Want Faster Economic Recovery? Raise The Cost Of Debt

By William A. Foster, IV

A pound of worry won’t pay an ounce of debt. — John Ray

My business school financial theory professor once gave our class the lesson of perfect arbitrage. A perfect arbitrage, requires zero capital investment, and a guaranteed return within a designated time frame. He loved hamburgers so his exampled involved us buying hamburgers at $0.25 with a loan, being able to sell them at a guaranteed set $0.50 which produces a return of 100% minus the cost of the loan, and of course we pocket the difference. While the numbers I just gave you seem inconsequential imagine that you bought $2 million worth of hamburgers. You just made yourself a $4 million dollars then repay the loan of $2 million and still have $2 million in your own pocket. Risk to yourself? Absolutely none. Upside to yourself? 100%. The bank has all the risk (loan) and you have all of the upside because of the guaranteed ability to sale all of  your hamburgers at a profit in short time frame. My professor also said it would be impossible to have a perfect arbitrage because as soon as the market saw the opportunity everyone would flood into it and the economic pressure would essentially undermine the fundamentals of the arbitrage. As the old saying goes “Oh ye, of little faith”.

Currently, the Federal Funds Rate sits in a “range” of 0.00-0.25 percent but most of us realize that range is more for appearance sakes. Banks have been enjoying basically borrowing at these rates and then buying Treasuries, guaranteed government debt paid by Joe and Jane Taxpayer, which for all intents and purposes currently are paying 300 basis points or 3 percent. Arbitrage anyone? Well, yes and no.  Yes, because the banks are doing as my professor described in arbitrage. Borrowing from the Federal Reserve at no risk and then buying a guaranteed return with the Treasuries while pocketing the difference. No, because in theory what is suppose to destroy perfect arbitrage is everyone would rush and create such a demand on money that it would force interest rates back up. However, the Federal Reserve is artificially keeping the interest rates down despite the demand for capital and more importantly not all banks are able to access the Federal Reserve window. This alone keeps the group small and that group gets even smaller when you factor in the political capital that the largest banks use in their influence through their conduits on K Street in Washington.

Ultimately, this creates a problem. As long as banks can get a guaranteed profit spread that keeps up with inflation, which traditionally runs at 3% per annum, then so to does the value of their profits buying power. That means that there is no incentive for banks to lend because the borrowing cost it would typically take for them to secure capital from the Federal Reserve which banks would then loan out to individuals, small business, corporations, and governments is simply not there. Why risk an uncertain thing when you have the sure thing? They would not and not only would not if they even thought about doing so they would have a shareholder revolt on their hands for taking risk when there is absolutely no need. Despite the fact that it is harming the overall economy.

Right now what many people and institutions are facing is a cash flow shortage. They have too many  bills with too many payments and not enough cash flow to meet them. In the past when debt was more expensive a banker would call you up and ask if you wanted to consolidate all your debt and have one payment. This would allow you to start to build savings or pay down the debt faster because more of your money would then be going to principal. Unfortunately, with interest rates so low in order to even get a bank to look your way you need pristine credit. Something that was long since destroyed for the majority of Americans and many of its institutions thanks to the Great Recession.

It seems counter-intuitive to make debt more expensive but simply put until the Federal Reserve raises the cost for banks to borrow they will see no reason to take on risk and let individuals, small business, corporations, or governments borrow. Chairman Bernanke is an academic so I’m sure even he should be able to do the math on this one.  Unfortunately, we are running at a time when the recovery of the banks and the recovery of the economy seems to be inducing policy decisions that run counter to each other so Main Street will continue to suffer.

Mr. Foster is the Interim Executive Director of HBCU Endowment Foundation, sits on the board of directors at the Center for HBCU Media Advocacy, & President of AK, Inc. A former banker & financial analyst who earned his bachelor’s degree in Economics & Finance from Virginia State University as well his master’s degree in Community Development & Urban Planning from Prairie View A&M University. Publishing research on the agriculture economics of food waste as well as writing articles for other African American media outlets.

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