Saturday, February 27, 2010

Leverage and Bankruptcy--A "Real" Problem

If firms have no leverage--they finance all of their activities with equity and use no debt--then they cannot go bankrupt. They can still suffer losses. To minimize those losses, they may contract production and employment. They can even run out of money and be forced to close. But a firm with no leverage cannot possibly default.

The greater a firm's leverage, the smaller the losses it can bear before it becomes insolvent and defaults. If "Corporate America" is highly leveraged, then widespread losses could be associated with more defaults and bankruptcies than if firms funded more of their activities with equity.

If bankrupt firms cease operation, then the productive capacity of a bankrupt firm is at least temporarily not available. The productive capacity of the economy as a whole is slightly less, and so, the total volume of real goods and services that can be produced is smaller--there is a slight decrease in potential output.

If firms are highly leveraged, then widespread losses could generate widespread bankruptcies, and so, reduce the productive capacity of the economy a significant amount. If there are widespread losses, then high levels of leverage by firms could result in a "real" problem--lower potential output.

However, this problem can easily be exaggerated. Suppose there is a shift in demand between different sectors of the economy. Firms in the sector losing demand can suffer losses. If the firms in that sector are highly leveraged, they may be unable to pay debts and go bankrupt. While that bankruptcy will temporarily reduce the productive capacity of the industry and at least slightly reduce the productive capacity of the economy, this hardly matters because the efficient response to the decrease in demand is reduced output. If the change in demand is permanent, productive capacity should decrease and resources be shifted to the expanding sectors of the economy. Any temporary reduction in productive capacity due to bankruptcy is simply a decrease in excess capacity.

Further, suppose some firms in the industry are more leveraged than others. Other things being equal, the most leveraged firm will fail first. Again, assuming its production is disrupted, then the result is increased sales for the surviving firms, reducing their losses and postponing the time before the next most leveraged firm fails. From the point of view of the particular firm that failed, this is a tragedy. But the disruption to production and employment for the economy as whole is minimal.

Of course, default and bankruptcy don't really require that a firm cease operations. All that is necessary is that creditors (or perhaps a bankruptcy judge) be convinced that some level of operation will reduce losses--increasing whatever partial payment the creditors will eventually receive. While default and bankruptcy are not free goods and require resources, and so other goods and services are sacrificed, the additional loss of output resulting from bankruptcies due to "over" leverage is easy to exaggerate.

However, suppose a firm is involved in multiple lines of business. One line of business suffers losses. The other lines of business remain profitable. If the losses from the troubled line of business add up to more than the firm's net worth, it can default and fail. If bankruptcy disrupts production in all lines of business, then the bankruptcy at least temporarily reduces the productive capacity of the economy and it is not simply a reduction in excess capacity.

This sort of collateral damage to other lines of business could be avoided if the firm had more equity and less debt. Of course, the solution is to make sure that profitable lines of business can continue to operate despite default and bankruptcy.

Changes in relative supply and demand conditions in various sectors of the economy generate profits and losses. Default and bankruptcy are a problem for firms suffering losses, and generally, those firms should produce less. If the changes in supply or demand are permanent, then productive capacity should be reduced for the firms suffering losses. That bankruptcy disrupts production is not a problem, it is rather a benefit.

But suppose there are losses throughout the economy, and there is no need to reduce production or employment in any sector of the economy? In other words, suppose the problem is monetary disequilibrium. If the quantity of money is less than the demand to hold money, the market process that returns the economy to equilibrium is a decrease in prices and wages, raising the real quantity of money to again match the amount of purchasing power that people want to hold. The signal that firms receive that these price adjustments are needed is a reduction in aggregate nominal expenditure. If prices and wages were perfectly flexible, then the lower nominal expenditure is consistent with unchanged real expenditure. The real volume of expenditure can remain equal to the productive capacity of the economy. The real quantity of money can rise to match the demand to hold money without any decrease in real output relative to productive capacity or any disruption in the employment of resources, including labor.

However, debts are claims to money, and so a decrease in the price level raises the real value of debt. If firms have no leverage, this would not be a problem for them. If they have sufficient equity, then the stockholders can bear the loss--really a transfer from stockholders to bondholders due to what amounts to a bet on the supply and demand conditions for money. But if the firms have "too much" leverage relative to the size of the needed change in the price level, then firms become insolvent and default. The real gain to the debt holders is less than the decrease in the price level because the stockholders don't have enough equity to lose. If the bankruptcy and default disrupts production, however, then an imbalance between the quantity of money and the demand to hold it would do more that shift wealth from debtors to creditors, it would also disrupt production and employment.

So, perhaps "excessive" leverage would be at least partly responsible for the adverse impact of monetary disequilibrium. Having firms finance their activities with more equity and less debt would meliorate this particular problem. Reducing the disruption to production from default--keeping firms operating in bankruptcy would be desirable.

However, the first best solution is too avoid an imbalance between the quantity of money and the demand to hold it. One of the many problems with monetary disequilibrium is that it makes all nominal contracts into speculations about changes in the quantity of money relative to the demand to hold it.

What is the best way to avoid monetary disequilibrium? I think the least bad solution is to target a stable growth path for nominal expenditure.


  1. "One of the many problems with monetary disequilibrium is that it makes all nominal contracts into speculations about changes in the quantity of money relative to the demand to hold it." But actual monetary disequilibrium is not necessary: the *mere possibility* of monetary disequilibrium is what "makes all nominal contracts into speculations about changes in the quantity of money relative to the demand to hold it." And there is no system in which monetary disequilibrium is not a *possibility*; all we can reasonably hope for is a system in which some compound of *probability* and *severity* is minimized.

    In what sense is *targeting a stable growth path for nominal expenditure* "best" ("least bad") for achieving this goal? It *does* seem to be a modest tweaking of the system we now have (thus, perhaps, "politically realistic"), and it *does* seem that it would be a big improvement. But is there some "utopian" system that would be even better?

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