Do you have an Interest in Interest?

You should!  Everyone today should have an intense interest in interest … and for a simple reason:  America’s, and the world’s, economy hinges on the rate of interest that debtors –at all credit levels – will be paying over the next few years.  Don’t flinch.  This is not hyperbole.  The world has over-indulged on debt.  By a lot.  There’s so much of it – on the books of students, consumers, businesses, corporations and governments – that the numbers astound.  No one can doubt than many of today’s hyper-leveraged excessively-leveraged over-extended will default …, the critical question being when.  U.S. student debt currently stands at $1.7 TRILLION – only a portion of which is even capable of being repaid, let alone serviced –, consumer debt is at $4.2 TRILLION – how many American workers are out-of-work and how many will exhaust their resources in 2021? –, U.S. mortgage debt is at $14.3 TRILLION – how many American homeowners are out-of-work and will be unable to service their mortgage debt in 2021? –, U.S. corporate debt is at $10.5 TRILLION – how many businesses have been sustained during 2020 by creditor forbearance and Paycheck Protection Program subsidies? –, States’ debts are at $1.2 TRILLION – States’ revenues have not kept pace with expenditures and some politicians already are calling for States that are deeply in the red to declare bankruptcy –, and Federal debt is at $27 TRILLION with the 2020 Federal deficit at $3.1 TRILLION (without counting the $7+ TRILLION of debt on the books of the Federal Reserve … and growing) – how is Federal debt to be both serviced and repaid without rapid economic growth that produces increased tax revenue … and how likely is that growth?

Consumer, business, corporate and government debt can remain in good standing only as long as such debt can be serviced …, which, at the least, means only as long as interest payments remain current.  Interest is what a borrower pays as a privilege of using borrowed money.  Today in the U.S. interest rates vary from a low of .09% for safe and secure 30-day US Treasury bills, to 2.7% for 15-year home mortgages, to 5% for risky corporate junk bonds, to between 13 and 25% for high-risk credit card debt, all of which are at historic lows.  Because so much of today’s outstanding debt is serviceable only because of unprecedentedly low interest rates, there is fear that defaults will become widespread should rates increase.

Happily, there is no basis for that fear … because interest rates will not be allowed to increase.  That’s a promise that’s been made by America’s Federal Reserve … and you can take that promise to the bank so to speak.

Even so, the high level of commercial leverage that existed prior to Covid-19 has increased significantly during 2020, with an unhealthy portion skewed towards high-risk borrowers.  Corporate issuers, for example, raised a record $6.65 TRILLION of new debt this year of which $4.25 TRILLION was “high-yield” junk debt.

But perhaps interest rates will decline further?  Debts could be more easily managed if interest rates were lower.  Commercial and individual rates, however, already are near rock bottom …, especially on a risk-adjusted basis.  Materially lowering those rates would take debt obligations into negative territory – meaning that lenders would have to pay borrowers for the privilege of lending money.  While that might work for highly-rated sovereign debt (and has worked so far to the tune of $18 trillion, most recently for Spain, Portugal and Australia), negative rates are unworkable for non-government obligations where creditors would sooner foreclose than pay for the privilege of lending to deadbeat borrowers.  Yet even a lower interest rate environment in 2021 would not necessarily be beneficial.  Rates are likely to decrease only in response to a recession … and recessions squeeze cash flow, creating a need for borrowers to issue yet more debt to offset deepening cash flow shortfalls.

What has led to this debt bubble burden for so many Americans, American institutions, American businesses and America’s governments?  How did all of them fall so deeply into this debt hole?

The debt burden began to build in 2008 in response to the Great Recession when governments showered the world with helicopter money liquidity and Central Bankers lowered, and continued to lower, interest rates in an effort to stimulate their countries’ economies.  In America, the Federal Reserve created a low-growth steadily-growing economy by deploying an arsenal of sophisticated monetary policy tools …, and inventing new ones as needs increased:  Quantitative Easing (QE1 began in 2008, QE2 in 2010, QE3 in 2012, QE4 in 2019, and QEforever QE5 in March 2020), the purchase of commercial and financial distressed debt instruments, reducing bank capital requirements, opening a lending window to banks and “main street” businesses, engaging in open market operations, lowering short-term interest rates, and telling the world that it would act as “the lender of last resort” to do whatever it takes to protect against economic calamity.

For the 11 years prior to Covid-19, America’s GDP was on a stable growth path during which the U.S. didn’t record a single negative quarter, setting a post-WWII record.  Moreover, job creation exceeded projections in every one of the years 2009-2019 with the unemployment rate similarly setting new multi-decade lows.

Those records were made possible by extraordinary fiscal stimuli – the Fed’s low interest rates and QE and governments’ deficit spending –, all of which significantly increased in 2020.  These truly massive stimulus measures led to excessive extensive household, business and government borrowing and an historically-unprecedented period of sustained, if mediocre, economic growth when American consumers borrowed to purchase consumer goods that they otherwise would have been unable to afford and American businesses leveraged their balance sheets like never before.  One reason for Americans’ increased borrowing has been that wages for the majority haven’t kept pace with inflation:  The Pew Research Center reports that wages after inflation have the same purchasing power today as they did 40 years ago, and that what wage gains there have been have flowed primarily to the highest-paid workers.  Americans have thrived survived over the past 11 years – and America’s economy accordingly has grown – “on credit.”  At some point, those borrowings will have to be repaid.  The music will stop.  Meanwhile, during the period of increased borrowing-and-spending, Americans purchased ever-more-expensive homes not because of higher earnings, but because of lower mortgage interest rates.  Businesses borrowed by betting that their floating interest rates would continue to decline even as cash flows eroded, recognizing that the low interest rate environment gave them a low-cost option on success …, with failure being at the risk of creditors.  Marginal corporate businesses have been issuing junk bonds at rates that not so long ago were available only to investment-grade borrowers, while many creditworthy corporations have issued their debt instruments to buy back shares to trigger stock options.  State governments borrowed because they were obligated to satisfy the wage and retirement packages promised by prior administrations.  And the Federal government borrowed because the only other option would have been to raise taxes, a sure-fire way for politicians to end their political careers.

It goes without saying that individuals and businesses will continue to borrow until they’re unable to do so.  Students, consumers, businesses, corporations and governments will deal with their leveraged lives as best they can … until they can’t.  The Fed’s response – including low interest rates – and the Federal government’s deficit spending therefore cannot change without triggering a calamity.  Fed Chairman Powell has stated that the Fed will continue into the very far distant future its $120 billion/month (over $1.4 trillion/yr.) of QE … and is amenable to increasing that amount should circumstances warrant, confirming that it will serve as the fiscal backstop for economic weakness and Federal government laxity.  The Fed’s unprecedented efforts to support the U.S economy during the Covid-19 pandemic have included a commitment to purchase Treasury securities and agency mortgage-backed securities “in the amounts needed to support smooth market functioning and effective transmission of monetary policy.”  That open-ended promise means that the Fed indeed “will do whatever it takes.”  Neither Political Party has proposed controlling deficit spending and even the tax increases proposed by the Biden Administration would have only a negligible effect on America’s deficits.

What then will happen to Americans’ and America’s debt?  Federal government debt can be – and in fact has been – managed by printing ever-increasing quantities of Dollars (discussed by TLR here).  Other debtors – individuals, businesses and State governments – can’t print money.  Without strong economic growth that raises their income and cash flow, their debts cannot be repaid … and strong economic growth is not in the cards for 2021 with the world focused on climbing out of pandemic, job losses, industry destruction, technological disruption and recession.  A credit crunch therefore is coming, quite possibly in 2021 – even cheap debt at some point must be repaid or refinanced.  Grace periods for the repayment of existing loans are coming to an end.  Further government stimulus is questionable.  State budget shortfalls will soon result in layoffs and service cuts.  An unknown number of businesses and households that no longer can service their debts or refinance them will face insolvency.  America accordingly may be faced in 2021 with some of the same problems it confronted in 2008 … only more so … as well as new ones.  The tools that the Federal Reserve used over the last decade to deal with those problems now have been supercharged.  The hope is that they will work as well as they did then.

In 2012, John C. Williams, who now is President of the Federal Reserve Bank of New York, quoted Milton Friedman in addressing the potential consequences of the Fed’s extraordinary use of monetary policy measures:  “‘Inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output.’  We are currently engaged in a test of this proposition….  Some commentators have sounded an alarm that this massive expansion of the monetary base will inexorably lead to high inflation, à la Friedman” (a subject addressed by TLR here).  America’s monetary base has been expanding for more than a decade and today is expanding at a truly historical rate.  The hope is that the expansion will once again fend off a massive increase in insolvencies and defaults without resulting in out-of-control inflation.

Finally (to hopefully mark the end of Covid-19 cartoons):

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