Borrowers never had it so good in the last decade when monetary policy was exceptionally benign. Central banks nudged by politicians drove interest rates to record lows to stimulate economic growth after the great financial crisis of 2008 and, sometime later, the onset of COVID. But the era of easy money is now over, even if some world leaders may still want the good old days of cheap money to return.
Low rates for over a decade have made borrowing so easy. We have rarely heard of sovereign defaults, not even in distressed countries in South America. The underestimation of credit risk led many governments to live beyond their means. Private retail investors similarly took on risks in the bonds market that they did not understand.
Businesses borrowed as much as possible in the capital market to lock in low-interest rates for up to three decades. When older bonds with high-interest rates matured, many businesses refinanced these bonds at exceptionally low coupon rates rather than repaying them.
With central banks finally admitting that inflation is not dead, they started raising interest rates. They will continue to do so for the foreseeable future. It is no surprise that borrowing costs and default rates are rising, and change is being forced on private and sovereign borrowers. The less developed nations will suffer the most as foreign creditors demand a higher return for lending to them.
Last summer, we experienced the ability of the bond market vigilantes to inflict pain on profligate UK politicians who pretend that their rhetoric and happy talk was enough to avert a sovereign debt crisis. Of course, tight money now affects all asset markets, including bonds, stocks and currencies.
The political drama that gripped the UK political system last summer will continue to serve as a reminder that markets often make up their minds rather than rely on politicians’ wishful thinking. Former Conservative UK prime minister Liz Truss was forced out in October after markets reacted to her unfunded cuts by dumping the pound. Her successor Rishi Sunak scrapped her agenda and tried to convince markets and British citizens that significant sacrifices were needed to improve the country’s economic prospects.
The Italian political scene never ceases to confuse economic observers. With the election of the first mainly right-wing government, many wondered how the new prime minister Giorgia Meloni would manoeuvre her way in the preparation of her first budget. She had to keep to her electoral promises of decreasing taxes. In contrast, she had to keep the EU on her side to ensure that the promised recovery funds agreed with her predecessor Mario Draghi will indeed be forthcoming.
Meloni somehow found the right balance after several U-turns on introducing a flat tax, the limits for cash payments, and the use of point-of-sale machines. Still, one would have to be a committed optimist to believe that the present government will make a significant dent in the mountain of public debt that makes Italy the weakest large EU member state.
The onset of another financial crisis may not be so remote. As long as profligate governments pretend that investors will continue to buy their debt at very low interest rates, the risk of a significant crisis remains high.
Markets will reward discipline. In the past they punished countries like Argentina and Turkey, who abandoned orthodox fiscal policies to cater for their local political agenda. Greece learned painful lessons after the humiliation it suffered when the IMF, EU and the ECB troika imposed harsh conditions to save the country from declaring bankruptcy.
Money, like most other essential commodities, has a price. Central banks have learned a lesson that trying to get away with low real rates to stimulate sluggish economic growth cannot be sustained indefinitely. They are now increasing interest rates, adding another risk to many struggling businesses.
Central banks have learned a lesson that trying to get away with low real rates to stimulate sluggish economic growth cannot be sustained indefinitely
Populist politicians are beginning to understand that they can no longer promise spending cuts, generous subsidies, and low taxation without risking the mistrust of institutions like the IMF and financial markets. They will, as usual, blame speculators when they find themselves in a tight corner. But fiscal and monetary orthodoxy will always prevail in the long term.
Fiscal management today has new nuances. It is not just developing countries that must deal with the end of easy money. It is about rich countries, like the US, borrowing excessively to support their social security system. It is also about Europe’s political leaders refusing to deal with structural reforms for fear of losing power.