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The Cost of Capital: China, Commodities, and Credit

The cost of capital is the linchpin that directs investment to the worthiest causes in a free market; however, sometime the market is not so free, and the actual behavior differs from that of the rational economic person. As the world’s central bankers direct, the cost of debt is lowered in a slowing economy to promote lending and discourage saving. A strategy that stimulates investment through debt comes with risks for real growth in an economy that is dominated by services and consumption. Risk increases with a fixed currency to a large trading partner, China, and globally traded commodities. The US economy will discover if the grand experiment will work.

The economics of loans is simple: lowering the cost of a good will increase its demand. The lower price induces business and consumers to gorge on cheap debt to finance investment and consumption, which then deploy slack resources. Low returns on savings persuade consumers to spend more as the opportunity cost is low. The expectation of higher growth leads the astute investor to move from low yield debt to the higher returns of risky assets, which itself increases consumption from the wealth effect. There is little to dislike of this virtuous circle.

Lower price, higher supply. In the last 20 years and all around the world, the counter-cyclical monetary policy of choice was the lowering of interest rates. The US, in particular, led the charge in the late 1990’s to avert danger through the Asian Crisis in 1997 and the failure of LTCM in 1998. These actions resulted in a stock market bubble as investors pushed into stocks in general and technology stocks in particular. The Federal Reserve countered the hot economy and elevating equity markets by reversing course and increasing rates. The subsequent equity deflation led to a pull-back in investment and final demand, which then resulted in an unprecedented lowering of interest rates.

Lower interest rates in the early 2000's led to an increase of debt issuance in the consumer sector as mortgage debt exploded across the US. The cost of this debt alone was not sufficient to provide debt financing to the US consumer: increased credit availability by financial institutions was required. Not to be outdone by the household sector, corporations, municipals, and asset-backed debt expanded to unprecedented levels. The flood of supply could not happen, however, without an indifferent buyer.

Buyer Beware. Two investors clamored for the debt: first, in response to low interest rates, insurance companies and pension plans moved into riskier and higher yielding assets in a search for yield. Second, the entry of China into the WTO with its fixed currency to the US dollar, which required them to neutralize their trade surplus through the purchase of US Treasuries. Supply thus met demand.

This collision of lower interest rates and increased demand also created the incentive for companies to issue debt. What was once funded by equity was now financed through debt. When combined with indifferent investors, corporate and household debt expanded in the US, particularly mortgages