Sunday, January 2, 2011

Investment and Leverage

Some have argued that monetary policy is ineffective sometimes, (like now) because business is already too leveraged. Their assumption is that an expansionary monetary policy involves an increase in lending. Firms are supposed to borrow this money and invest--purchase new capital goods. Because firms have already borrowed "too much," they don't want to borrow more. Instead, they are busy using current earnings to pay down debt. Perhaps, one day, after firms have paid down their debts, they will be willing to borrow again and purchase additional capital goods.

While there is surely some element of truth in this account, it is shot through with intuitions that come from a fallacy of composition. Most importantly, for every borrower there is a lender and for every debtor there is a creditor. This basic truth is essential for any decent macroeconomic analysis of debt, leverage, and investment.

Suppose Firm A is earning $60,000 per year in profit. The managers can purchase additional capital goods and anticipate a rate of return of 6%. If they retain the $60,000 profit and use it to purchase those capital goods, then investment spending is $60,000. There is no debt and no leverage.

What is the problem with leverage? Apparently the morality play is that tempted by the lure of easy money, the managers of Firm A do more than reinvest their profits. They borrow, say, $40,000 at an interest rate of 5%. Total investment expands from $60,000 to $100,000. And now Firm A has $40,000 in debt and is leveraged.

If Firm A had assets of $1,000,000, then its leverage ratio is pretty microscopic--just under .04. Still, if we imagine really easy money and that Firm A is unaware of the dangers of debt, then it might borrow $5,000,000 and investment expenditure would expand from $60,000 to $5,060,000. The leverage ratio is now 4.72. An excessive increase in investment is matched by excessive leverage.

However, this story ignores that there must be lenders who fund the borrowers. This ignores that the debts of the firms that borrowed are assets to some lender. To a remarkable degree, businesses lend and borrow one to another.

Suppose that there is a second firm, Firm B. It makes $40,000 per year profit. The managers can purchase new capital goods, and they anticipate a return of 4%. Investment for this firm is $40,000, and there is no debt and no leverage.

Looking at Firm A and Firm B together, total investment is $100,000. Firm A spends $60,000 on capital goods, anticipating a 6% rate of return and Firm B spends $40,000 on capital goods, anticipating a rate of return of 4%.

There are gains from trade available. Firm B can lend $40,000 to Firm A at 5% interest. Firm B now invests nothing. And Firm A invests its $60,000 profits and the $40,000 it borrowed from Firm B. Total investment is unchanged at $100,000. However, the rate of return increases. The average rate of return was a bit over 5% and it is now 6%. The owners of Firm B gain $400 from the exchange, and the owners of Firm A gain $400 as well.

As explained above, this transaction creates only a tiny bit of leverage for Firm A, a bit over .04. Firm B has no leverage, but rather has accumulated assets, the corporate bonds of Firm A. The total leverage ratio for the two firms together is very small, just under .02. If the real assets of the business sector, $1,100,000 is compared to the debt, then the leverage ratio is slightly above 2%.

Suppose Firm A and Firm B repeat this process year after year, with Firm B lending not only its $40,000 earnings from operations but also its growing interest income to Firm A. Firm A takes is growing profit and reinvests that as well. After ten years, Firm A would have a total debt of $441,063, but its assets would have grown to $2,149,132. Its leverage ratio is .26.

Firm A is earning 6% on its assets, which is approximately $128,000. It has to pay interest to Firm B, of approximately $22,000. This leaves Firm A with a profit of $106,000. Firm B, on the other hand, keeps the same real assets and operating income ($1,000,000 and $40,000,) but has total assets of $1,441,063 and interest income of about $22,000. It's total profit is then $62,000. Firm B has no debt and a leverage ratio of 0.

With the assumption that all earnings are lent or invested, total investment has increased substantially. Firm A invests all of its profit, but borrows from Firm B, so that its investment is $168,000. Firm B invests nothing, and so total investment is $168,000.

If the total assets of both firms are added and compared to the total debt, then the leverage ratio is approximately .13. And if only the real assets of the two firms is compared to the debt, then this leverage ratio is approximately .18. Of course, if the net assets are compared to the net liabilities of the two firms together, then the leverage ratio is zero.

Now, suppose that Firm B no longer wants to lend to Firm A. It looks at Firm A's leverage ratio of .26 and worries that it won't be able to pay the money back. Or, perhaps it is willing to lend more funds, but only at an interest rate of 7%. Firm A no longer wants to borrow additional funds at 7%. Alternatively, suppose it was Firm A that became worried about its excessive leverage. It no longer is willing to borrow. Or, again, perhaps it will borrow, but only at an interest rate of 3%. Perhaps both occur at the same time. So, rather than making loan transactions that benefit both parties at 5%, the lender now wants 7% and the borrower is only willing to pay 3%. They don't trade.

Now that Firm A is no longer borrowing, clearly investment expenditure must fall. There is too much leverage and borrowers or lenders or both are not willing to expand debt. All that Firm A can invest now is its profit of $106,000.

So, total investment must fall from $168,000 to $106,000 (approximately 50%) Right?\


Firm B no longer lends its earnings to Firm A and now invests the funds internally. That is its $40,000 in operating income and $22,000 in interest income for a total of $68,000 in profit. Firm A invests $106,000 and Firm B invests $68,000 for a total investment of $168,000. Investment remains unchanged, and total debt and leverage is not increasing.

Perhaps the problem is deleveraging? If Firm A begins paying down its outstanding debt, then surely investment must decrease. Of course not. The profits of Firm A are ample, but $106,000 is not nearly enough to pay off its $441,063 debt all at once. But suppose it pays off $106,000 per year. While Firm A invests nothing, Firm B continues to earn $22,000 in interest, plus receives $106,000 in loan repayments. Firm B can now invest the $106,000 funds received in repayment, its $22,000 interest payment, and its $40,000 earnings from operations. It adds up to $168,000.

During this period of develeraging, Firm A invests nothing. But Firm B, the creditor, does the investing. Total investment is unchanged. Each year, the interest payment made by Firm A is smaller and the interest earnings of Firm B are smaller. After about 4 years, Firm A has no more debt and its leverage ratio is zero. Firm B has no financial assets and earns no interest income, but it has substantially more real assets.

If it is really true that Firm A can earn a 6% return and Firm B only can earn a 4% return, the unwillingness to increase leverage involves the sacrifice of future real income. Worse, all of the deleveraging would involve a shift from projects providing a 6% return to projects only providing a 4% return.

Notice that the excessive leverage caused credit markets to "freeze." Firm A will only pay 3% and Firm B will only accept 7%, and so there are no credit transactions. From a real business cycle theory approach, the problem of this frozen credit market would be the reduced real return. From a technocratic perspective, coming up with a way to motivate Firm B to continue to lend to Firm A, (perhaps some kind of government guarantee to Firm B against loss on its loans to Firm A) would be the solution.

From a quasi-monetarist perspective, what is important is that total spending be maintained. In particular, that as Firm A reduces investment as it borrows less or repays debt, then Firm B, which is no longer lending and perhaps receiving funds in repayment of loans, invests more. Whether leverage grows, stays the same, or shrinks is not important. While the particular investment projects undertaken are important, the key role for government is to enforce debt contracts and let each firm determine whether it is best to invest directly or else lend so that another firm can invest more. The other side of the coin is that each firm needs to decide for itself whether it is willing to borrow money and "leverage up" to better exploit investment opportunities.

With thousands of large firms (and millions of firms altogether,) the notion that the government can determine what are the true returns and direct investment is a chimera. The market price that coordinates the movement of funds among firms is the interest rate. Those firms with strong current earnings and low yield investment opportunities can lend. Those with investment opportunities beyond their current earnings borrow.

If there is a sudden determination that many firms are overleveraged, then the effect on credit markets is ambiguous. If the problem is that creditor firms, like Firm B, don't want to lend, then the decrease in the supply of credit results in a higher interest rate and a decrease in the quantity of credit. On the other hand, if the problem is that the overleveraged firms, like Firm A, no longer want to borrow, then the result is a decrease in the demand for credit. If both occur at the same time, then effect on the interest rate is ambiguous and the quantity of credit falls.

Of course, there is not really a single interest rate but rather many interest rates, depending on, among other things, perceived risk. For example, as creditor firms reduced their loans to highly leveraged and risky debtor firms, they would likely increase the supply of credit to other creditor and less leveraged firms. The interest rate for those firms would fall and the quantity of credit should rise. On the other hand, for the more highly leveraged firms, their quantity of credit would still fall, but their interest rates could rise or fall depending on to what degree the highly leveraged firms want to reduce their debts.

Some interest rates fall, and others are ambiguous. The quantity of credit for firms with little leverage rises, but the quantity of credit for highly leveraged firms falls. The likely net effect would be a smaller quantity of credit as firms reduce lending, collect on loans, and use the funds for internal investment.

For example, when Firm B ceased lending to Firm A, either because it was worried about the excessive leverage, Firm A didn't want to borrow, or both, then it would be willing to lend to some other firm, that had little or no leverage. But if the interest rate falls enough, below 4%, then Firm B would stop lending and instead spend on capital goods.

Why the view that overleverage leads to reduced investment? The reason is simple. The lenders are ignored, with the implicit assumption being that funds that aren't lent are held. That is, a reduction in the supply of credit is the same thing as an increase in the demand for money. For example, suppose when Firm A stopped borrowing and began paying back loans, Firm B received the money. Rather than spending it on capital goods (or lending it to some other firm that wasn't so highly leveraged,) suppose Firm B just left the money sitting in its checking account. If the quantity of money is unchanged, the increase in the demand for money results in less spending. Since the actual reduction in spending was by Firm A, it is investment spending that falls.

An alternative situation would be that Firm A didn't borrow from Firm B, but rather from a bank. When it repays the loan, then the quantity of money falls. Given the demand for money, this results in a decrease in spending. Again, it is Firm A that is spending less, and it is a reduction in investment spending. Of course, if the bank makes a new loan, perhaps by purchasing bonds, then the quantity of money doesn't fall after all.

From a quasi-monetarist perspective, the key is to prevent deleveraging from reducing total spending. And what that means is that to the degree that those who lend less choose to hold more money, the quantity of money should be increased to match.

To say that there is "too much" leverage, means that firms should invest internally rather than shift funds by borrowing and lending to take advantage of higher returns. Alternatively, it is to say that firms should use equity rather than debt financing. Firm A should issue new shares to fund its investment, which Firm B should buy. To identify overleverage with excessive investment is to take what is true of the debtor firm (Firm A,) and generalize to the entire economy. It is to ignore the creditor Firms. It is to ignore that for every borrower there is a lender. it is to ignore that for every debtor there is a creditor.


  1. "If it is really true that Firm A can earn a 6% return and Firm B only can earn a 4% return, the unwillingness to increase leverage involves the sacrifice of future real income." Well, it is not simply the unwillingness to increase leverage that has this unfortunate result. As you point out later, instead of selling bonds Firm A could offer to sell new shares of its stock to Firm B, which could accept the offer. For A this would be *dilution* rather than *leverage*; but apparently those against whom you are arguing don't mind dilution, while they are concerned about leverage. If future real income is sacrificed, this must be attributed partly to the firms' unwillingness to engage in such a stock transaction.

    In your scenario, "the excessive leverage [is supposed to have] caused credit markets to 'freeze'." If everyone had been confident that Firm A would earn 6% on its capital forever, no one would have been worried about leverage. The 6% figure must have been the *expectation*, amid uncertainty about what the actual amount would be in any particular year. The appetites for risk of Firm A and Firm B, respectively, will then determine how much leverage for A would make the credit market "freeze." A would and should borrow from B up to that point, obtaining the rest of the capital it can profitably employ by issuing new stock. (But the 6% expected return must decline as the extra capital investment increases.)

    "From a quasi-monetarist perspective, the key is to prevent deleveraging [i.e., paying back loans] from reducing total spending." Symmetrically, it is equally key to prevent borrowing [i.e., taking out new loans] from increasing total spending.

    "To identify overleverage with excessive investment is to take what is true of the debtor firm (Firm A), and generalize to the entire economy. It is to ignore the creditor Firms." Well said! (Is this an attack on Austrian economics, in particular?)

  2. This was not meant to be an attack on Austrian economics in general, or the Austrian Business Cycle Theory. (And it is a serious error to identify the two. I am a skeptic regarding Austrian Business Cycle Theory, but I think the Austrian approach to understanding the market process has a lot to recommend it.) In my view, the Austrian Business Cycle Theory theory is that an excess supply of money leads to malinvestment. On the other hand, I think that Austrian economists, particularly of the amateur variety, sometimes shift over to a view that excessive leverage represents excessive investment. There are plenty of good Austrian economists who don't confuse the real and nominal supply of credit and the real and nominal value of capital goods. If anything, the view I am criticizing is "liquidationism." Larry White has a good article pointing out how Hayek, especially, differed from that view.

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