U.S. Federal Reserve

America's economic enemy: Super-low interest rates

April 4, 2014: 9:05 AM ET

The Federal Reserve wants to reduce unemployment, but low borrowing costs could translate to more debt.

By Sanjay Sanghoee

Loans: Get them while they're cheap?

Loans: Get them while they're cheap?

FORTUNE – In a speech in Chicago earlier this week, U.S. Federal Reserve Chair Janet Yellen eased investor fears that interest rates may rise in the very near future by saying, "[an] extraordinary commitment from the Fed is still needed and will be for some time …" Even though she did not explicitly backtrack from her earlier stance of raising rates six months after the Fed's stimulus plan ended, Yellen made it clear the central bank was determined to boost the sluggish U.S. job market.

Her remarks are obviously welcomed, given that the unemployment rate has remained stubbornly high at 6.7%, and the stock market rose following the speech, but unfortunately, the Fed's plans might actually hurt the economy.

By focusing entirely on unemployment, the Fed is ignoring an equally big problem that affects the labor market indirectly: runaway borrowing. America's economy may be recovering, but is fundamentally fragile because of its excessive dependence on debt for growth. Debt, rather than being a last resort or a bridge to self-sustenance, has instead become the primary fuel of the American dream, and that is a serious problem.

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Current levels of indebtedness, compared to GDP, are frightening, and yet we continue to borrow more. As you can see in the chart below, America's debt totals almost $60 trillion, of which household debt accounts for a hefty 22% and business debt close to 50%, while our GDP is only $17 trillion. That means our nation has $3.40 of debt for every dollar it makes in income, or to put it another way, a 3.4 times leverage ratio that would be considered pretty full in the business world.

Debt-Graph-Sanghoee

Sources: U.S. Federal Reserve, Bureau of Economic Analysis, and U.S. National Debt Clock

True, the Fed is not obligated to teach the nation fiscal responsibility, but it is within its power. An increase in interest rates would certainly cool down our economy in the short term, as higher borrowing costs discourage business investment, hiring, and spending. All that is temporary, however.

What will replace it is a more conservative culture of borrowing, smarter investment policies (by necessity), and intelligent spending. When money costs what it should, it will force the government, businesses, and consumers to recognize the real value of that money and cut their aspirational coat according to their financial means.

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It's no accident that it was a violation of this basic principle that led to the subprime mortgage crisis. Millions of Americans bought homes they couldn't afford, investors bought risky mortgage securities without assessing the fundamentals, and reckless lenders and investment banks made the whole thing possible by fabricating and selling the illusion of cheap debt.

Debt, contrary to popular opinion, is not cheap.

Even when interest rates are low, debt can come back to haunt households, organizations, and, as we saw in the battle over the debt ceiling, even the federal government. It is a useful tool but only when used to complement equity and not as the primary source of funding for creating artificial growth. This is what the Fed is ignoring.

Yellen's concerns are that workers are leaving the labor force not because of unemployment fatigue, but because there are simply not enough jobs in our economy, which is why the Fed needs to provide additional support. That may be true, but whatever jobs are created through super-low borrowing costs will vanish again when the Fed eventually raises its rates -- which it must eventually do if it wants to maintain its credibility. In her debut as the new Fed Chair, Yellen was firm about reducing the stimulus now that the economy is recovering, to prevent inflation as well as encourage the markets to find their natural level for the long term. Softening that stance now sends mixed signals and will make it harder for the Fed to influence the markets later. Inflation may be tame for now, but that too could change.

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America needs more jobs, but those jobs have to arise organically and through responsible financial management on the part of businesses and prudent spending by consumers -- not through more debt. The Fed can't really control the economy, but it can point it in the right direction.

Yellen's trying to do the former, but she should really focus on the latter.

Sanjay Sanghoee is a political and business commentator. He has worked at investment banks Lazard Freres and Dresdner Kleinwort Wasserstein, as well as at hedge fund Ramius. Sanghoee sits on the board of Davidson Media Group, a mid-market radio station operator. He has an MBA from Columbia Business School and is also the author of two thriller novels. Follow him @sanghoee.

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