Administrative gimmicks aren't going to make the credit crunch go away. Household net worth, the foundation of American prosperity is melting like an ice cream cone on a hot day.

The Federal Reserve has been busy since December cranking the Federal funds rate down a quarter point at a time, searching for the level of interest rates that will breathe life back into the dead economy. It might just as well save its breath. The issue for policy makers is not how to make people willing to spend money, it is restoring their confidence so they'll stop trying to unload the stockpile of houses, cars and other fixed assets that they already own. There is no level of interest rates that will make the public content to hold the existing stock of houses, plant and equipment, commodities and other real assets as long as it expects their prices to fall. Economies with declining net worth don't grow.

Deflating Assets

The problem is deflating fixed-asset prices and therefore declining household net worth. Net worth increased in every single year since World War II, at an average annual rate of 8.3% between 1946 and 1989, providing a solid foundation for rising incomes and a growing standard of living. At that historical growth rate, households could have expected their $17.3 trillion net worth at the beginning of 1990 to increase by more than $1.4 trillion during the year. Instead, in 1990 household net worth fell by $181 billion dollars its first decline in two generations. According to Federal Reserve data, the worst hit asset was owner-occupied real estate, which dropped by $141 billion in the first countrywide drop in land prices since 1946.

Property values matter because they are such a big piece of the economic landscape--land ($3.7 trillion) and residential structures ($4.6 trillion) together account for more than half our country's net worth-and because the home is most families' largest single investment. Last year land prices fell by 9.8%, enough to catch the attention of stunned homeowners across the country. Deflating prices have stripped people of their confidence in their homes as a store of value.

It is the drop in household net worth, and particularly the value of houses, not the Gulf War, that has paralyzed American consumers and investors. In order to repair their net worth gap, consumers are attempting to save money the old fashioned way, by not spending their paychecks. Americans paid down their installment credit balances last month by $1 billion, the eighth decline in credit card balances in the past nine months.

Fixed-asset deflation is the key to understanding the credit crunch. Falling property values and commodity and other asset prices lead directly to reductions in working capital availability. Banks typically calculate the amount they will lend a borrower by considering the values of allowable receivables, inventories, work-in-process and plant and equipment. In addition, more than one-quarter of bank loans, as well as nearly all saving-and-loan loans, are collateralized by property values.

Although the root of the net worth decline is falling property values, it is business loans, not real estate loans, that have taken the brunt of the credit crunch. Commercial bank business loan portfolios have shrunk at a 9.3% annual rate (negative $21.6 billion) since the beginning of the year, while their holdings of government securities and other investments have grown by 25.8% ($31.6 billion) over the same period. The reason the credit squeeze has shown up in business loans is simple-they are easier to kill than property loans. Taking a half-built real estate project off the books can be tricky, involving contractual commitments and write-offs. But canceling a revolving credit agreement with a small business is just a phone call away.

The Federal Reserve has been administering its all-purpose elixir, lower Fed funds rates, to combat the crunch. Lower short-term interest rates have, if anything, worsened the problem by steepening the yield curve to the point where bankers can make more profit by borrowing in the Fed funds and short-term certificate of deposit markets and buying government bonds than by making business loans. Lower interest rates in the public markets-Fed funds, T-bills and commercial paper-may lower the cost of capital for the giant companies who feed there for working capital, providing big companies with an opportunity to refinance their balance sheets. But the money is not getting through the clogged pipeline of the banking system to the small companies that create nearly all new jobs, because they must rely on their banker for working capital.

It is the availability of money for business, not its cost, that is at issue. The U.S. does not need lower interest rates, it needs a Roto-Rooter for the banking system. As long as bank regulators pay more attention to credit risk than interest rate risk, however, bankers will keep socking their money away in treasuries, and businesses will go hungry for working capital.

Bankers, accused of leaving their post during battle by their customers, have reasons for what they are doing. Falling net worth, if it were to continue, would turn a lot more good loans into bad loans. It is up to someone else to solve the problem by setting net worth on a growing track again.

Unfortunately, matters are still getting worse. Commodity prices have declined by 17.1% in the past 12 months, industrial commodities by 23.8%, metals by 30.2% and aluminum prices by an astonishing 38%. Plagued with falling product prices and inventory losses, cash flow is down, manufacturers are struggling to keep their heads above water, and business failures are 22% higher than a year ago.

This erosion of corporate balance sheets helps to explain why the sharp decrease in interest rates since a year ago has failed to raise stock prices above their pre-Gulf War levels. Most analysts believe real interest rates-the difference between interest rates and inflation-are low today. But the inflation rates that should be used in the calculation are not the consumer price index rates but the rates of change for the fixed assets held by real companies on their balance sheets.

From this perspective, real interest rates today are staggering. For an aluminum producer that experienced a 30.2% drop in the value of its aluminum holdings during the past year, the real cost of holding inventory was close to 40%. The only way to get these real rates down and get the economy moving again is stop the deflation in its tracks.

The decline in net worth has slowed tax revenues, and thus has led to a destructive round of tax rate increases. These are making the problem much worse. After a massive federal tax increase last year, 36 state governments are raising tax rates again this year.

Washington must break the game of tug-of-war between the Resolution Trust Corp., whose property auctions continue to torpedo real estate values, and the Federal Reserve, whose preoccupation with zero CPI inflation is allowing asset prices to fall. Normally, the Fed tries to print just enough money to finance its gross national product growth targets, based on the idea that GNP is a fair representation of the amount of goods and services being offered for sale.

Let Money Grow

But as long as the RTC real estate workout continues, the supply of real goods being offered for sale on the market will be much, much higher than the output of the factories and the barber shops. The Fed's job, if it is to accomplish its objective of long-term price stability, is to let the money supply grow at a rate sufficient to create the demand to take all those goods off the market at current prices. So far the Fed has failed miserably, as the net worth numbers show.

The Fed should work together with the RTC to estimate the size of this aggregate supply bulge from the resale markets and to target a money growth rate sufficient to sterilize the effects of the RTC sales on net worth. In retrospect, this is precisely what Paul Volcker's Fed did in 1983, when growth in M2--cash, deposits and money-market accounts--jumped to 11.8%. It happened again in 1986, with 9.5% M2 growth, under somewhat milder deflationary circumstances created by corporate restructuring programs. An explicit announcement by the government that it will use monetary policy to stabilize the price of real assets would restore the public's confidence in their homes and in their futures, and would provide a firm foundation for long-term growth