Interest Rate Cure Turns Into a Malady

As midterm elections approach, a volatile stock market and sluggish recovery have made many a politician long for the Clinton administration’s economic policies. In 1993, the federal government imposed stiff tax increases to reduce budget deficits so interest rates would fall. Soon afterward, there was a boom. Today, the red ink is flowing again in the public sector, and there’s talk of aborting the next phases of the Bush administration’s tax cut to lighten government debt burdens, keep interest rates low and trigger another economic miracle.

But Americans’ investment strategies have dramatically changed in recent years, and that transformation has altered how interest rates affect government finance. In the mid-to-late-1990s, low rates stimulated investments that ultimately produced a bonanza for government coffers. Today, savvy investors are using them in ways that are starving government.

Then-Treasury Secretary Robert E. Rubin was the chief driving force behind the 1993 tax hikes. He believed that government borrowing was sapping the nation’s economic vitality by keeping interest rates too high. Money that could be invested in stocks, business start-ups or other wealth-creating activities was instead parked in high-yield CDs or Treasury bonds. If taxes were raised, Rubin contended, interest rates would fall and people would make more productive investments.

It’s hard to know if Rubin was right. Interest rates were dropping before Bill Clinton became president, and they only exhibited a sustained decline after 1997, when the Asian financial crisis forced the Federal Reserve to ease monetary policy to keep the world economy afloat. But there’s no denying that hundreds of billions of dollars moved out of savings and retirement accounts into stocks after the tax increases. Venture capital became plentiful. Stock-driven earnings boosted high-end executive incomes and produced huge tax windfalls. Public budgets that had long bled red ink were in balance. America was suddenly blessed with what many thought was endless prosperity.

But Rubin’s economic strategy can’t save us today, for many reasons. The U.S. trade deficit, which also affects borrowing rates, is incomparably larger today than in the early 1990s. Oil and other import commodity prices are far more volatile. U.S. manufacturing was expanding in 1993, not declining at the most rapid pace in a century. And the post-Cold War euphoria that enabled Congress to cut billions from defense and further shore up the federal budget evaporated after Sept. 11.

Indeed, with interest rates already near historic lows, it’s difficult to believe that cheap money is our most pressing economic problem. And the idea that tax increases are needed to drive borrowing rates even lower is especially risky when consumer spending is generally cited as the main reason why the country has, so far, avoided a double-dip recession. Why pinch America’s pocketbooks at such a crucial time in the hope of nudging remarkably low rates downward a few more ticks?

But even if, against all evidence to the contrary, mounting government deficits are keeping interest rates too high, the public’s response to lower rates is quite different today. During the 1990s, a combination of low savings yields, media hype and an unprecedented comity between Washington and Wall Street transfixed investors with the seemingly limitless prospects of the “new” economy. Everyone invested in stocks and largely ignored other investments, like real estate. The decade’s obsessive focus on paper equities produced almost all that period’s stunning fiscal benefits.

When the stock market collapsed, resourceful investors transferred their attention to more tangible assets, particularly tax-subsidized residential real estate. Put another way, they abandoned the kinds of investments that produced windfall income gains and increased tax revenues. Exploiting home-refinancing opportunities, higher-income, high-tax-paying Americans, in particular, now manage their wealth in ways that dramatically reduce government income.

During the last two years, for example, about $4 trillion in new home mortgages was financed in the United States, an all-time record volume. More than half of these transactions were refinancings--a higher-interest loan was replaced by one with a lower rate--unrelated to buying a new home. This, too, is a very high ratio. By contrast, refinancings accounted for just about 30% of all new mortgages from 1994 to 2000.

More important still, more than 60% of the most recent refinancing activity, or roughly loans totaling $2.4 trillion, were “cash out” transactions. Borrowers retired their old loans and secured tens of thousands of dollars to spend as they wished. All this extra cash was financed with tax-deductible real estate mortgages.

This financial pattern represents the greatest difference between today’s economy and that of the 1990s. In the heyday of the boom, people financed their consumption by selling what were often wildly appreciated paper assets, and they paid correspondingly enormous taxes on their earnings. Since stock-price speculation was so extreme, consumers, in most cases, had more than enough money left over for cars, vacations or fancy furniture even after paying the government.

Today, Americans are generating disposable income by refinancing homes, cashing out their equity and charging the interest on their new mortgages against their taxes. Refinancing old loans, even at lower rates, generates a larger proportion of currently deductible mortgage interest with each new loan payment. Cash-out transactions add hundreds of billions of dollars worth of tax-deductible interest on top of these amounts. All this is generating billions of dollars of new tax deductions that are further straining public budgets.

It seems folly to argue that tax hikes, or canceled tax cuts, are critical to assure lower interest rates, particularly if they stimulate even greater tax-avoidance borrowing. People are looking for safe ways to build and spend wealth. Tax-subsidized real estate financing has clearly emerged as their strategy of choice. And with each dollar of increased borrowing, they draw funds from increasingly challenged public budgets. That’s one reason why Federal Reserve Chairman Alan Greenspan called for more discipline in public spending--not new taxes--during his congressional testimony last week.

There is no quick-fix tax and interest-rate panacea for America’s current economic challenges. In any case, it seems especially inappropriate to look to one of the most profligate decades of U.S. history for guidance. Instead, we have no choice but to rebuild our now-declining productive economy and encourage steady, rational savings and investment.