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Is the Era of Cheap Credit at an End?


If the U.S. Federal Reserve decides to raise its benchmark interest rate this week, as investors widely expect it to do at its next board meeting on Dec. 16, the fallout is likely to send shock waves throughout global financial markets.

The reasons for this are simple. Over the past decade and a half, and in the last six years in particular, the world economy has been weaned on – and become addicted to – cheap credit. Ever since the crash of the dotcom bubble in 2001, the Federal Reserve has kept its interest rates at historical lows.

In the mid-2000s, the Fed’s cheap credit policy made it extremely easy for investors to borrow money, leading to a wave of speculation in the market for subprime mortgages – a boom that eventually turned to bust, bringing down a number of systemic financial institutions and nearly bringing the capitalist world economy to its knees.

Financial authorities in the U.S. and around the world responded to this crisis by lowering interest rates even further and pumping trillions of dollars into the global financial system. While this prevented wholesale collapse, the nature of the response only fed investors’ addiction to cheap credit, blowing up a series of new bubbles in the process.

Now the Fed is finally showing signs that it wants to “normalize” monetary policy by raising interest rates from their historic lows for the first time in nearly a decade. Officials seem to believe that the crisis is now over, pointing to the return of growth and the stabilization of credit markets as evidence for a recovery.

The problem is that this supposed recovery always rested on a bedrock of speculative investment – all of it made possible by the same cheap credit that causes the crisis to begin with. In the last six years, the Fed and other major central banks papered over deep-seated structural problems in the world economy by showering investors with free money in the hope that some of it would trickle down into the “real” economy.

Of course this “trickle-down” effect never materialized. Fresh data from the Pew Research Center shows that one in five U.S. adults now live in or near the poverty, with 5.7 million people having joined this category since the financial crash of 2008.

In response to the data, the Financial Times notes that “many of the new poor, or near-poor, have become so even amid an economic recovery that is widely expected to lead the US Federal Reserve to raise interest rates next week … [A]lmost 2.5 million adults have joined the lowest income ranks since 2011, long after the post-crisis recession was ostensibly over.”

In contrast to ordinary working people, the junkies in the financial sector thrived during this period – but their high will only last so long as their dealer remains willing (and able) to maintain its supply of cheap credit.

For this reason, an interest rate hike this week would pose a host of problems for investors, who may now be forced to go cold-turkey on their lucrative carry trades, in which they borrowed cheaply from the Fed to speculate dearly in risky bond markets.

In fact, the warning signs are already on the wall – with corporate bond markets, junk bond markets and emerging bond markets all experiencing intensifying financial stress and becoming increasingly jittery ahead of the expected Fed announcement.

To take just one of the most egregious indicators, the total value of corporate bond defaults has shot up to $95 billion this year, the highest level since the global financial crisis, as corporate borrowers – led by US oil and gas companies – struggle to pay back the loans they took on when credit was still cheap and commodity prices high.

The trouble has been especially pronounced in the so-called “high yield” or “junk bond” markets, centered on the most risky corporate investments. Signs of financial stress in junk bond markets were compounded last week when the major investment firm Third Avenue announced the suspension of its $800 million Focused Credit Fund, marking the largest failure of a US mutual fund since the financial crisis of 2008-09.

The announcement sent jitters throughout financial markets, especially in light of the Fed’s expected interest rate hike, which will inevitably increase corporate default rates and is likely to lead to more mutual fund and hedge fund failures in the months ahead.

Corporate bond markets are not the only ones under stress: emerging markets are feeling the heat as well as investors increasingly withdraw money from once-fast-growing developing countries like Brazil, Turkey and South Africa. China, meanwhile, the world’s second biggest economy, is struggling with serious financial troubles of its own.

Whether all of this will lead to another crisis in the short term remains to be seen. The Fed may even hold off its interest hike, or increase rates very slowly, in attempt to prevent fresh panic. Still, as the era of cheap credit inexorably draws to a close, an important question arises: will U.S. officials still be able to keep their Wall Street junkies under control when the withdrawal symptoms kick in?

If the answer is no, which looks increasingly likely, we may be in for tumultuous times.

Jerome Roos is a PhD researcher in International Political Economy and founding editor of ROAR Magazine. Follow him on Twitter at @JeromeRoos.

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