Debt and the economy

Kevin Erdmann comments,

Debt isn’t a sign of risk taking. Equity is. The reason Ford has lots of debt isn’t because risk-seeking shareholders demand that they leverage up. Risk-seeking shareholders buy unleveraged Tesla shares. The reason Ford has lots of debt is because a lot of investors want cash flow certainty, and Ford, with a large base of physical assets, can credibly provide it.

I am inclined to disagree. My thinking is that small changes in perception of the risk of debt have larger effects than small changes in the perception of the risk of equity. In 2000, people really changed their perception of dotcom stocks by a lot, and the economy experienced a minor blip. In 2007-2008, people revised their perception of the risk of mortgage securities, and all sorts of bad things happened.

If people revise up their perception of the risk of sovereign debt, I predict that this will lead to the greatest economic disruption of our lifetimes.

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18 Responses to Debt and the economy

  1. R Richard Schweitzer says:

    “Ford, with a large base of physical assets, can credibly provide it.”

    For some reason, such statements remind me of Bethlehem Steel’s Sparrow’s Point works back in the late 40’s.

  2. Laura says:

    Equity is optimism. You buy debt Instead owing to pessimism either about the future generally or the firm.

  3. baconbacon says:

    People who want to die might jump off a bridge, people who want to experience jumping off a bridge might go bungee jumping. I don’t think it makes sense for either of these two desires to be called “wanting risk”. The outcomes are what you want, the safety issues are what you tolerate.

    People who buy Ford bonds are risk intolerant (probably) and people who buy Tesla shares are less risk intolerant. This walks us to Kling’s conclusion, a person, company, world etc that relies heavily on debt implies that they are heavily risk intolerant, which would lead us to believe that a risk event (call it a black swan, fat tail, variance, whatever) will have worse outcomes.

    If you assume that investors control risk with their purchases then you can come to the conclusion that Erdman does, if you think of risk as an exogenous force for investors then excess debt (what ever that means) is a symptom of a fragile system.

  4. B.B. says:

    Just a qualification. Owning securitized mortgages is no different from owning equity. Both are risky, and their prices change with changing perception of risk.

    What is different is that banks did not leverage up to buy dot.com stocks, but they did leverage up to buy securitized mortgages.

    The risk of assets does not matter that much. The risk of liabilities matters a lot.

  5. baconbacon says:

    A little more fleshed out version of why Erdman’s point needs context

    http://sebwassl.blogspot.com/2017/07/risk-neutral.html

  6. Handle says:

    Nominal debt is “the stickiest price.” If circumstances change, the terms don’t, not without a potentially ruinous bankruptcy process. For private companies, that’s fine. For huge amounts owed by “systemically important institutions”, to include the national government itself, that’s not fine. When a Minsky-like sentiment cycle suddenly shifts gears, the effects can be very disruptive. A common proposal is to make certain debts more equity-like, bearing a little equity-like risk, and having some kind of built-in contingency-convertible (CoCo) character that writes them up or down in real terms automatically and without the need for adjudication. That would help to dampen the procyclical nature of debt growth during the sentiment cycle.

    One argument in favor of NGDP level targeting is that (inflation+real growth) will be kept at a predictable annual constant, so that if growth comes in higher than expected, the windfall is shared with debt holders, and if growth diappoints, inflation rises, to allocate some of the burden to creditors. That regime would help give ordinary nominal debt – and especially national debt – the above qualities without the need to write up new and complicated debt contracts. Those who want to limit even this risk can stick to TIPS.

  7. Matthew Young says:

    We take on debt when we have priced things too high in the past.

    If sovereign debt crisis happen one a generation, then let’s look back and compare the last two, the Roosevelt gold repricing and the Nixon shock, under the assumption. After the Nixon shock we did not start a world war, and we have high inflation for ten years.
    Not bad, a big improvement over the two generations.

    So, our current sovereign debt crisis should be milder than even the Nixon shock. All the king’s princes and clowns have a full view of how we did it the last two times, and third time is a charm. We may be able to default half the debt away and keep inflation under 5% for ten years, as long as we keep the senators with their nose to the grindstone.

    The new money technology will include a default machine for Janet, but the machine only works in a competitive currency environment.

  8. I agree with your comment Arnold. When risk perception leads to a sharp increase in risk spreads, very bad things happen. But, this is really associated with disequilibrium. By 2007-2008, we were in a state of crisis.

    But, I think the thing that is not widely understood at all is that in 2006 and early 2007, there had already been an extensive flight to safety. We misinterpreted the CDO boom as a form of risk taking and of excess. But, the only reason that market developed at all was because there was already massive demand for low risk (AAA) savings and there was such fear of equity that there was even a flight from real estate equity. They couldn’t find borrowers to take the equity stake, so they had to start using other securities to construct new AAA securities.

    The CDO boom only began to build steam in late 2005 and was mostly in 2006-2007. For that period, first time homebuyers were declining, there was a rise in homeowners selling out and exiting ownership, thus homeownership rates were declining pretty significantly, employment growth was declining, NGDP growth was declining, housing starts were collapsing.

    The leverage people talk about during this period mostly has to do with financial intermediaries trying to construct securities to meet this demand. The owners of those securities were not leveraged – money markets, foreign savers, etc.

    The reason we had a financial crisis in 2007-2008 is because we had all the preliminaries in 2006-2007 and we interpreted those preliminaries as excess instead of contraction. In August 2007, the Wall Street Journal explicitly called for the Federal Reserve to create a financial panic. We did that because broad intuitions about debt are wrong. The gulf between, say, that Wall Street Journal op-ed and sanity is wide.

    http://www.wsj.com/articles/SB118636001831688824

    • baconbacon says:

      “But, I think the thing that is not widely understood at all is that in 2006 and early 2007, there had already been an extensive flight to safety. We misinterpreted the CDO boom as a form of risk taking and of excess”

      A flight to safety does not decrease risk, it shifts risk from one party to another. If there is a general flight to safety then it is a demand for less risk, which highlights your interpretation here

      “The leverage people talk about during this period mostly has to do with financial intermediaries trying to construct securities to meet this demand.”

      If intermediaries are trying to fill this demand they are adding net risk to the system that is specifically calling out for less net risk. By creating obligations to pay out in worst case scenario events they increased the disruption when the even occurred.

      ” The owners of those securities were not leveraged – money markets, foreign savers, etc.”

      The majority of those securities were leverage themselves, therefore their holders were leveraged. If I write a CDO where you pay me $1 a year an I pay out $100 in the case of a $100-1 shot then I am leveraged. The only way I could be un leveraged is if I had 99$ worth of assets that were uncorrelated with that 100-1 shot.

      • Yes.

        The way to manage that scenario isn’t to have the central bank posture that it expects home prices to crash and to watch various funding markets crash. The way to manage it is to call it what it is – a flight to safety and a downshift in sentiment – and to provide nominal support in 2007 when all of these measures were declining, to draw savings back into equity and out of debt.

        A rebound in housing in 2007 would have actually been disinflationary, because much of the inflation was rent inflation due to collapsing housing starts.

        • baconbacon says:

          “and to provide nominal support in 2007 when all of these measures were declining, to draw savings back into equity and out of debt.”

          The Fed stopped raising rates in 2006, and dropped the Funds rate by ~1.3 percentage points from July 2007-Jan 2008, and down 4 points from its peak by April 2008 (4 points in 10 months, which is a large move for the Fed). 10 year Tips spreads, iirc never dropped below 2%, and were around 2.5% in April 08. UE had gone from ~4.4% to ~5% in roughly that same span, which is pretty square in the range of moderate recessions for the US.

          Additionally the US government passed a (again iirc) 180 billion dollar stimulus bill in Jan/Feb 2008.

          ” The way to manage it is to call it what it is – a flight to safety and a downshift in sentiment – and to provide nominal support in 2007 when all of these measures were declining, to draw savings back into equity and out of debt.”

          I don’t believe there is much evidence supporting the notion that the Fed controls NGDP (my reading), I have never seen an argument that the Fed controls the components of NGDP and could actually force people to invest in equity instead of debt.

          • What would you consider a neutral measure of monetary policy in 2006 and early 2007? Holding rates steady doesn’t tell us much if that rate is too high. The New York Fed yield curve model would suggest it was too high. This is a measure widely recognized in the finance sector, based on yield curve inversion, and it was giving a recession signal in 2006.

            I am referring to NGDP growth as a signal of neutral monetary policy. If it was 10%, we can presume it was too loose and if it was 0% we can presume it was too tight. By late 2006, nominal GDP growth was at levels typically associated with recessions. They don’t control NGDP growth, but we might hope that the central bank doesn’t spend two years after NGDP growth enters recessionary territory vocally worrying about inflation.

          • baconbacon says:

            “By late 2006, nominal GDP growth was at levels typically associated with recessions”

            Briefly. Q1 of 2006 had RGDP growth of 4.9% and Q4 at 3.4% and PCE inflation minus food and fuel was >2% from 2005-2007, basically there is a 6 month dip in 2006, and Q2 in 2007, and the Fed is easing by traditional methods 6 months before the recession officially starts.

            Given that data comes in with a lag and is revised several times, and that several measures (PCE inflation minus food and fuel) looked strong and forward looking measures (TIPS spreads) looked fine, and the size of the decline in 2006 wasn’t anomalous, (https://fred.stlouisfed.org/series/A191RL1Q225SBEA, RGDP is noisy).

            “Holding rates steady doesn’t tell us much if that rate is too high. The New York Fed yield curve model would suggest it was too high. This is a measure widely recognized in the finance sector, based on yield curve inversion, and it was giving a recession signal in 2006.”

            If you don’t think that the Fed controls NGDP then you can’t expect the Fed to avoid every recession. The Fed doesn’t view its own role as to totally eliminate recessions (though some board members might argue that perfect real time data would allow them to), and criticizing them for not acting immediately when there was maybe a recession on the horizon with a good amount of evidence pointing to it either being mild or non existent and maybe reacting a quarter or two later than they would optimally appears to be on the line of wishing for a perfect and omniscient Fed which is an argument against any Fed.

            “but we might hope that the central bank doesn’t spend two years after NGDP growth enters recessionary territory vocally worrying about inflation.”

            Core PCE was at 10 year highs and TIPS spreads hit their peak (iirc) at ~2.9% in 2005, and the yield curve inversion of 2006 didn’t knock core PCE back at all, and TIPS spreads were still well above 2%. STILL the Fed eased (in the traditional sense) starting in mid 2007. They talked about inflation because they have a dual mandate, some people were saying “worry about a recession”, some “worry about inflation”, talking about one and having you actions address another is Fed speak for “don’t worry, we here both complaints”.

          • All reasonable points. We didn’t really go off the rails until 2008. Until late 2007 things were marginal. And of course hindsight is easier than real time. One’s reaction to the initial panic in 2007 comes down to whether one thinks it was inevitable or not. If not, then something was really wrong by then. And how we conceive of debt is important in where we come down on that issue.

  9. collin says:

    If people revise up their perception of the risk of sovereign debt, I predict that this will lead to the greatest economic disruption of our lifetimes.

    My guesses:
    1) Japan goes first and we get to see what happens.
    2) I bet this crisis does not happen in your lifetime and 50/50 in my lifetime (I’m 47)
    3) Other global crisis will happen first.

  10. Various says:

    I think the last sentence of your post is very interesting and has a good chance of being correct. Sovereign debt prices do seem to be in bubble territory these days. I don’t remember who did the study (Ken Rogoff) but the literature indicates that sovereign debt defaults have historically occurred in bunches. I think most of the investing public is overly complacent because the incidents of sovereign defaults have been low in the past 20 years. However….on a fundamental basis, e.g., debt/gdp and more importantly, debt (including off balance sheet debt/gdp are absolutely terrible relative to historical norms. One of my persona theories is that very few decision makers understand accrual accounting and fewer still understand the prevalence of off-balance sheet liabilities. This includes many people in the top echelons of Wall Street. I worked on Wall Street for years and was often shocked at the general ignorance of accounting concepts such as these.

  11. Mark says:

    Curiously, Nasdaq’s website will tell you that 64% of Tesla’s shares are held by “institutions” and only 57% of Ford’s.

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