Well, evidently the first impact was to add nearly 1,000 points to the Dow Jones. That’s positive. But in the medium term, it’s useless; and in the longer term, I think it will be harmful.

The market barely moved on the news that consumer confidence had hit its lowest point ever. (Worse economic conditions than the multi-year recessions of ‘73-’75 or ‘80-82? Apparently, no big deal). Then it rose 900 points (see chart) on a consensus call that the Fed would cut interest rates by half a point today to 1%. This strikes me as bizarre.

What can we expect over the next few weeks or months?

Another half-point cut will do nothing, just as it did nothing on Oct. 8. The Oct. 8 cut didn’t stop the Wall Street bleeding, and stocks still haven’t recovered (see chart). Nor have the rest of the Fed’s cuts done much.

Chart: Stock market prices in daily highs and daily lows on the Dow Jones 30 Industrial index and the Fed’s key interest rate, the Fed funds rate on the right axis.

Cutting interest rates is a desperate move. The housing asset bubble was produced when Alan Greenspan left interest rates at 1% for too long. Now, we’re back at that 1% level.

Ultimately, cutting interest rates is far too broad an approach to fix what ails the banking system. Banks have had their capital wiped out by losses. To comply with lending regulations of roughly 20 dollars out for every one dollar of capital (shareholder equity), they must pull back their loans. Lower rates don’t fix that problem. Neither does buying bad loans.

Only four possible scenarios will enable banks to lend.

• Remove regulations and let them lend with abandon. Of course, that’s exactly what got us into this mess — investment banks being able to lend 40-1.
• Allow them to continue to de-leverage, pull back loans and contract lending. That will deepen the current recession, but it is a path through the mess.
• Have the federal government buy the banks. Yes, socialize the banking system, have the Feds purchase massive equity positions and, over time, let the banks buy back their shares.
• Give the banks money for nothing. Bail them out and make the current shareholders whole. That will re-capitalize the banks and allow them to lend again. It’s politically unfavorable, but a possible solution.

None of the four has anything to do with cheap money (low rates).

What about the longer run?

Plenty of banks don’t need lower interest rates. Healthy banks, hedge funds, investment companies and those with cash will undoubtedly start investing in questionable projects with this cheap money. It always happens when hurdle rates fall below historical norms. You run out of profitable projects to fund, so you start considering projects you otherwise wouldn’t. That starts another asset bubble all over again. One-percent interest rates got us into trouble last time, and undoubtedly they’ll do so again.

In our weekly “Ask the Economist” feature, our resident Economist, Mike Donnelly, will be tackling your questions about the economy. If you’ve got a question — and no topic is too big or small — you’d like him to field, e-mail us at economist@pbp.com or leave your queries in the comments section.

Tags: Consumer confidence, Dow jones, Fed, Interest rate cuts