End of an Era
The McKinsey Quarterly recently published an article entitled “The era of cheap capital comes to a close” and described how the global economy has enjoyed an continually increasingly flow of capital in both developed and developing markets.
The authors, Richard Dobbs and Michael Spence, argue that the trend of “easy capital” and “hot money” has already begun to reverse and that we may see an era of financial protectionism on the horizon.
I agree with the authors that extremely cheap capital will most likely be a phenomenon of the past at some point within the next 5 years, but how and when it happens is up for debate. Let’s start at the top . . .
The Federal Reserve is going to have to raise interest rates at some point. There doesn’t seem to be much debate about that. The Federal Funds Rate and Discount Rate are each below 1% and have been for several consecutive quarters. Essentially, that means that banks can borrow money overnight from each other and from the Fed at just above 0%. This allows them, in theory, to allocate more of their cash as loans of some sort. I say “in theory” because in practice only a few banks have been able to completely reopen the spigot of debt that borrowers seem to demand.
In practice, we have seen a case study of East Egg vs. West Egg. The “Haves” are bidding on deals aggressively and the “Have-Nots” are not even getting to bid on transactions.
Borrowers able to obtain debt financing on their properties have been able to pay very aggressively for the right properties and we have seen a rejuvenation of the CRE market that some might call too frothy. That is why we have seen buyers in the commercial real estate market paying for Class A office and apartment space on a 5% cap rate. A 5 cap would have been aggressive in 2006 and seems almost silly in 2011, but that is the effect that cheap capital (in this case debt capital) has on transactions. If you borrow the money cheaply, you can pay more for the same property.
Bernanke and the Fed haven’t stopped at low interest rates to induce spending. They also use Quantitavive Easing (QE) to pump more cash into the economy. QE is basically when the Fed prints money in order to buy government bonds and other financial instruments in order to give the economy a substantial cash infusion.
Well, let’s go back to Economics 101. What happens when the supply of dollars increases substantially and the demand for dollars doesn’t? INFLATION. It’s gonna happen. Get used to it. Because there is such a huge supply of dollars and there is not an equivalent demand for dollars, the value of our currency is going to drop relative to other currencies (particularly the Euro).
Bernanke knows this but he also believes that he has the Ace up his sleeve. He seems to believe that incremental adjustments to the FFR and the DR will be able to keep inflation in check. That is, raising rates will restrict the flow of capital enough to offset the impending devaluation of the dollar. A dollar that is harder to borrow is a more valuable dollar. I would be willing to bet that at the first sign of substantial inflation in the CPI (Consumer Price Index), you will see the FFR and the DR jump by 25 basis points. As the CPI continues to creep up, so will the Fed’s rates.
(Editors note: This also involves the concept of “The Velocity of Money,” but those are deeper waters than we need to get into here and we will assume velocity is constant for this article.)
Intuitively, no one wants a devaluation of their currency, but why not start the process now and stop inflation before it begins (like China has failed to do.)? The answer is that the Fed fears something more than inflation: a longer recession. Conventional wisdom is that even a slight increase in interest rates will cause bankers to clamp down on lending and borrowers will be completely left out in the cold. Even the mighty East Eggers will have no access to debt capital, the economy will shut down, and the current recession will drag on and on and on . . .
While that scenario is certainly possible, I don’t think it is very probable. In my opinion, creditworthy borrowers/investors will have access to capital regardless of interest rates. Investors with a long track record of success and prudent investment will always find capital available. If no debt is available, equity will enter that space and require similar returns. That is why we have still seen deals trading hands over the past three years. The best borrowers still have money and want to deploy it in sound investments.
The problem the Fed and the President have is that, in that scenario, not everyone is spending as much money as they can. There is a large amount of capital on the sidelines waiting to be deployed. My question is: Why is that bad? That seems like slow, cautious growth to me. That is a scenario where prudent deals get done and fringe deals are hit or miss. Again, why is that so bad?
I have seen our president try to spend his way out of the recession. All that I can see that he has accomplished is $1.6 Trillion in debt that me and my children are going to have to pay for and headline unemployment remaining around 9-10%. So, as a borrower, why should I try and do the same? Why should I just try and spend a bunch of money to boost the economy? Why should I go out and invest gobs of money on fringe deals and assume everything is going to be better because we are “spending money?” Again, the core, vanilla deals are being financed right now with ease. Why do I need these low interest rates to chase fringe deals that probably shouldn’t been done in a shrewd investment portfolio?
By now you can probably guess that I am in favor of raising rates. I think the Fed should start boosting rates by 25 basis point every quarter for the next several quarters. That way, the deals that should get done still get done and fringe deals with razor sharp margins that require a 1.75% interest rate on debt will not.
Maybe I am the only one, but I think we should return to growth patiently and cautiously. We should make our capital available but not free and we should fight inflation before it takes over our currency. I want our country to continue to grow and progress, but I want it at a sustainable and intelligent pace. Let’s not just grow and spend for growth and spending sake. Let’s be smart and intentional and our children and grandchildren will know a better economy and better quality of living than we can even imagine. Let’s try and plan our policies based on the success of the economy for the next 100 years not the next 2 years.
So, back to Mr. Dobbs and Mr. Spence, I certainly hope their prognostication comes true. Let’s hope that countries are protective of their capital and that money is lent and spent on strong and attractive endeavors that promote growth and not bubbles.