Driven by the Federal Reserve’s policy of financial repression (cutting interest rates) since the Great Financial Crisis, the central bank’s measure of the ratio of nonfinancial corporate debt to GDP has risen from about 69% at the end of the fourth quarter of 2007 to more than 78% by the end of the second quarter of 2022. — a relative increase of about 13%. During the same period, the ratio of household debt to GDP fell from about 98% to about 75%, a relative decrease of about 23%. It is also worth noting that at the end of 1992, the ratio of non-financial business debt to GDP was only about 55%, and the ratio of household debt was only about 61%. The result is that over the past 30 years, the Fed’s measure of business debt to GDP has risen by 23 percentage points, and household debt by 14 percentage points.
This is not a US-only phenomenon. Corporate debt has grown significantly around the world, especially in emerging markets. While US households have improved their balance sheets since the GFC, corporate debt burdens have increased amid the growing likelihood of a global recession fueled by the war in Ukraine and tight monetary policies to fight inflation. This increases the risks of excess debt as business earnings could come under pressure.
Findings of empirical research
Òscar Jordà, Martin Kornejew, Moritz Schularick and Alan Taylor, authors of the October 2021 study “Zombies on the loose? Corporate Debt Overhang and the Macroeconomy,” collected data on non-financial business liabilities (primarily bank loans and corporate bonds) for 17 advanced economies over the past 150 years to examine the impact of rising corporate and household debt on the economic cycle. Given the disagreement over how to measure the business cycle, they focused on assessing how leverage in expansions was related to the severity of subsequent recessions. The following is a summary of their findings:
- The boom in corporate debt in an expansion says almost nothing about how the subsequent recession will play out. It doesn’t seem to matter whether the economy experiences a financial crisis or not, or whether the debt-to-GDP level is high or low. For example, a 10 percentage point increase in the business credit-to-GDP ratio in an expansion—a significant growth rate by historical standards—was not associated with a slower recovery.
- Recessions preceded by household credit expansions were not only deeper, but were followed by significantly slower recoveries—a 10 percentage point increase in household debt during the expansion was associated with dire consequences, as five years later the economy barely recovered to the level of beginning of the recession—the boom in business loans was rarely accompanied by such a macroeconomic hangover.
- The household credit boom was followed by a long period of household deleveraging with lower aggregate consumption, resulting in higher unemployment and lower inflation than in the average recession, although the inflation response was less clear. Therefore, the recession that follows the household credit boom seems to require stronger monetary support. These same features were not evident in the business credit boom.
- Both house and stock prices were more negatively affected after the household credit boom compared to the business credit boom.
- Finding no effects on the mean, they also investigated the relationship between corporate debt and slow growth in a worst-case scenario and again found no relationship. This is in stark contrast to the way the household debt boom increases the risks of deeper and longer recessions, as households take years to rebuild their balance sheets.
- By using the legal tradition as an instrument for the costs of debt renegotiation, where institutions encourage efficient restructuring and liquidation, the brake on the business debt boom has been small. However, in countries where renegotiation cost frictions were high, the recovery from corporate over-indebtedness could be as slow as that from household over-indebtedness.
- Debt settlement frictions make the recession deeper and longer. For example, inefficient liquidation increases the survival probability of zombie firms (overcapacity reduces investment and productivity).
- Frictions are much higher for household debt. Coordination misunderstandings among many dispersed creditors, retention problems, asymmetric information, weak contract enforcement, and other frictions can make renegotiations difficult or even prevent them altogether—an important factor in explaining differences in the impact of growth in household credit and growth in business credit.
To explain their findings, Jordà, Kornejew, Schularick, and Taylor note that the possibility of underinvestment encourages owners and creditors to restructure debt. Underinvestment pushes the value of the company below its potential, so both parties benefit from implementing an effective investment policy. In addition, “asset reduction” through underinvestment is a credible and effective threat to bring creditors to the negotiating table. They also cited previous research that found that differences in bankruptcy law regimes affect the investment behavior of near-default firms, thus highlighting the role of friction in debt renegotiation.
Since household debt has much bigger problems, the household credit boom had much bigger effects on the economic cycle. The authors explained: “Individual banks have no interest in restructuring household debts because such policies are only useful at the macro level. But it’s obviously different for businesses. Such frictions are a natural mechanism that could explain the contrast between household and corporate debt.” They added: “Frameworks that effectively facilitate debt restructuring or liquidation reduce the macroeconomic consequences of rising corporate debt. Conversely, legal and regulatory friction will accelerate excessive debt and the zombification of businesses, thereby dampening productivity growth and slowing post-recession recovery.”
The findings of Jordà, Kornejew, Schularick, and Taylor were consistent with those of the authors of a 2012 study, “The Macroeconomic Effects of Corporate Default Crises: A Long-Term Perspective,” which found that default events were only weakly correlated with business downturns over 150 years of US history.
Statements for investors
Aggressive interest rate hikes by the Federal Reserve, while also engaging in quantitative tightening (reducing their holdings of financial assets), have worried investors about the risk of a recession and its increased risks to corporate earnings and credit. While the corporate debt-to-GDP ratio has increased substantially over the past 30 years, the good news for investors is that empirical research findings show that at the aggregate level, corporate debt does not play an economically or statistically significant role unless frictional debt renegotiations impede the process. Excessive debt can lead to underinvestment by firms—when institutions are expensive and inefficient, investment disappears and does not recover for years after the debt boom. This highlights the importance of limiting friction (inefficient legal processes and institutions) in dealing with excess debt.
The other good news is that while household debt (which cannot be easily restructured) remains high from 30 years ago, it remains well below pre-GFC levels and the labor market is about as tight as it’s ever been; the unemployment rate is 3.5%, and there are more than 10 million open jobs and only 5.8 million unemployed. The result is that even in a recession, labor shortages could make companies reluctant to shed employees who would be hard to attract once the recovery begins. This should help the economy, but be a drag on corporate profits.
One source of concern is that the combination of tight labor markets (putting pressure on wages) and the fact that the U.S. has a housing shortage of about 4 million homes (putting pressure on housing prices, especially rents) could make it harder for the Fed to lower inflation to a target of 2%. The result could be that the Fed will have to raise interest rates more than the market currently expects and keep rates higher for longer. This would not be good for either traditional stocks or bonds. Forewarned is forearmed.
Larry Swedroe is the author or co-author of 18 books on investing. His latest is “Your Essential Guide to Sustainable Investing”. Any opinions expressed are solely his own and do not reflect the opinions of Buckingham Strategic Wealth or its affiliates. This information is for general information purposes only and should not be construed as financial, tax or legal advice. LSR 22-399