On Friday night, I dropped my daughter off at Wezz in Donnybrook for the first time. This is a traumatic experience, but one which many thousands of Dublin fathers have either gone through, or will have to go through in years to come. Indeed, I myself went to Wezz – a teenage disco – when it was called Wesley and we, the boys and girls, went on the bus. These days, that has changed.

Rather than getting the bus, today’s Wezz teenage girls go to each other’s houses to get made up. This, apparently, is half the fun (let’s hope so!). Young teenage girls cake on loads of slap, giving them that unmistakable ”bewildered raccoon” look.

Seeing the transformational effect that a Mac palette and a massive brush can have on the girls got me thinking about the similar impact of low interest rates on companies. The teenage girls put on make-up to look older and more mature; their mothers use similar stuff to look younger and more girlish – but the net effect is to change them.

Low interest rates do a similar thing. They make a bad company look good and a fairly decent company look better. In short, low interest rates flatter to deceive.

Now that interest rates are rising unambiguously in the US – the benchmark for the rest of the world – what is likely to be the economic effect?

Long-term US rates will probably hit 4 per cent by the end of the year. This doesn’t seem too significant, until you realise that this time six months ago they were at 1.5 per cent. Given that inflation was about the same level, real interest rates in the US were zero. Long-term rates have more than doubled in less than half a year. This American move may or may not have an impact on European short-term rates, but it will affect the amount of liquidity sloshing around the world. This will mean that, in time, the financial markets will once again refocus on the sustainability of certain countries and companies.

During periods of excess liquidity, stock markets rise rapidly, but do the underlying companies in the stock markets change in a fundamental way? Not really. In fact, they are probably run by the same people, doing the same business, making the same sales. So why are they worth so much more?

They are made more profitable by the subterranean interest rates that allow the companies to borrow at historically low levels on interest. This cheap money allows companies to refinance expensive existing debt, lowering interest expenses and thereby pushing up net profit margins.

They can also use the cheap money to buy back their own shares, raising their share prices – and making them look more profitable and more attractive.

When people expect interest rates to rise, the first thing they do is sell risky assets because they know that the interest rate balm is giving an unfair picture of what is really happening. This process lasts until they sell other assets and in the same way as when the credit was plentiful everything looks hunky-dory, when liquidity dries up, it will expose some of the flaws.

The same thing happens in countries. When interest rates are extremely low, even heavily indebted countries can look quite sensible. In fact, growth rates may turn positive and the debt burden may actually look manageable.

However, if countries don’t take the opportunity when things are calm and when rates are low to materially reduce their debt burdens, they will get hammered when rates rises again – as they eventually will do.

For the past few years, as European and obviously Irish interest rates have been extremely low, the mainstream economic view has contended that the cure to all this debt is austerity. If we could cut back on public and private debt and pay off debt as quickly as possible, the period of low interest rates will be the background noise to a successful reduction of overall debt levels.

Well it turns out (as argued here in the column until I have become blue in the face) that that hasn’t been the case at all.Not only have Irish (and European) debt levels not fallen relative to income, but they have in fact risen. This is because incomes have fallen faster than people can pay off debt, so debt relative to income goes up, not down.

All across Europe, countries – particularly after five years of austerity – still have too much debt, public debt and, in some countries, private debt. Austerity, by hitting growth, actually makes debt ratios worse because the policy can reduce income faster than debts can be repaid – meaning that the afflicted country actually ends up with more debt, rather than less, after a period of austerity which was supposed to reduce it.

If you don’t believe me, look at the chart. Lo and behold, which is the most delinquent of all the European debtors? Why, it’s the one which followed austerity to the letter. This is exactly what this column predicted all along: the country with the highest debt and the most dramatic austerity will end up still the country with the highest debt.

It turns out that the country that has come out of the bailout quickest is the one with the most public and private debt.

Now, how could this be? How could the underlying figures be so stark while the skin-deep spin be so believable? It is because of our old friend, very low interest rates. In the same way that low interest rates can make companies look extremely profitable, they can also make indebted countries look almost solvent.

So what should you do when interest rates are low? You should cut your debt burden, so that it doesn’t cut you to shreds when rates rise.

On Friday, the IMF released a paper written by Harvard professors Carmen Reinhart and Kenneth Rogoff, which claimed that European debts were too high and should be addressed not by austerity and deflation, but by the opposite: debt restructuring and inflation. It warned – as we have done here on many occasions – that the alternative was 1930s-style debt defaults.

Does it not seem logical for our government to use the next few months, when rates remain low, to figure out a way of reducing our debt burden, negotiate it now and prevent a financial meltdown when rates rise? The data doesn’t lie: we are only looking good because rates are so low. Now is the time to be courageous.

They are already on the way up in the US. If we wait till interest rates rise, it will be carnage, with yet more panic and we will be back to square one.

Have you ever been at a teenage disco and received the shock of your life when the lights came on suddenly, and the brightness did what brightness does late at night?

Think about it.

David McWilliams writes a daily economics and finance newsletter. Sign up for your free trial today at globalmacro360.com

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