Today's date:
Fall 1987

Sorting out the Debt

Benjamin Friedman - Friedman is professor of economics at Harvard University His most recent book is Financing Corporate Capital Formation, and be is currently writing a book on US fiscal policy in the 19801 In the following article, be soberly sorts out the realistic dangers of corporate and government debt burdens; concluding that serious inflation will be the ultimate result.

America has two debt problems - one private, one government. Of the two, it is private debt that is most likely to lead to dramatic economic consequences for the average citizen. But it is the federal government's relentless borrowing that spells the more serious economic problems, even though they will be more subtle, and therefore harder to see at work.

Rise in Private Debt
It makes little sense to speak of debt totals in isolation. What matters is debt in comparison to something else: debt in comparison to assets; debt in comparison to incomes; in the case of government, debt in comparison to the scale of the country's overall economic activity.

The increasingly widespread talk of financial fragility in the United States stems primarily from the fact that both American businesses and individual Americans are more heavily indebted even in relation to rising income levels - than at any time since World War II. As a result of the combination of higher debt levels and higher interest rates, it now takes more of their available cash flow than ever before just to meet interest payments. This situation has led to growing fears of debt default on a scale that could threaten the nation's prosperity.

These fears are probably not warranted for individuals' debt. They probably are for businesses' debt, however. And because of the way in which our government policy makers will respond when the time comes, the result is as likely to be a renewed burst of inflation as a downward spiral of defaults and bankruptcies.

By the end of 1986, individuals' debts amounted to an unprecedented 66% of that year's income. While individuals have borrowed heavily in the 1980s, they have also invested heavily. Much of this investment has been in houses and cars, but individuals have also accumulated large amounts of financial assets that, in a pinch, could be readily liquidated to service their debts. The -heady rise in stock prices has only accounted for about half of the increase in individuals' financial assets. Between December 1980 and December 1986, individuals' holdings of deposits and other credit market instruments rose even faster than their outstanding debt - from 74% of total income to 95%.

By contrast, American businesses have borrowed in record amounts during the 1980s without significantly budding either their physical investment in plant and equipment or their holdings of financial assets, in comparison to the size of the US economy. By year end 1986, American corporations in nonfinancial fines of business owed debt equal to a record 57% of the country's income that yew, up from an historically more normal 48% in 1980. Their financial assets were unchanged relative to income at 35%.

The 1980s has been by far the worst period for business investment in physical assets like plant and equipment since World War II. Instead of borrowing to build new facilities or even to build liquidity, the corporate business sector as a whole has mostly used the proceeds of its extraordinary volume of borrowing since 1980 to pay down equity through mergers, acquisitions, leveraged buy-outs and stock repurchases. In the past three years alone, American nonfinancial corporations have retired a quarter of a trillion dollars more in equity than they have issued. Despite predictions that this wave of corporate reorganizations would cease when the new tax law became effective last January, it has continued unabated into 1987.

This massive substitution of debt for equity, in conjunction with the onset of record high real interest rates, has sharply raised the debt service burden that the average American business faces. In the 1970s, it took 32% of corporations' available earnings to meet the interest on the debt they owed. And on average during the 1950s and 1960s, interest claimed only 16% of corporate earnings. Since 1981 American business corporations have needed 54% of their available earnings to pay their interest bills.

Debt and Bankruptcy
The ability of borrowers to pay back debt depends on the size and stability of their earnings, as well as on the value of the assets that they can sell off if they face a real bind. And both business earnings and business asset values in turn depend heavily on whether there is prosperity or recession in the economy at large. In particular, a business downturn typically shrinks the earnings of many companies, slows the earnings growth of most others and, in many cases, also reduces the market values of the assets that companies have in reserve to sell if the need arises.

The increasing indebtedness of American businesses in the 1980s has already led to an extraordinary proliferation of bankruptcies and debt defaults. Since the 1981-82 recession was the most severe since the 1930s, both the number of firms going bankrupt and the volume of business debt declared in default rose to record levels in 1982. What is remarkable is that both these measures of business debt distress have continued to rise to new record levels since the recession's end.

On average during the bottom years of previous postwar recessions, 49 out of every 10,000 American businesses failed. In 1982 there were 88 failures for every 10,000 firms. In 1986 there were 120. This experience still falls short of the records set at the bottom of the Great Depression. In 1932, 154 of every 10,000 businesses failed.

In the event of another economic contraction, which would again slash earnings and depress asset values, business bankruptcies would doubtless increase substantially further: perhaps even by enough to threaten the country's economic stability, if they reach a level at which firms not yet in difficulty on account of their own business begin to fail merely because of their customers' failure.

Risk of Inflation
The real risk posed by the recent rise in business indebtedness is not a cumulative debt default, but a renewed acceleration of price inflation. Because of the heightened danger of financial instability, American monetary policy makers are now probably more reluctant than ever before either to seek a business recession on their own or to tolerate a recession that stems from independent causes. The real costs of a business recession - costs in terms of foregone output, incomes, jobs, capital formation and even tax revenues - are now much greater than they would be with a more normal business debt structure. Faced with a hard choice, policy makers are likely to conclude that a recession would be not just more costly, but too costly. As a result, American monetary policy will seek to avoid a recession at almost any cost.

This country's record suggests that the most likely outcome of a no-recession monetary policy, sustained over time, is a return to high inflation. Just as the ballooning federal deficit, even under conditions of full employment, has probably eroded the ability of fiscal policy to combat an unwanted recession in the event of another OPEC-type price shock, who will be bold enough to propose a tax cut when a recession is already widening the deficit to $300-$400 billion? The burgeoning business debt has probably rendered monetary policy impotent to halt the return of inflation.

Federal Deficit and Debt
America's current fiscal policy is a failure. In retrospect, the idea that reducing tax rates would increase tax revenues, and thereby finance a major defense build-up without cuts in major spending programs like Social Security and Medicare, was a joke. The economic consequences of this ironic turn of events (in presenting his first budget to Congress in February 1981, President Reagan asserted that "the ship of state" was "out of control" because the government's debt was then nearing $1 trillion) are by now well known. The federal budget deficit for the five fiscal years from 1982-86 added up to $955 billion.

There is no sign that this hemorrhage is healing. The government's deficit for the 1987 fiscal year will probably be some $50 billion below list year's record $221 billion, but only because both individuals and businesses hurried to conclude a wide variety of transactions before the new tax rules legislated last summer took effect on New Year's Day 1987. The result was a surge of tax payments. The Congressional Budget Office has now estimated that without a tax increase the deficit will be back on its relentless upward course in fiscal 1988.

Investment and Competitiveness
Since 1981 the government's borrowing has absorbed nearly two-thirds of all the net saving by American businesses and individuals. As a result, real interest rates - interest rates measured in comparison to price inflation - have been at record levels on average throughout the decade. With the high cost of funds, net business investment has averaged just 2.4% of America's total income, less than in the 1950s or the 1960s or the 1970s, despite the business investment incentives legislated in 1981. The policy that was supposed to stimulate saving and investment in America has instead led to the poorest investment performance, and the lowest saving rate, in 40 years.

The popular impression that investment has been robust in the 1980s is the product of a familiar kind of statistical illusion based on rapid percentage growth from a small base. Because the 1981-82 business recession was so severe, net business investment as a share of America's total income sagged in 1982 and 1983 to the lowest level since 1945. As a result, even the limited rebound of investment to sub-par levels, as the economy recovered from the recession, was huge in percentage terms. After all, if investment had dried up altogether in 1983, the subsequent growth of investment measured from that year's base would have been infinite in percentage terms.

With the 1986 tax "reform" having more than reversed the investment incentives put in place at the outset of the decade, yet with the federal deficit continuing to absorb the bulk of the country's private saving, prospects for private business investment arc weakening again. There is no reliable way to predict what gains in productivity American business will achieve in the next few years. But to the extent that those gains will depend on investment in physical capital, either private or public, they are sure to be disappointing. At the same time, the government's own borrowing has hardly gone to finance any surge of investment in roads or bridges or other infrastructure that might serve as a substitute for private capital formation. The share of federal spending that has gone into non-defense capital investment has steadily shrunk, from 2.1% on average in the 1950s and 1960s, to 1.5% in the 1970s, and now just 1.2% in the 1980s.

The consequences of America's misbegotten fiscal policy of the 1980s have been even more serious in the international context. By raising real interest rates in America above real interest rates abroad, die federal government's massive borrowing also drove the US dollar exchange rate to unsustainably high levels in relation to major foreign currencies. As a result, the international competitiveness of American business collapsed. One industry after another lost the ability to make sales abroad, or even to defend its markets at home. Since September 1985, when Treasury Secretary Baker first met with the finance ministers of Japan, Germany, France and Britain at New York's Plaza Hotel, the dollar has fallen sharply. But this country's trade gap has only just begun to turn around.

America as a Debtor Country
Meanwhile, America's dependence on foreign lenders to finance the country's trade imbalance continues to grow. Having to pay for this steady flow of imports in excess of exports has not only dissipated what was once the world's largest net international investment position but transformed America into the world's larges debtor country. The swing since 1981 has already amounted to some $9,000 for every family of four. It is little wonder that most Americans think they are living well. After borrowing that much from foreign lenders, they certainly should be.

America's foreign debt is real, not a statistical illusion. It makes no sense to argue that this massive inflow of funds merely reflects this country's stable political environment, or its favorable business climate. Ecuador and Zaire also have large capital inflows and, as a result, growing debts owed abroad. It would be absurd to pretend that those countries' growing debts were due to anything other than an inability to export enough to balance their imports. The same is true in America's case.

Americans will have to service these debts. We will do so in part by paying interest to foreign lenders outright, but probably even more so by selling off to foreign buyers the ownership of the country's businesses and real estate. Foreign conversion of American bank deposits and US Treasury obligations into equity securities, office buildings and outright ownership of whole companies has only just begun. America's assets will still be there and they will still be profitable. But Americans will no longer own them.

The resulting erosion of Americans' ability to increase their living standards will be gradual, and therefore difficult to address with this country's crisis-activated political machinery. But it will be real nonetheless. America must now live with the damaging consequences of the borrow-and-spend fiscal policy that we have pursued in the 1980s.

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