Flood of US Debt Threatens To 'Crowd Out' Other Borrowers

By Jeff Cox
|  Monday, Apr 13, 2009  |  Updated 11:15 AM PDT
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All the government borrowing programs aimed at increasing liquidity have some economists worried that there could be a steep price to pay down the road—especially for borrowers.

The influx of cash that government borrowing will push into the economy is expected to cause inflation, which in turn will send up interest rates. As savings stagnate and unemployment rises, already-burdened consumers and businesses may not be able to afford to borrow at those rates.

"The prescription of massive debt, of money printing, of releveraging the economy, is exactly what engendered the depression of 2008, and all of the remedies are the same virus that killed us," says Michael Pento, chief economists at Delta Global Advisors in Huntington Beach, Calif. "You've exacerbated everything that went wrong in the beginning. You're increasing the money supply and you're releveraging the economy."

"Crowding out," an economic term that pops into view during times of inflation, is being discussed more as government cash is set to flood the marketplace in the months ahead. The phenomenon would be felt in several ways—through savings as well as borrowing.

And while the coast seems clear for the moment—credit spreads have narrowed slightly and borrowing seems at least anecdotally to be on the rise—there's fear that the cure for the credit blues could be worse than the disease.

For investors, buying corporate bonds and their gaudy yields of 7 percent or more helps provide safety and returns that could offset the cost of borrowing. Stocks and other assets also could benefit because dollar-denominated assets will do well as rising interest rates push up the value of the dollar and discourage hoarding cash. And as the appetite for risk grows, investors will ditch Treasurys and head for higher returns.

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"Consumers are gaining more confidence, the (stock) market is gaining stability," says Tom Sowanick, chief investment officer at Clearbrook Financial in Princeton, N.J. "At some point the switch is going to turn on and investors are going to move as quickly out of the safety of government as they recklessly went in. They will go into corporate assets and the Treasury market will be left holding its socks, dirty as they may be."

Reverberations in the markets have already been felt, Pento says, and there probably already have been effects in areas such as metals along with stocks.

Gold prices have cooled off but are still near $900 an ounce, while copper and oil also have risen amid the influx of government programs.

"The averages will try to seek a bottom here in monetary terms then make an advance," Pento says. "The Federal Reserve is going to punish anyone who holds cash. Anything that's priced in dollars will rise--that includes commodities, base metals, energy and, yes, equities."

Higher Rates, For Sure

That interest rates will move higher as the economy grows, money circulates and government debt explodes is virtually axiomatic. As the government uses its programs to encourage investors to go into riskier products, it will have to raise the yields on its own debt to pay for its borrowing.

The question is whether the rates will have to come up so much that the government will be the only one that can afford to pay them.

"Printing money is not necessarily a correlation to prosperity," Pento says. "That is inflationary and that is not going to promote growth. It promotes imbalances in the economy. You get these huge asset bubbles like we had in real estate."

Indeed, finding a market for the money, particularly in the short term, has proven just as problematic as making the money available.

Lack of faith in Washington seems to be the main problem, and that could weigh on investor sentiment going forward.

"Investors are worried that the government will punish those who receive too much profit on these programs and then come in and change the rules," says Quincy Krosby, chief investment strategist at The Hartford. "It certainly is a worry down the road."

Too Soon?

But other economists consider worry over crowding-out premature, if nothing else.

An economy in substantial disinflation needs a heavy dose of capital flow, they say, and talk about inflation and its accompanying surge in interest rates is a problem better left for another day.

"Given the weakness in the economy and the decrease in inflation that we're looking at, I just can't see that happening before maybe 2011 and maybe late 2011," says Kurt Karl, chief economist at Swiss Re. "A real sharp rise in interest could be a problem, but it's pretty far in the future. It would be nice to get the recession over with first."

Still, there are signs of difficulties in the credit markets that are raising concern.

Consumer credit dropped at an annual rate of 3.5 percent while revolving credit slumped 9.75 percent in February, according to Federal Reserve statistics.

High-yield and leveraged loan markets also have yet to benefit from the numerous government programs aimed at goosing credit issuance. Year-to-date volume is just $13 billion, about a third of what would be expected.

Part of the immediate problem is investor reticence to get hooked up with the government, on fears that Washington might change the rules midstream or impose harsh restrictions on those getting access to capital for lending.

"It goes back to that perception that the government is a partner abiding by arbitrary rules," Krosby says.

Krosby is among those who believe the government needs to address the deflationary concerns first, then worry later about inflation, which it can control with monetary policy and the setting of key lending rates.

Yet she also says battling the crowding-out phenomenon later will be difficult because it's never occurred with "the enormity of the kind of borrowing we're doing today."

"They're going to allow a little more inflation than most of us think at that stage," she says. "They'll want to make certain that the economy is strongly reflated before they start weaning us off the measures taken to fight deflation."

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