In early March, the European central bank (ECB) decided against further rate hikes in 2019, and offered banks a new round of cheap loans to help revive the euro zone economy. Earlier this week, the US Federal Reserve also announced that it was not planning any more rate hikes in 2019 and just one in 2020. If you are unsure how this impacts you, you’re not alone.
We all can understand that central banks raise interest rates to make borrowing money more expensive. This is often done to stop irrational exuberance. For example, to reduce stock buybacks that inflate the stock price of a company, making it harder to get a mortgage on higher priced real estate that you may not be able to afford, or to curb riskier, leveraged investments, like mortgage backed securities in 08-09. In contrast, central banks will offer cheap loans or inject money (ie. Quantitative Easing [QE] in the US) to try to encourage spending to make an economy continue growing. Is this a bad thing? Don’t we want our economy to keep growing?
To illustrate how credit cycles work on a whole economy level, we only need to look to one of our favorite games, Monopoly™. Early in the game, people have a lot of cash and only a few properties, so it pays to convert your cash into property. As the game progresses and players acquire more and more houses and hotels, more and more cash is needed to pay the rents that you are charged when you land on a property that has a lot of them. Some people are forced to sell their properties at discounted prices to raise the cash. So, early in the game, “property is king” and later in the game, “cash is king”. Those who play the game the best understand how to hold the right mix of property and cash as the game progresses.
Now let’s imagine how Monopoly™ would work if we allowed the bank to make loans and take deposits. Players would be able to borrow money to buy property, and rather than holding their cash idly, they would deposit it at the bank to earn interest, which in turn would provide the bank with more money to lend. Let’s also imagine that players in this game could buy and sell properties from each other on credit (i.e., by promising to pay back the money with interest at a later date). If Monopoly were played this way, it would provide an almost perfect model for the way our economy operates.
The amount of debt-financed spending on hotels would quickly grow to multiples of the amount of money in existence. Down the road, the debtors who hold these hotels will become short on the cash they need to pay their rents and service their debt. The bank will also get into trouble as their depositors’ rising need for cash will cause them to withdraw it, even as more and more debtors are falling behind on their payments. If nothing is done to intervene, both banks and debtors will go broke and the economy will contract. Over time, as these cycles of expansion and contraction occur repeatedly, the conditions are created for a big, long-term debt crisis.
What does this mean for the average investor? Typically, the value of their investments drop, and there is no money available to grow a business or invest in other assets. The key to success is to learn how to hedge your risk and protect your investments.