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One part of risk management is recognizing the risks while they can still be managed. One of the biggest unrecognized risks in recent years is debt. Whether one thinks of subprime mortgages or leverage ratios of some investment banks, over the past decade or so, far more people embraced debt than feared it. The result was a large increase in the amount of debt, both in the U.S. economy and among developed nations. Many of the emerging markets in Asia suffered a severe financial crisis and economic downturn in 1997 following capital flight and difficulty in paying down debt. Their response was to minimize the use of debt while building up large cash reserves. The results of these actions included their relative success in weathering the last few years and their increased holdings of U.S. Treasury securities.
‘Debt Means Risk’
Debt means risk. This is true at the national level and throughout the economy down to companies and individuals. Given successful risk management, however, debt and risk may not necessarily spell disaster. Risk has two dimensions—less flexibility because a portion of income must be diverted to debt service; and leverage, which raises both the potential returns and the chance of failure. Consider two companies in the same business, one financed 100 percent with equity and one 50/50 with equity and debt. The one with 100 percent equity financing has the flexibility to choose how its income should be split between investment in the business and returns to equity investors. The one with 50/50 debt and equity must distribute a portion of its income to the debt holders, no matter how attractive other potential investment opportunities may appear. If either company’s income represents a 10 percent return on the total capital invested, the all-equity company made 10 percent for its equity investors while the 50/50 leveraged company made 20 percent for its equity investors. That’s the upside of leverage. But, there is a downside as well. If the economy turns down and income is zero, the 100 percent equity company will survive, though the shareholders will be disappointed. The 50/50 leverage company, in the same story, will not be able to cover its debt service and will most likely become bankrupt.
The same story can be told about individuals and households or about entire countries. Indeed, recently the press and the Web have been filled with speculation that Greece and other nations won’t be able to repay their debts.
We Should Have Seen It Coming
Some people did see the financial crisis coming; unfortunately, others didn’t listen as carefully as they should have. But even then things might not have turned out differently. Debt levels in the U.S. economy rose significantly in the last decade or more and reached levels that weren’t seen previously except in major wars. Figure 1 shows debt levels in the U.S. economy as a percentage of GDP from 1945 through 2009. Beginning in the late 1990s, debt levels began to rise more rapidly and to outpace increases in GDP. Looking only at nonfinancial debts (excluding the financial sector in the chart), original borrowers—as opposed to securitized and other debts recirculated in the financial system—averaged 130 percent of GDP from 1947 through 1987; 175 percent of GDP from 1988 to 1999; and 196 percent of GDP from 2000 to 2009, peaking at 236 percent in 2009. The biggest increase was in mortgage debt borrowed by households. Financial sector debts rose even faster than household debt, from 49 percent of GDP for the 1988-1999 period to 95 percent of GDP in the 2000-2009 period.
There is no absolutely “safe” or “low risk” level of debt in the economy. Until the late 1980s, debt levels measured against GDP were relatively stable, and some analysts thought that this stability was some unknown economic law. The “Great Moderation”—the period of consistent economic growth beginning in the mid-1980s and extending through two mild recessions to 2007—seems to have convinced many people that taking on debt was prudent risk management and desirable. However, as we have seen, the results were quite different.
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