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Financial Dominoes

Capital structure is relevant.  Promises are significant.  Contracts are definitive.

This will be short (it better be, I’m tired and want to sleep), but I have no end of friends asking me how bad it is out there.  First I tell them my opinion is a minority opinion.  Second, I tell them that debt-laden economies are inherently inflexible.  Third, I tell them that when the banks are compromised, ordinary monetary policy is useless, because there is no way to make a bank that is worried about its solvency lend more.  Fourth, even extraordinary monetary policy may not work, as the Fed tries to target lending markets, and finds that they can absorb bad assets, but can’t readily recycle them.

The aggregate capital structure of the economy is not a matter of indifference.  If there are many debt claims, and firms with debt finance other firms via debt, who finance other firms via debt, etc., then we set up a bunch of financial dominoes, where a disturbance can knock one down and carry others with it.

This is why the total debt to GDP ratio matters so much.  Economies stop functioning when they have high levels of embedded debt and a slowdown hits.  That is where we are now, at levels of Debt to GDP that exceed those of the Great Depression.  Until we get that ratio down from 350% down to 150%, normalcy will not return.  Air is leaking out of the debt bubble, and the ability to reflate is not there, because the market value of the assets have sagged to such a level that even a zero Fed funds rate will not raise the market value to the levels where the assets are booked.

People are not reliable; they sin; they default.  Economic systems that are primarily equity financed are better able to deal with the nature of man, because they have more flexibility.  Economic systems that are more heavily debt financed face more problems when someone cannot live up to his promises, because it means that others relying on the performance may not be able to live up to their promises also.

Things are different now.  In past economic cycles, there were sectors of the economy that could be stimulated by the Fed lowering the Fed funds rate.  But now, because of too many fixed committments, there is no sector of the American economy that can absorb more debt, and stimulate everyone else.

Thus the task of levering up falls to the Federal government.  But will they be able to honor all the promises that they have made?  Given that they control the printing press, the answer is yes in nominal terms, but no if in inflation-adjusted terms.

Macroeconomics, Structured Products and Derivatives | RSS 2.0 |

4 Responses to Financial Dominoes

  1. BarryB says:

    Thank you for all of your informative posts. I’m a regular reader and I always learn something when reading your blog (although most of it goes over my head).

    I think alot of amatuers like myself who have managed to move some of our retirement money into short term treasuries know that the money cannot stay there forever at < 1% yields.

    Do you see corporate bonds as a “trade” or a longer term investment? Do you see future inflationary pressure as something that would then cause a trade out of those same bonds down the road? Thanks for your insight.

  2. Rusty says:

    How will the debt / GDP ratio normalize?
    Seems like debt will decrease rapidly only via default.
    Seems like GDP is likely to only shrink.

    Absent some pro-growth policy suggestion like lower taxes or regulation (which no one is promoting), we left with only a bad outcome?


  3. matt says:

    Mr. Merkel:

    I was just reading about capital structures in my corporate finance book and noted that for tax reasons, the marginal cost of capital actually decreases as companies add financial leverage up to a point of some optimal capital structure (effectively, capitalizing a company with debt increases its value to a certain point).

    It seems like government policies such as this actually encourage unstable balance sheets. I think that you have mentioned in the past how the ability to write off mortgage interest on personal taxes encouraged people to borrow money to buy homes in a speculative market.

    In fact, the more I look, the more it seems to me that a large portion of government policy enacted over the past 30 years encourages debt financing by businesses and people. The banks must be incredible lobbyists.

    It seems like eliminating the tax advantage of debt financing could foment a more stable financial system.

  4. Bailouts Must Be Odious…

    David Merkel submits: There has been a significant shift in bailout psychology over the last week or two.  The grand shift has been to make the cost of receiving money from the U.S .government smaller, which gets “banks” to line up for…


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