euros--i.e., going long on euros and short on dollars, rather than the other way around--and the dollar's value will decline.

And that would help American business. A strong dollar makes American goods too expensive relative to competitors from foreign countries, thus depressing sales. International Paper, for example, is having trouble competing with paper producers from Canada and Sweden because the strong dollar inflates the price of its exports. Meanwhile, some big American exporters, like pharmaceutical and food companies, are paid in local currency when they sell their goods abroad. Converting that currency into dollars is a very expensive transaction given the current dollar-euro spread. The currency disparity cost U.S. companies billions of dollars in profits last quarter alone.

So why won't Greenspan turn on the gas? Because he thinks the economy may be recovering already. Last year, when he wanted to break the economy, he increased rates too hard, too fast, and now look at the mess he has created. He fears that, with four straight months of positive leading indicators, a tax rebate now in the bank, and dramatically lower energy costs, things might just be getting hot on their own. He doesn't want people to look back at 2001 and say, "The economy was already catching fire, and he doused it with nitro. Greenspan overreacted again."

But the truth is that there's almost no danger of the economy overheating. Those $300 tax-rebate checks were supposed to stimulate back-to-school sales, but the figures are still disappointing. Indeed, with the possible exception of the housing sector, there's no momentum in any sector of the U.S. economy. Greenspan is bound to recognize this eventually. But "eventually" means recovery in 2002 at the earliest, too late to save this year from being the weakest in a decade. Which is why there's good reason to doubt Alan Greenspan--just not the institution he heads.

JAMES J. CRAMER is a markets commentator for CNBC and TheStreet.com. At the time of his writing, he owned stock in International Paper, Ford, and Philip Morris.