What Is Cheap Money?
Cheap money is a loan or credit with a low interest rate or the setting of low interest rates by a central bank like the Federal Reserve. Cheap money is money that can be borrowed with a very low interest rate or price for borrowing. Cheap money is good for borrowers, but bad for investors, who will see the same low interest rates on investments like savings accounts, money market funds, CDs, and bonds. Cheap money can potentially have detrimental economic consequences as borrowers take on excessive leverage if the borrower is eventually unable to pay all of the loans back.
BREAKING DOWN Cheap Money
When money is cheap, it is a good time for borrowers to take on new debt or consolidate existing debts. The borrower can take out new loans at a lower cost of borrowing, or interest rate, than the previous loans. They can then use the new loan money to pay off the old loans. This is a way of refinancing debt and ends up costing the borrower a lower fee for interest over the life of the loan, saving them money.
Regardless of how cheap money becomes, a borrower should always be careful that they can pay back the loan, even if rates happen to go up. Taking out cheap loans with low payments based on a low introductory interest rate, which then ballooned was one of the catalysts of the global financial crisis of 2008. When borrowers couldn’t afford to make their payments after the interest rate reset and their payments increased, structured products backed by those loans imploded. Bad debt, fueled by a desire for cheap money, brought down the economy.
Cheap Money and Monetary Policy
In theory, cheap money is supposed to boost struggling economies by making it more affordable for consumers and businesses to borrow money. The cheaper loans are, the more money people will borrow to buy homes and vehicles, start new businesses, and undertake other ventures that will gird the economy.
However, cheap money puts more money into circulation, which can contribute to inflation, because it drives up prices. Higher prices equal higher inflation. As a result, if an economy is too strong, central bankers will raise interest rates to combat inflation.
Cheap Money in Practice
Although cheap money should, in theory, encourage private borrowing and spending, consumers have been more reluctant to borrow money since the 2008 recession, perhaps because most consumers continue to carry more debt than they did before the recession. The use of cheap money successfully mitigated the lows of the Great Recession and boosted recovery in the U.S. and Japan. However, economies remain sluggish, and the use of cheap money as a stopgap measure to boost a struggling post-recession economy has become a more permanent arrangement. Economists warn that governments should increase deficits to protect against the effects of the next recession, which could come when interest rates remain low.