The Cheap Credit Trap

by The Zman

The Federal Reserve is making noises about cutting interest rates for the first time in several years. The reason is the trade dispute with China and now Mexico is potentially having an impact on the global economy. Even though it is only a signal of an intention, markets rallied on the news. Global investors and their robot traders love cheap credit from the Federal Reserve, so anytime there is the promise of more cheap credit, there is a rush into equities. It is a reminder of what actually drives stock indices.

It used to be that recessions were seen as a correctives for the system, as they eliminated unproductive and parasitic elements from the economy. In good times, all sorts of inefficiencies are tolerated, as everyone is making money. When times get tight, everyone gets serious again. Inefficient businesses and industries fail, thus putting those resources into more productive areas. The recession was the economy’s way of policing itself, so it was considered a necessary, if unpleasant, feature.

No one thinks like that today. Any sign of a downturn produces panic, especially among office holders. Part of it is no one has any respect for office holders, so voters will look for any reason to throw the bums out. For people who live off the public, losing an election is worse than death. Another part of it seems to be the sense among the ruling classes that they have only a tenuous grip on power. This is a bread and circus world now and they better make sure both are in ample supply.

That’s all speculation, of course, but it’s also a reminder of the long running problem that no one can figure out how to remedy. That is the interest rate trap. Lowering rates to address a slowing economy or a financial crisis is easy. Raising the rates back up again appears to be impossible. It has been over a decade since the mortgage crisis and the Federal Reserve is still trying to unwind its position and bring rates back up to historic norms. This news suggests they will never pull it off.

One reason the Federal Reserve is trapped in a world of ultra-low interest rates is the world economy is based on credit. The foundation of the credit system is U.S. treasuries. When the government borrows money, it is also creating an asset to be used in the financial system. Stable and predictable interest rates make treasuries valuable collateral, as their value will never decline. In fact, the market has an insatiable appetite for American sovereign debt. Those super-low rates are a big part of it.

Of course, the flip side of this is the U.S. government can only exists as it does with super-low borrowing rates. Current debt stands at $22 trillion and goes up by a trillion per year, give or take. Even if the so-called fiscal conservatives got all the items on their wish list, the cost of the great Baby Boomer retirement guarantees massive borrowing for the next several decades. That is only possible in a world of cheap credit, so both sides of the debt transaction need super-low interest rates.

Then there is the retail side. Whole industries have become hooked on super-low borrowing rates. Imagine what happens to housing if mortgage rates return to historic norms, in terms of interest rates and terms. Imagine what happens to the car business when car makers cannot offer 84-month terms and low interest rates. The answer is these industries shrink considerably and take the economy into a depression from which it would unlikely recover. These industries need low rates to survive now.

Now, there is an argument that borrowing rates are normal for a highly efficient modern economy. Historic averages are not useful, as the world where men paid debts with gold coin, or mortgages were processed by hand, is nothing like today’s world of automation and complex financial instruments. There is a lot of truth to this. Automation has not just made transaction processing faster, it has made it more reliable, thus reducing systemic risk and friction. Cheap rates are a reflection of cheaper costs in the system.

There’s also the fact that central banks have greater control of the global economy than at any time in human history. The microprocessor has had no greater impact on the world than in the financial system. Not only do central banks have more information about the state of the economy, they have tools that allow them to see trends before they get going, thus allowing them to anticipate problems before they reach crisis level. It’s not perfect, but managed capitalism is more efficient and predictable.

That said, the main tool central banks have in fighting a financial crisis is lowering borrowing rates. The reason they could soften the blow of the mortgage crisis is they could spread the cost of remedying it across the following decades. In the simplest terms, the Federal Reserve used a payment plan to cover the cost of fixing the mortgage crisis in 2008. That was only possible with the room to lower rates and borrow heavily from the private economy to soak up bad debt and warehouse it at the Fed.

Inevitably, this topic leads to questions about whether the current credit based economy is sustainable in the long run. The old joke about “in the long run, we’re all dead” is true here as well. The current monetary system has been in place since the Louvre Accords in the 1980’s. While there have been recessions, there have been no depressions that threaten the political order. The ability to borrow has never been stronger, which means the West should be able to manage the great demographic change over.

Still, there is that haunting sense that this credit regime is a slow-motion bust-out where social capital is turned into cash and used to perpetuate the current order. At some point, when the West is nothing but a shopping mall full of strangers, with no connection to one another, what happens then? The West is haunted by the sense that the true cost of cheap credit makes the credit based economy unsustainable. In the end, the cultural capital will have been exhausted and there will be nothing left to borrow.