Addicted to Cheap Debt
Before the pandemic, corporations and governments were loading up on debt thanks to low-interest rates. After markets collapsed following the Covid-19 lockdowns, the United States and many of the world’s largest corporations took borrowing to a whole new level and are now carrying more debt on their balance sheets than ever before.
While some are viewing these high debt levels with caution, the Federal Reserve seems steadfast in its commitment to keep pumping the markets with money to prevent the system from falling flat on its face.
For now, investors find this comforting enough as markets continue to surge forward. At the time of writing, the S&P 500 had just reached a record closing all-time high for the 42nd time in 2021.
But if interest rates rose tomorrow and the Fed turned off the printing press, would markets continue their journey upward or come crashing down?
Could Cheap Debt Benefit the Economy?
Had interest rates not been so low at the time governments instituted lockdown measures that led to an economic collapse, many large corporations and small businesses would have been in much larger trouble than they already were. In this extreme circumstance, we can be thankful our government overlords provided convenient assistance to the problem it created.
These cheap borrowing costs and government stimulus payments allowed businesses to replace lost income, stock up on cash, refinance old debt obligations to more affordable rates, and issue cheap new long-term debt.
Now as the economy starts to recover, businesses are loading up on credit that they will hopefully use to produce goods and services in the coming months. Interestingly, companies are taking out loans but not drawing funds into their accounts yet because they are still flush with cash that they haven’t been able to spend yet.
The hope is that this pile of cash and credit will allow businesses to ramp up spending and economic output by building inventory, investing in technology, and even paying down other debts.
At least in the short term, cheap debt has benefited the economy. Many folks also believe this will benefit the economy in the long term if companies can earn enough profit to service these debts. Opposite to that, others believe this amount of debt will only drag down future economic growth.
Eventually, these debts will have to be repaid and we will have to wait and see if all of the recent borrowing is beneficial for the economy or not.
Looming Threat of Cheap Debt
Just as the economy saw following the collapse of the financial system in 2008-09, increased lending does not necessarily lead to increased economic output, especially when borrowing costs have been artificially suppressed or lending standards have been dropped.
Prolonged periods of artificially low interest rates can have negative impacts on the long-term health of the economy as unproductive businesses are kept alive when a free market would allow them to fail.
If the economy experiences another economic collapse from another round of government-induced lockdowns, creditors may not have the capacity or willingness to continue lending to businesses. This would force the government to step in with more fiscal stimulus or allow the free market to take out the unproductive businesses.
However, this may be an issue as the federal government is fast approaching the debt ceiling that had been suspended until the end of July this year. The Congressional Budget Office estimates that the ceiling will be hit sometime around October or November if it is not raised.
Although the Federal Government has raised the debt-ceiling nearly 100 times since it was instituted during World War I, lawmakers are signaling they may not want to raise it this time. We will see how that goes.
But if for some reason conservatives pretend to follow their ideology this fall, the markets could be in for trouble as the government would be forced to default on debt obligations, likely causing interest rates to spike in the process and threatening an increase in borrowing costs for businesses.
With the record levels of debt, this could be disastrous for the economy and the government.
How To Break an Addiction
The first step in overcoming any addiction is admitting there is a problem. Just about everybody except the government and supporters of Modern Monetary Theory acknowledge that our financial system is addicted to cheap debt.
For the most part, both governments and businesses have replaced income with cheap debt. This is a fragile system that exposes itself each time an economic crisis occurs.
The only way to break the never-ending cycle of money printing and cheap debt dependency is to return to a sound monetary system. However, as appealing as this may sound, for now, this is a far-off reality. Until that day comes, we may just have to buckle up for the volatility and uncertainty this addiction affords us.