The world is recently more attracted to the questions of debt than ever before, as it reacts to the very currency of events sparked off by a crisis; there is a general consensus that the crisis was far more menacing than what a business cycle would ordain in its downturn, as it got intertwined with a debt crisis as asset prices inflated to a point of inflection and their downward movement propelled the entire financial systems including governments to revisit the question of debt as a driver and as a destroyer of value.
I am more than attracted to the data: ratio of debt to GDP of a number of leading advanced nations and (Refer to Morgan Stanley Report http://www.businessinsider.com/dept-to-gdp-revenue-2010 or http://www.gfmag.com/tools/global-database/economic-data/10403-total-debt-to-gdp.html). I do not know whether it is cheerful news that the most advanced economies are the most entrenched ones as far as debt is concerned. This leads me to go back to some of the early lessons of man in his quest for seeking prosperity before the banking system with its fractional reserve system of creating a money flow was brought into being.
Before money as a means of exchange was born and when barters ruled the world of exchange no man was indebted; it was not possible to deposit an expected real output of man’s labor by drawing from the future. It would be quite unlikely that men could create a promissory account of future goods or services to be supplied and get in exchange equivalent goods or services. This could be a timing issue, but could not be a practice. The fundamental reason is that first of all that pledging an asset that is yet to be produced held a check to the level of counter-flow. However there were always the King’s way of dealing with this, either generosity or malevolence got the better off or worse off.
The creation of money was the first step that delinked the actual goods or services to the exchange, someone who wanted to promise a future service could get in exchange a current goods or service that he needed, provided he had a promissory account in form of either money or money equivalent (debt).
Debt in other words is the money equivalent, created by the needs to service a time lag or a gap in our ability to balance a transaction of goods or service. I want a haircut, but I do not want to part with the brush that I produced and that the barber needs as I want to enjoy more than what the production of the brush allows me to do. Somewhere the need to enjoy more than what the current output ordains to do have taken the men to the idea of drawing from the future pool of resources, while pledging a part of the future proceeds in a continual flow that brings a pattern of revenue to the person who is prepared to stake his current asset as an exchange.
Here there is another very great innovation of olden times, the concept of investment as a driver of growth came into being as savings equaled investment and economic progress started. Without this man would have stayed cutting hairs and providing combs in exchange. However the current spate of innovations have changed the very concept of debt and investment by taking it many times forward in to the realm of multipliers that has led to hastening of economic growth at the cost of higher risks for the future. We shall examine this shift.
Let me go back to the core concept of debt once again. For this concept there are three important determinants:
- Presence of an excess money or goods and services that could be monetized that can be pledged for a transaction
- Partial revenues from Goods or service that would need to be produced in the future to pay back
- The level of trust that the borrower can exude in absence of a collateral
So the starting point is that the intermediary who acts as a lender must have a stock of ‘excess’, the revenues from future goods and services should be able to create a stream of pay-outs to cover the services of debt and finally there needs to be created a bond of trust that is sufficient ground for the lender to believe that the principal sum could be returned in the future.
1. Presence of an excess money or assets, goods and services that could be monetized that can be pledged for a transaction
Point number one means that there must be the existence of surplus created that could be gainfully disposed. In absence of this condition we could have a situation that the lender himself is a debtor, which is not unusual, but if there is a continuous line of debtors who appear as lenders, there has to be a lender of last resort. I think that quite rightly portrays the very current brand of lenders who are called commercial banks and the lender of last resort is the central bank in any economy.
I now draw my attention to some very successful companies of the current times who have continuously generated a lot of cash by virtue of the goods and services that they produced for the society’s benefit. Let me take the example of Microsoft. Taking the 2009 balance sheet, it’s size of $77.8 Billion of assets and cash in hand of $6 Billion, while it has a total debt of $5.7 Billion, while its stock holder’s equity stood at $39.5 Billion. Is this not the ideal portrait of a lender? Is this not what we can term as the ‘excess money’ that could be spared for the society for any other productive use that Microsoft could not employ? (Refer:http://www.microsoft.com/investor/reports/ar09/10k_fr_bal.html)
The decision to play the bank hinges on one single calculation, what would the rate of return on equity be when part of the equity is employed in a transaction outside of the normal business of Microsoft. So if Microsoft continues to gainfully employ its cash in its business and generates a surplus that gives the return on equity well in excess of the other potential opportunities that exist, there should be no reason for Microsoft to part with its equity to be employed for that purpose. In fact when in a boom and other businesses need cash, it could well be more profitable to lend others in form of inter-company loans.
On the other hand with such a great debt equity ratio (in fact they hardly have any need for debt as all its growth objectives could be met with its internal accruals), some people could argue why Microsoft not take in more debt (and with debt now being so cheap) to lend to others and act like a bank as it could potentially draw debt at a much lower interest rates with its robust balance sheet, while it could lend to others in need at a higher. Unfortunately this condition either does not exist or Microsoft has no interest in such a venture.
No great company that continuously creates value and generates cash has any great need of debt to grow, unless that desire of growth is disruptive in nature. Such disruptions are path-breaking and game changing examples and not in general a rule that can be applied as an ordinary way of transacting. Unfortunately the current motley of transactions by the financial community has shown that exceptions are the very rule on which investment banking thrived and eventually led to the string of asset bubbles. This would take me to the rationale of leverage as a means of growth given that such leverage would create value, but that is a subject matter by itself. However the recent crisis has shown that leverage must take into account the realities of times and cannot be based on a view of the future that is not based on the fundamentals of the current.
This leads me to look at the balance sheet of S&P 500 and excluding the financial companies the cash at the end of 2009 touched close to $850 Billion and actually rose by a whopping $150 Billion during the crisis from pre-crisis days. (Refer http://www.zerohedge.com/article/accounting-cash-gimmicks-have-boosted-collective-sp-500-cash-balance-over-150-billion-start-). This is quite a stark revelation given the preponderance of doubt that the Main Street had a great credit issue to deal with and needed substantial help from the Fed in terms of flow of funds through open market operations, interest rate interventions or quantitative easing. The debt however has quite a spread in these companies from debt equity rations varying across the range of companies from moderately low to very high.
The point number one is yet not over. It leads me to delve into the balance sheet of the Federal Reserve of United States. The $2 Trillion Balance sheet has grown over the years, while the net worth of the U.S. households has shrunk from 2006 to 2009 by an excess of $12 Trillion, refer Federal Fund Flow Statements (http://www.federalreserve.gov/releases/z1/current/). When the net worth of U.S. households increased substantially in the period 2003 to 2007, the Fed had progressively reduced interest rates and the M2 soared thus providing excess liquidity that finally fueled a bubble in housing that spilled over to stocks. The most interesting feature of this report is that the debt to net worth increased over the entire period and this leads me to believe that excess money supply for any economic activity results in continuity of indebtedness as a spiral which some term as the debt spiral or the debt trap. When the total debt floating in the market is a whopping $35 Trillion and with households at $13 Trillion and businesses at $11 Trillion, it is interesting how much time it would take to pay back this debt. The more interesting thought is that we seem to be stuck in the middle as more debt is needed to make the economy move on its track, so the indebtedness continues by drawing from the future. The only change we see in this statistics is that in 2009 the percentage change in debt was on the negative side and that fuelled a frenzy of recession. So this proves my original point that for any economic growth we needed rising and surging levels of debt.
The current economy of U.S. poses a strange challenge. Before the run-up to the crisis the interest rates were moderately high and as asset prices started to mount the flow of credit should have been moderated through Fed interventions by adjusting the reserves. This could have immediately taken the excess liquidity out and adjusted the prices to return back to normal. The Fed did the opposite and expected the market to correct the bubble on its own. The market on the other hand with its spate of innovations had other ideas that moved it to its peril. When the bubble eventually burst there was no way that the market could do anything on its own and the Fed acted with a range of policy actions and had to pump a great deal of liquidity through open market operations once again. The already indebted became more indebted in the process as the government had to step in to spur the economic activities and the maximum growth of employment actually happened in this sector.
Employment growth in the government sector needed higher levels of debt in the government. However the debt to revenue ratio standing at 358 percent goes to show that much of this employment generation in the government sector did not add to the revenue. This is quite an alarming denouement. The bottom line is that marginal debt to marginal revenue is growing and is unsustainable.
We have so far looked at point number one, which is the lender’s side. The moot point is that the lender of last resort also needs to have a surplus or the semblance of surplus to draw from in times of crisis. Unfortunately the net worth of Fed is hardly worth mentioning.
2. Partial revenues from Goods or service that would need to be produced in the future to pay back
Now we move to point number 2, which is the continuity of payments that have to be made from the fractional revenues that would be generated in the future to pay back debt. This seems to be a pre-condition for any debt to be serviced as any lender would have to depend on the flow of funds inwards to be able to repay his own debt taken from a lender (the lender in the worst case could be himself which means he has used his own funds to dole out the original debt).
This is what the original concept of debt servicing was, now it is different as a retail bank in the corner of the village or town could effectively dole out a loan and sell the flow of mortgage receipts to another bank to be able to lend further. This in fact could be done many times as long as there is an insurance given by someone that takes care of the entire risk of the system. Unfortunately we have seen that in the run up to the crisis the main insurer himself was in trouble. So this shows that there is a limit to what the revenue streams can be pledged to the cause of further debts.
But I am attracted to the core principle of fractional reserve system. When a $100 loan is taken from a bank and only $10 is spent while $90 is deposited, this bank needs only $9 as a reserve and could potentially loan the balance $81 to individuals and institutions or other banks and thus create a pool of transactions that we term as the money multiplier. If all reserves are added they would keep adding to a higher number but never reaching the original $90, while every time a loan is forwarded there is a stream of spending that it brings with it. There is a dual purpose of the fractional reserve; to create a flow of money multiplier and secondly to create a flow of spending. If the first one happens while the second one does not we have an effect that higher money flow chases fewer options of spending. This is a recipe for disaster. The Fed is supposed to balance this through interest rate interventions, however there is always a flip side that such intervention would hamper what you want to achieve in the short term versus the long term. In the short term one would be bent on creating higher output in the economy at almost any cost, while the needs of the longer term is to be able to balance the fiscal and monetary needs of the economy as well. This is a paradox that must be solved.
There is another dimension that cannot be left out, the dimension of demographics. If in a population there are less working men feeding the overall needs of the society from what it was a quarter century ago, it means that there is a need of postponing a part of the working population’s consumption needs so that those who do not work can take the benefits. It could also mean that if the distribution is not going to improve, part of the consumption would also have to be sequestered for the future.
This is the problem of Japan. While more ageing has taken place in the demographic profile, more savings have to be undertaken to fuel the needs of the future and thus less consumption can be done at the present. Postponement of consumption is equivalent to savings and in U.S. there is a dearth of both, which only leads to the hypothesis that drawing from the future is based on an insurance that our children would be working to cover up for our consumption needs by either raising their productivity or by consuming less. Either way the seeds have to be sown now. But are we?
3. The level of trust that the borrower can exude in absence of a collateral
The third condition, but the most important condition is the matter of trust. I remember the bank manager of State Bank of India telling me an incident with one of his poor widowed clients who had received a loan from him for buying a sewing machine. The lady had come to request him for extension of the payment schedule one day as she was not in a position to pay as per the schedule. When her request was granted, she went bank quite happy but returned the next day with the money that she owed the bank. She said, ‘Sir, being entrusted by your kindness, I could not sleep the whole night and thought of selling my ear-rings to be able to pay you back’. This was the level of trust that held the transactions between a lender and a borrower.
Today there is no face or a heart of a lender or a borrower, as who is the lender and who is the borrower is not known, lost in the greatest invention of our times, the fractional reserve system. Only the lender of last resort is known; trust has therefore been relegated to the scrutiny of rating agencies who have their own bouts of sound and not-so-sound judgments as information asymmetries get compounded with rising number of intermediaries with less and less of direct contact.
There is an added issue of packaging of debt into clusters where the originators of debt lose their independent identity completely. This raises the question of information quality and the role played by regulatory authorities to stop the propensity of adverse selection that might creep in.
Debt as a growth driver has its advantages that it allocates capital to those parts of the economic activity which in its absence would have to depend on current ability to generate cash for funding its growth. This had proved to be a very efficient way of providing a cushion, provided the conditions of trust and the continual flow of fractional revenues could be allocated to the purpose of paying back the debt.
The world however with its spate of innovations in the area of finance found better ways of dealing with both the fractional flow of revenues to be set aside and to the problem of trust. It created on one hand the concept of mortgage backed securitization of credit and on the other creation of ‘pool risk’ instruments where the very character of each individual debtor was lost in the pool. As long as there were potential investors who were willing to bet on these pools and were ready to take the related risk, there were no issues involved.
The first problem however remained; the problem of constantly finding a surplus that could be deployed. This needed a virtual constancy of debt instruments on one hand that could be backed by an ‘Overlord’ of all lenders who would at the end act as an insurance. This role had to be taken by the Central banks. The more prudent institutions like the BIS, or the Swiss Central bank or the Austrian central bank in the pre-Euro era were institutions that were extremely conservative to dole out this constant stream of monetary supply that finally got ordinary people entangled in a myriad of debt instruments.
There were of course others who were more innovative and the world knows in which direction an economy should move.
Actually if any asset class that had a tendency to grow in value (by whatever means) and that asset could be linked to a debt through a pledge of a mortgage, there was no problem to find the source of surplus.
The provider of the surplus was the asset itself that was pledged to the banks.
The small problem however is to prove that every asset could be linked to this tendency to grow in value at all times, regardless of the business cycles, or levels of credit in the economy or fiscal policy of the government.
Extreme corrections in net worth of U.S. households in the last two years have taught precious little about which direction is a better one, follow the debt model and consume, or follow the savings model and invest in the future.
There are successes and failures in every model. There is no last line to be drawn.