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The End Of Cheap Credit?

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By Robert J. Samuelson
Wednesday, June 13, 2007

The most important price in the American economy is not the price of oil, computer chips, wheat or cars. It's the price of money -- interest rates. When rates move, they ultimately affect the price of almost everything else. Which poses some intriguing questions. Is the era of low interest rates ending? If so, what's next? The answers will hover over the 2008 election. A shaky economy would help Democrats; a stronger economy, Republicans.

The economic expansion, both in America and the rest of the world, has rested on a foundation of abundant credit. Low interest rates famously drove the housing boom. In the 1980s, mortgage interest rates averaged 10.9 percent; after inflation, the "real" rate was a hefty 7.2 percent. During the decade, home prices rose a meager 1 percent beyond overall inflation. Since then, mortgage rates have dropped sharply. From 2000 to 2006, they averaged 6.5 percent, and after inflation only 4.2 percent. Lower rates meant people could afford to pay more. The result: Existing-home prices rose 29 percent more than overall inflation from 2000 to 2006. (The figures are from a study by economists Jonas D.M. Fisher and Saad Quayyum of the Federal Reserve Bank of Chicago.)

It's not just real estate. Low interest rates have fueled the private equity bonanza. Private equity refers to investment funds that, borrowing massive amounts, buy all the stock of publicly traded companies. In 2006, private equity buyouts of U.S. firms totaled $375 billion; some well-known firms "taken private" included Univision (the Spanish language television network) and Harrah's (the casino company). Similarly, low rates enabled governments and companies in developing countries to borrow huge amounts. From 2005 to 2007, borrowing will total about $900 billion, reckons the Institute of International Finance. Russia, Turkey and South Korea are all big borrowers.

But now rates are edging up. There are two ways that credit tightens -- that is, the price of money rises -- and we're seeing both. The first is that government central banks, such as the Federal Reserve in the United States, deliberately try to restrict the amount of new credit. The second is that private investors and lenders (collectively known as the market) become more stingy and risk-averse. They demand higher rates on bank loans, bonds and mortgages.

Until last week, many economists and investors thought the Fed would cut rates this year. From June 2004 to June 2006, it had raised the federal funds rate from 1 percent to 5.25 percent. But the latest speech from Fed Chairman Ben Bernanke changed views; Bernanke repeated earlier worries about inflation. Now, the consensus is that the Fed won't cut rates this year -- and maybe not next. Abroad, the European Central Bank raised its key rate from 3.75 percent to 4 percent. Even the People's Bank of China is tightening credit.

What central banks do mainly affects rates on short-term loans of a year or less. (For example, rates on Fed funds involve overnight loans between banks.) But "the market" has recently raised long-term rates, too. In mid-March, 10-year U.S. Treasury bonds fetched about 4.5 percent; last week, the rates moved decisively above 5 percent. It's not entirely clear why. The higher rates usually spread to riskier corporate bonds and mortgages.

As the price of money increases, borrowing and the economy might weaken. The deep slump in housing could worsen. We could also discover that the long period of cheap credit has left a nasty residue.

In this view, bad loans were made as lenders flush with cash poured money into riskier bonds and loans for private equity firms, hedge funds and developing countries. So defaults and losses mount; in effect, the "subprime" mortgage losses of earlier this year are repeated on other types of credit. The stock market sags under the weight of higher rates and all the bad news (interest rate fears sent the market down sharply again yesterday; the Dow Jones industrial average is now 3.4 percent below its recent peak).

But this grim fate is hardly preordained. Judged by historical standards, the increase in interest rates is modest and may reflect a strong economy as much as tighter credit. Indeed, credit is still ample, just less so than a few months ago. Aside from subprime mortgages, delinquencies on other bonds and loans remain low. Interest rate "spreads" -- the gap between rates on safe and risky loans -- also remain low.

Government central banks are attempting to restrain economies enough to prevent higher inflation, though not so much as to cause a recession. It's a delicate maneuver. Perversely, worsening inflation could push interest rates higher as investors strive to recover the eroding value of their money. The drama is technical and mostly invisible. But the outcome will shape the 2008 economy -- and help determine the next president.


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