A major change in the financial balance of power took place in the autumn of 1979. The advantage shifted from borrowers to lenders when interest rates rose from below the underlying inflation rate to well above it.
The financial balance of power shifted in response to a change in Federal Reserve policy. The Fed's old policy kept interest rates low to stimulate the economy and to assure low-cost funds for borrowers such as the Treasury. An unwanted byproduct of low interest rates was an excessive money supply growth and the inflation that accompanied it.
Under pressure to control inflation more effectively, the Fed abandoned its old policy for a new one of controlling the money supply growth. A byproduct of the new policy is higher and more volatile interest rates.
Interest rates are high in absolute terms and relative to the underlying inflation rate as well. Today's mortgage rate of about 15 percent and prime bank rate of nearly 20 percent are well above the inflation rate of about 10 percent.
Once a rare event, high real rates of interest now are the norm. After decades of enjoying abundant and low-cost credit, borrowers of all kinds now find themselves at an unaccustomed disadvantage.
Borrowing to buy a home was a very attractive proposition when mortgage rates were 7 percent and home prices were rising at 12 percent per year. Financial leverage multiplied the gain and no tax was paid when the seller bought another home.
The situation looks very different today: With mortgage rates about 15 percent, to buy an asset appreciating at 12 percent is distinctly unprofitable. p
The situation looks even worse considering that the buyer guarantees the payment of high mortgage rates, but no one guarantees the buyer will enjoy the expected gain in the price of his home. Home prices have been rising at less than the inflation rate since October 1979 and may decline in some markets if interest rates stay at current high levels.
Corporate borrowers face a similar unpleasnat situation. The average corporation earns about 12 percent pre-tax profit on its assets, which is well below the current cost of borrowed money. Company treasurers know that borrowing at today's high interest rates is likely to be unprofitable, but there are three reasons why they go on borrowing anyway.
A few companies have investment opportunities so profitable they can justify borrowing at a prime rate of 20 percent. A larger number of companies borrow because they hope that interest rates will decline soon. Still other companies borrow because they are so addicted to debt they cannot survive without it. The British, who are further down the path to financial perdition than we are, have an understated but accurate term applicable to the practices of companies like Chrysler for which debt is more a matter of present survival than future profits: distress borrowing.
When the advantage shifted away from borrowers, it shifted away from most shareholders as well. Shareholders enjoy their earning and dividends only after payment of interest on debt. Since debt cost much more in real terms, there will be less left over for shareholders in debt-intensive corporations.
Corporate bankruptcies may be more common in the new era of high real interest rates. Marginal companies that survived through access to low-cost credit now find credit more expensive and less available. If serious recessions accompany high interest rates, marginal companies may face the worst of all possible worlds.
Lesser developed countries also feel the squeeze of higher interest rates. Most of their commercial debt is tied to short-term interest rates, so high real rates in interest in this country are viewed by them as a costly and unwanted U.S. export.
As the advantage shited away from debtors and shareholders, it shifted to creditors who enjoy a positive real return on their investments, at least on a pretax basis.
Tax-exempt creditors such as pension funds now enjoy substantial real returns in both long- and short-term debt instruments. Long-term corporate bonds currently yield about 15 percent, or 5 percent in real terms after allowing for inflation. Short-term yields are higher, but also are more volatile.
Taxpaying investors are still caught in the middle. An investor in the 50 percent marginal tax bracket does not enjoy a real return on a 15 percent bond after paying 7 1/2 percent in taxes. In this case both borrower and lender lose in real terms, but the government wins, as usual.
The Fed's new policy forced interest rates up and made them more volatile as well. Returns on Treasury bills have varied from 6 1/2 percent to 15 3/4 percent since the Fed began its new policy, which is extraordinary volatility by past standards.
High and volatile interest rates put borrowers in a double bind. High interest rates make borrowers uncomfortable with the present. Volatile interest rates make them uncertain about the future. To be uncomfortable and uncertain is an unpleasant way to go through life, but that is the prospect for borrowers as a result of the Fed's new policy.