Somebody Please Tell Bernanke to Relax

Poor Ben Bernanke. Amid the wave of economic wobbles, he's become America's punching bag. People point to him when asked why the stock market keeps falling, why the price of oil is on a tear, and why once-solid companies, like Bear Stearns (NYSE: BSC  ) and Thornburg Mortgage (NYSE: TMA  ) , go from "well capitalized" to suffering a TKO in a matter of hours.

We Fools haven'tbeenshy about expressing our distaste for Bernanke's recent barrage of attempts to pull the financial markets out of the doldrums. Some of our ranting is based on the unfairness of proposed measures -- such as shifting risk onto taxpayers -- but let's look past the law of unintended consequences. Are Bernanke's efforts to help the economy doing any good at all? More importantly, are they actually making things worse?

Since the credit crunch began unfolding last summer, the federal funds rate has been slashed six times, from 5.25% to its current 2.25%. These cuts have done squat to tackle the real problem of eliminating excessive leverage, but they've done quite a number on the rest of the economy. Think about these not-so-trivial side effects:

  • Oil recently pushed past $110 per barrel, an all-time high.
  • The dollar has lost almost 20% of its value versus the yen just since last July.

"A" for effort, "F" for implementation
Cutting rates makes it cheaper for banks to get cash into our pockets and thus give the economy a shot in the arm. But the cost of money isn't the problem here. Not by a long shot. If anything, it's been far too easy to get money in our pockets to begin with. The problem has been bad loans that have vexed banks from Citigroup (NYSE: C  ) to Goldman Sachs (NYSE: GS  ) to Merrill Lynch (NYSE: MER  ) . These bad loans have scared the pants off everybody, to the point where very few people are willing to come within 10 feet of even healthy banks without latex gloves and a respirator.

The predicament we're in now is that for the debt that's sitting out there, the assets backing it -- mainly real estate -- are worth much, much less than they were when the loans were made. And insane amounts of debt were piled up to finance those loans. That's caused financial rivers of wealth to become dammed up. No matter how many economic wonks turn the problem on its head in an attempt to find an easy solution, there's really just one answer: Prices need to come down. A lot.

Interest-rate cuts won't do that. You could cut them to zero if you wanted to. Heck, you could even go negative. But as Japan learned during a miserable decade of economic malaise, the only way to get back on track is to fess up to the mistakes and purge out the excess. That's partially why Alan Greenspan mentioned back in December, "It's far less damaging to the economy to create a short-term fiscal problem ... than to try to fix the prices of homes or interest rates. If you do that, it'll drag this process out indefinitely."

Interest rates are not the problem
Yes, lower interest rates do give homeowners more wiggle room to save the roof over their heads. Especially for homeowners who have adjustable-rate mortgages and are facing a reset that puts the payment outside their financial means, lower interest rates might be the only saving grace. Nonetheless, you still run into the same problem: If you've bitten off more than you can chew, lowering interest rates may only prolong the inevitable. It's estimated that nearly 9 million homeowners owe more on their mortgages than their homes are worth. That leaves them with less incentive to keep paying the mortgage, even if lower rates make monthly payments manageable. With home prices still faltering, that number could rise even higher.

You can't stop the bum rush
The truth is, financial institutions are in trouble, with or without rate cuts. Real estate prices are exorbitant, with or without rate cuts. Assets need to be marked down, with or without rate cuts. When overleveraging -- not the cost of money -- is the problem, there's little that Bernanke and his boys can do but forestall the inevitable. In the meantime, however, low interest rates can have a serious impact on the average Joe's bottom line by stoking inflation and punishing those of us who actually save money by giving us paltry rates on our savings accounts. You shouldn't be happy about that.

When we get in over our heads, we pay. That's capitalism. The quicker we come to terms with the severity of our overleveraging, the quicker we can get back on track. We're only as strong as our weakest link.

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