We’re trapped. Decades of easy money have driven debt at all levels to historically unprecedented levels. According to data from the Institute of International Finance, the indebtedness of governments, financial companies, other companies and private households in industrialized countries reached new highs in the first few months of this year. One man’s debt is another man’s wealth, which is why some commentators argue that the debt is not a problem.
As in the Jenga game, we built a tall tower with an increasingly shaky foundation. Companies have increased return on equity through the use of debt. Investors have taken on greater risks in the face of low interest rates, pouring more money into illiquid investments such as private equity – direct participation in companies – and borrowing to increase returns.
The financial sector has also relied on debt to generate the expected returns. This goes from private equity to hedge funds to pension funds – often packaged in financial instruments that are not very transparent. The collateral required for this, mainly US government bonds, is often pledged several times.
In theory, all of this can be reversed in an orderly manner, but not in practice. The danger of the situation was seen when the rapid rise in interest rates put pressure on UK pension funds, which had relied on derivatives, effectively debt, to boost returns.
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It doesn’t matter where the problems first appear: whether it’s with the companies that took on too much debt in good times, whether in some overvalued real estate markets, or with investors who are sitting on big losses in their bond portfolios after the rise in interest rates.
Interest rates that are too low lead to a crisis
None of these risks will inevitably trigger another financial crisis. Like in 2009, this requires a chain reaction. Back then it was the mortgage securities held around the world, this time it could be the reduced supply of quality collateral. The banking system is more solid than it was ten years ago, but the shadow banking market has ballooned dangerously.
Walter Bagehot, the legendary publisher of the British weekly newspaper “The Economist”, stated a good 150 years ago that interest rates that are too low lead to speculation, bad investments, excessive consumption and thus to a crisis. He also said that the central bank has a duty to help in the event of a crisis – but only for solvent houses, at high interest rates and only for a short time.
Daniel Stelter is the founder of the discussion forum beyond the obvious, which specializes in strategy and macroeconomics, as well as a management consultant and author. Every Sunday his podcast goes online at www.think-bto.com.
(Photo: Robert Recker/ Berlin)
These principles applied until the euro and financial crisis. Since then, low interest rates and the central banks’ purchases of securities have become permanent fixtures, and it is reasonable to doubt the solvency of some debtors, including government borrowers.
The debt tower was growing taller and wobbly and would not be able to withstand a sharp rise in interest rates, certainly not to levels seen in the late 1970s. This explains the relief on the financial markets about lower-than-expected inflation rates in the USA, which make it appear possible that interest rate hikes will end soon.
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The central banks and states will do everything in their power to cap interest rates. The heavily indebted states cannot cope with higher interest rates, and the central banks would have to accept considerable losses on their massively increased bond portfolios. The Dutch central bank has already warned that a government subsidy could be needed to cover the losses.
This means that we must permanently say goodbye to the periods of low inflation. It is quite possible that inflation rates will soon fall significantly in view of the global recession and the associated drop in demand, which would confirm those who attribute inflation solely to the external shock of Corona and the Ukraine war.
However, a look at history shows that inflation comes in waves. The current wave of inflation is not the last and is unlikely to mark its peak yet.
Daniel Stelter is the founder of the discussion forum beyond the obvious, which specializes in strategy and macroeconomics, as well as a management consultant and author. Every Sunday his podcast goes online at www.think-bto.com.
More: A severe economic crisis is imminent – four reasons that speak in favor of it.