June 10, 2018
OMG! It’s the Mother of All Credit Bubbles!. That’s not my line, Steven Pearlstein is beating the drums in the Washington Post telling us we should be very afraid because a number of corporations are taking on too much debt.
His basic story is that corporate America is getting heavily leveraged, with many companies likely finding themselves in a situation where they can’t repay their loans. I wouldn’t dispute the basic story, but there are few points worth noting.
First, companies have an incentive to borrow a lot because interest rates remain at historically low levels even though as Pearlstein tells us that the Republican tax cut is “crowding out other borrowing and putting upward pressure on interest rates.” The interest rate on 10-year Treasury bonds is under 3.0 percent. By contrast, it was in a range between 4.0 to 5.0 percent in the late 1990s when the government was running budget surpluses.
Much of his complaint is that many companies are borrowing while buying back shares. I’m not especially a fan of share buybacks, but I don’t quite understand the evil attached to them. Would we be cool if these companies paid out the same money in dividends? There are issues of timing, where insiders can manipulate stock prices with the timing of buybacks, but they actually can do this with announcements of special dividends also. Anyhow, to me the issue is companies are not investing their profits, I don’t really see how it matters whether they pay out money to shareholders through buybacks or dividends.
This brings up another bit of silliness in this piece. Pearlstein tells readers:
“At the 535 firms that spent the least, relatively speaking, on stock repurchases (less than 5 percent of the company’s market value), market value grew by an average of 248 percent. These companies included Facebook, Amazon.com, Google, Netflix and Washington-based Danaher, all of which mainly used the buybacks as compensation for employees. (Amazon chief executive Jeffrey P. Bezos owns The Washington Post.)
“By contrast, the 64 firms that spent the most repurchasing shares (the equivalent of 100 percent of market value) saw an average 22 percent decline in the firm’s market value. These include Sears, J.C. Penney, Hewlett-Packard, Macy’s, Xerox and Viacom, for all of which the primary purpose of the buybacks was to prop up the stock price in the face of disappointing operating results.”
Anyone see a problem here? Let me suggest that the causation goes the other way. Sears, J.C. Penny and the rest are giving money back to shareholders because their management doesn’t have good ideas on how to use it productively. That doesn’t speak well for their highly paid management, but it is quite likely the case that if these companies invested more of their money, they would end up losing much of what they invested.
But my real issue with Pearlstein’s diatribe is that he refuses to seriously think about the consequence of this bubble bursting, as opposed to housing bubble. Presumably, if some of this debt goes bad, then the holders take a hit. Suppose that 20 percent of corporate debt (roughly $1.2 trillion) goes bad, leading to losses of 50 percent to the holders (this would be a very high loss ratio). This would imply total losses of $600 billion.
This is in a country with over $100 trillion in assets. Some financial institutions or pensions could be hard hit if they were heavily concentrated in risky corporate debt, but sorry, this is not an economic crisis.
For those of us who were old enough to remember the housing bubble, the issue is that the bubble actually was driving the economy. We had record rates of construction spending measured as a share of GDP. Here’s the picture.
Housing peaked at over 6.5 percent of GDP in 2005. When the bubble burst, it didn’t just fall back to a more normal range of around 4.0 percent of GDP, it fell to less than 3.0 percent, due to the enormous overbuilding during the bubble years. What source of demand was supposed to replace this 3.0 percentage points of GDP (roughly $600 billion annually in today’s economy)?
In addition, the housing wealth generated by the bubble led a consumption boom, with the consumption share of GDP hitting record highs. When the bubble burst and this wealth disappeared, consumption fell back by roughly 3.0 percentage points of GDP. (The plunge in consumption generated lots of good-paying jobs for economists who came up with elaborate theories as why people were spending less.) This gave us a total gap in annual demand of around 6.0 percentage points, that could not be easily replaced. (The stimulus replaced roughly a third of this lost demand.)
Anyhow, this massive loss in demand was a predictable consequence of the bursting of the housing bubble. What are the demand consequences of these companies defaulting on a lot of debt? We know it won’t affect investment much, as Pearlstein points out, these companies are not investing.
A loss of wealth could affect consumption, but what are we talking about? Suppose that we see a plunge in the market along with this default on bonds, how much wealth do we lose? Say we lose $10 trillion total, more than 15 times the amount of losses directly from the bonds described above. If we assume a wealth effect of 3–4 cents on the dollar, this implies a loss of consumption demand of between $300 billion to $400 billion or 1.5 to 2.0 percent of GDP. That is definitely a hit to the economy, but probably not enough to cause a recession, especially if the drop is spread out through time, which it would be.
Anyhow, we do not face another 2008 crash. It would be nice if the people continually warning of one would take a few minutes to learn what actually happened in 2008. It really isn’t hard.
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