The Bear’s Lair: Why would you want to preserve this economy?

Financial media are now worrying that, if the Fed is even hawkish enough to raise rates by 0.5% instead of 0.25% at its meeting in March, the U.S. and global economies will tank. In reality, with producer price inflation at 9.7% in the year to January 2022, even a 0.5% interest rate rise is the first step in a very long road, perhaps back to the double-digit interest rates of the early 1980s. So, the economy is probably doomed anyway – and just why would you want to preserve it, in its current form?

To get a view of the universe from the opposite direction from my own, I occasionally read effusions from “Jacobin” so I was amused this week by Grace Blakeley’s column “Raising Interest Rates is about Screwing Workers.” It makes the well-known arguments against Margaret Thatcher’s high interest rates of the early 1980s, then argues against repeating them by pointing out that, according to a Trades Union Congress study, British workers’ wages have suffered the longest period of stagnation since the 1800s. For most of Blakeley’s readers, that argument is doubtless convincing, but I would point out that the period since 2008, that covered by the study, has suffered the lowest interest rates in recorded history, in both Britain and in most of the rest of the Western world. Thus, it is low interest rates, not high, that have “screwed the workers.”

The ultra-low interest rates of the past quarter century have formed a huge subsidy to asset values as compared with earned or unearned income. You can see the effect of this in a recent Financial Times study of the remuneration of private equity managers compared with investment bankers. In the past, investment bankers were the Masters of the Universe, in Tom Wolfe’s famous phrase, because their activity in reshuffling the deckchairs on the economy’s Titanic generated more returns per capita than any other. Now private equity investors, who simply leverage the hell out of random companies and wait for asset price inflation to do its work, make more than twice as much per capita, over $2 million per employee (which includes the janitors) compared with $1 million for bread-line investment bankers. The pecking order in the Hamptons and at Gstaad is out of whack!

One of the other features of our low interest rate economy is that it has inspired a tsunami of consumer credit. The consumer credit does not bear low interest rates, of course – those are not for little people! However, the gargantuan interest rate spreads between the rates at which the consumer credit companies can raise their money and the rates at which they lend it mean that creditworthiness is almost entirely absent from their calculations. If you are making a 25% spread between borrowing and lending rates on a credit card, and it takes five years for your borrower to max out both your credit card and the increasingly dubious credit cards to which he will have access as his credit score deteriorates, then you are ahead of the game when he defaults. And if even a few of your borrowers do not default, then your profit margins are positively mouthwatering!

Low interest rates and the asset-inflating economy also maximize the gap between the ultra-wealthy and everybody else, whether working class, middle class or upper middle class. The ultra-wealthy can raise cheap leverage, invest it in assets and make themselves even more wealthy, whereas that is not possible for the rest of us. Consider for example a prosperous dentist making $300,000 a year. He must take on a gigantic mortgage to buy a suitable house in the suburb convenient to his practice, on which the interest payments may be modest but the principal payments eat into his income badly. He must pay health insurance at exorbitant rates for his family, he must pay school fees for his children, since the local public schools are hopelessly “woke” and inadequate, and he must make substantial contributions to a self-employed pension that is invested conservatively and so rises in value only moderately. He will never be rich, because he will never have accumulated the level of assets that would allow him to maintain a rich person’s lifestyle on his income. His only contact with the truly rich person will be to drill his teeth.

Fifty years ago, when real interest rates were positive and leverage was harder to obtain, this was not the case. Inflation ate away at the rich person’s wealth, and if he levered up, he had to find large interest payments on his borrowed capital. Conversely, the dentist paid only a modest amount for his house, drove a Buick for ten years instead of leasing a Lexus for three, sent his children to the excellent public schools and paid only modest health insurance premiums. At retirement, the dentist would have saved an amount of money that was truly competitive with the really rich man’s capital and would have a large well-earning young family to help support his retirement if necessary. With positive real interest rates, the rich man is on a level playing field compared to the dentist, and society is much healthier for it.

The asset-oriented economy has also hugely encouraged “quick buck” artists. With high leverage and quick asset creation the easiest way to big money, chicanery has grown apace. Cryptocurrency, “NFTs” and other novel asset markets exist only because real interest rates have been held below zero for several years, so borrowing to buy or create an asset with no yield has been profitable. Likewise, the explosion in new gambling opportunities such as legal sports betting owes a great deal to this phenomenon; an ordinary person has no way of creating lasting wealth through hard work, so is tempted to wager on winning it through lotteries and the like. Needless to say, this explosion in spurious assets and gambling opportunities “screws the working class” more than any other feature of today’s investment world.

Sorting out inflation, unless it disappears of its own accord (which I do not expect) will require interest rates for long-term debt to be raised above the inflation rate, in other words into double digits or close to it. That is the process that Ms. Blakeley describes as “screwing the workers” but in fact there is every likelihood that workers will be less affected than other groups. The most affected will be those with huge asset holdings, especially if those holdings are leveraged or dependent on stocks with high price-earnings ratios. There will unquestionably be a massive cull of billionaires, probably reducing their number by three quarters or more (though bear in mind that the inflation itself, before interest rates reach the optimum, will first have inflated their number substantially.)

Among those in less exalted strata, the over-leveraged will suffer worst, both the workers who have over-extended themselves and, more severely, the middle-class intellectuals with excessive student debt and poor employment prospects. Homeowners themselves will be less affected, provided they do not have to move. The value of their homes will collapse, making them “underwater” as so many borrowers were in 2008-10. However, if they have borrowed on a responsible basis, their low-cost fixed-rate mortgage will save them as inflation will reduce the real value of their mortgage payments while their income from work will increase with inflation, generally speaking. The biggest winners will be the young working class with decent jobs but no assets; their incomes will rise with inflation and house prices will decline substantially, making it much easier for them to create a stable home-owning family.

We have seen before a period in which heavy gambling and bankruptcies gave way to hard work and asset accumulation; it was roughly the period 1815-30 in England, when the Evangelical movement was dominant and the Prince Regent’s dissolute way of life went out of fashion. Both upper and middle classes became Victorian, as we understand it, with fewer mistresses, less drunkenness and no gambling. The state itself had raised much of its income from lotteries in the 18th century; these lotteries were abolished by Lord Liverpool in 1826 and no state-sponsored gambling was then permitted until Harold Macmillan invented Premium Bonds in 1956.

The return to positive real interest rates will eliminate inflation and be enormously beneficial for the economy, eliminating speculative manias and replacing them with sound, creative long-term investment. To benefit from it, however, it would be best to adopt some of that old-time Evangelical spirit. A top hat and a wing-collar (for the men) and corsets (for the ladies) will help you achieve this!

(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)