Paradise Regained

From Prudent Bear.

"Emerging market central banks in China, India, Brazil and elsewhere are now raising interest rates fairly aggressively, and even in the United States long-term Treasury bond rates have risen significantly in spite of Fed Chairman Ben Bernanke’s efforts to hold them down. Given the continued rise in commodity prices, it’s likely that these are just the first moves in a lengthy period of interest rate rises. In the medium term, this could raise real long term interest rates, net of inflation, to the 5%-6% levels of the early 1980s, necessary to quell inflationary forces and compensate for the lengthy and unjustified period of ultra-cheap money. It’s thus worth contemplating what such a world of high interest rates will look like.

Much though one may wish for such a world, it has to be admitted that there will be some fairly severe side effects, albeit temporary ones. The incipient U.S. housing market recovery that began in spring 2010, which has since shown signs of petering out, will disappear altogether. With mortgage rates at around 7-8% or quite possibly higher the current generation of homebuyers will gasp when told what their mortgage payments will be. Congressional action to limit the home mortgage interest deduction may well increase the sticker shock further. The result will be further declines in house prices."

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"Higher interest rates will not just affect investors in mortgage bonds. Private equity funds buy companies and leverage the purchase, relying on the company’s cash flows to pay debt service costs. As interest rates rise, debt service costs will rise, reducing the capital value of a given corporate cash flow and causing the fund’s outflows to exceed its inflows in many cases. This will quickly cause a high mortality rate among the private equity fund community. Similarly hedge funds, many of which rely on excessive leverage of moderate but fairly predictable returns, will find a high interest rate environment very unpleasant indeed.

So far I have covered only the adverse effects of a high interest rate environment, most of which will be fairly short-term although the fiscal discipline imposed on politicians will be with us over the longer term. However, as readers were perhaps guessing when I expounded the high mortality levels high interest rates would produce among hedge funds and private equity funds, a high interest rate environment will have a number of positive effects, most of which will be structural and long-term.

For a start, the culling of the private equity and hedge fund industry will decimate the excessive bonuses of Wall Street (because there will no longer be such an active market for top traders’ services) and will sharply reduce the percentage of top graduates heading for these mostly unproductive activities. Leverage in the economy as a whole will decline; it will have become too expensive. The search for short-term gain will also decline, because it will be too expensive and difficult to collect together the money pools for such speculation. These changes will over time greatly benefit the rest of the economy. They will also benefit such people as successful dentists, who will no longer find their purchasing power overwhelmed by the whims of snot-nosed 28-year-old traders. New products and services will consequently appear, as in the golden years of the early 1960s, when an upsurge of earnings and wealth among the Belgian dental community facilitated the creation of the Eurobond market.

The high interest rate environment’s benefits will spread far beyond the dental community, however. It will at last encourage saving, since savers will be rewarded with positive real returns. Since saving will increase and consumption consequently diminish, the pressure of imports will also diminish and the U.S. balance of payments deficit will finally decline towards zero, reducing the country’s vulnerability to foreign finance providers.

This combination of higher saving and a lower payments deficit will begin to recapitalize the U.S. economy. One of the principal factors tending to weaken the earning capacity of the U.S. workforce has been the steady de-capitalization of the U.S. economy since 1995 through low savings rates, periodic asset price crashes and high payments deficits. Meanwhile the capital resources of competing emerging markets, particularly in East Asia, have increased. With interest rates higher and the U.S. economy being recapitalized, the erosion of U.S. living standards will diminish and (if immigration laws are properly enforced) the 40-year decline in the living standards of the U.S. blue collar worker will come to an end."

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"Short-term pain, long-term gain; that’s what we have to look forward to once interest rates rise to their proper level. However while the short-term pain will be concentrated on Wall Street, politicians and a few overenthusiastic homeowners, the gain will be more general. For the great majority of the American people, the long term effects of higher savings, lower house prices and faster job creation will feel like Paradise Regained."