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There's Good Debt and Bad Debt

Irwin M. Stelzer

Janet Yellen, keeper of the Federal Reserve Bank’s money store, announced on Wednesday that free money remains on offer, at least for a while longer. Even cash-rich companies such as Apple can’t resist accepting that offer, and our deficit-ridden government can keep on borrowing at phenomenally low interest rates—until it can’t. But “can’t” comes later, and for politicians “now” matters a lot more than later.

Now, there is nothing wrong with borrowing. If a company borrows in order to invest in capital goods that increase its efficiency or in a new factory that can turn out stuff that is in demand, it should do so if the interest it pays for the cash doesn’t exceed the profits from the investment. If a nation borrows in order to build up the infrastructure its economy needs to grow, or parents borrow in order to invest in their children’s education and future earning power, they are justified in doing so.

But that’s not what is happening here in America. The government is borrowing not to refresh our infrastructure but to finance current consumption by those on the receiving side of the entitlement state—and both candidates for the nation’s highest office say they will resist efforts by Paul Ryan and a Republican congress (assuming control remains in Republican despite the downward tug of the head of the ticket) to rein in such spending. Consumers are borrowing to buy vehicles that are worth less than the amount of the loan as soon as the car is driven off the dealers’ lot. Corporations are using borrowed cash to buy in their shares or to pay dividends, both moves aimed at keeping their share prices high, neither adding to their ability to produce goods.

McDonald’s sold $6 billion in bonds last year to finance pay-outs to shareholders, reports Bloomberg, not to refresh its stores or invest in new technology that might offset the pressure created by rising minimum wage rates. McDonald’s is not alone. Overall, investment in business equipment—nonresidential fixed investment is the Fed’s term—has declined for two consecutive quarters, the first such consecutive declines since 2009.

Bloomberg also reckons that if we exclude the 1 percent of the richest companies, the remaining 99 percent of companies included among the S&P 500 have less cash on hand relative to debt than at any time in the past decade. Michael Contopolus, Head of High Yield Strategy at Bank of America Merrill Lynch says that in this “Peter Pan economy—it just won’t grow up”, the worst credit risks are coming to market. Moody’s, the rating agency, says that under the most pessimistic assumptions about the economy and interest rates, the current business default rate of 4 percent could rise to 14.9 percent by the end of the year. And more than one analyst expects holders of these high-yield IOUs to lose more than 80 percent of their investment, a risk that Contopolus says is not being adequately compensated for by the current interest rate paid to these junk-bond investors.

As the man who jumped off the 102-floor Empire State building said when he reached the 50th floor, “So far, so good.” But the worst is yet to come. Or, so many observers of the U.S. economy believe. They start with the fear that the recent decline in corporate profits, if continued, will reduce the ability of many companies to pay the interest due on the debt they are piling up. That’s what happened to many energy companies when oil prices fell and their cash flows could not cover interest payments, resulting in default.

American corporations are in the unhappy position of having to bid up the wages of increasingly scarce skilled workers although their output is not rising. More labor costs, no increase in the goods produced, and profits are squeezed. No one is quite sure why this is happening, why output per worker is not increasing to offset higher wages. One culprit most mentioned is the failure of companies to invest in the latest machinery and technology. So we have the dangerous combination of profits down and debt up.

But so far, so good, because the inevitable day when interest rates, the cost of carrying debt, will rise has been postponed yet again. Chairwoman Yellen and colleagues stayed their hand this week, and kept interest rates at close to zero, because of a weak jobs report and uncertainty surrounding the effects of a victory for the Brexiteers on the world’s economies and the international financial system. And although the Fed still expects the economy to grow at an annual rate of 2 percent, she reversed her prediction of a few weeks ago that interest rates would soon start to rise, confessing “We are quite uncertain about where rates are heading in the longer term.”

That stay of execution for the indebted does not relieve worries about all sorts of borrowing.

  • Heavily indebted shopping malls, which seem to be the new dinosaurs of the Internet age, will have trouble covering their interest payments as more and more mall-based shops are shuttered, and rents from those remaining decline as sales and earnings fall prey to increasingly tempting offers of instant gratification from Amazon.
  • Synchrony Financial, the largest US issuer of retail store credit cards, reports a rise in overdue payments, and S&P/Experian Consumer Credit Card Default Indices report that defaults on general-purpose credit cards rose in April for the fourth consecutive month.
  • Auto loan balances are at record levels, especially among subprime borrowers, prompting Jamie Dimon, CEO of J.P. Morgan Chase to characterize that market as “a little stretched.”

In short, companies, among them the least credit-worthy borrowers, are taking on record amounts of debt at a time when corporate profits are under pressure. Should the Fed, which seems to change its outlook on a weekly basis, decide when the next jobs report is published on July 8 that the gloomy June report was an aberration; that the Brexit vote and accompanying uncertainty have come and gone and the international financial system has not collapsed; and that the inflation rate has risen to levels consistent with its target, it might close the free money counter in its money store. Interest rates might start up, and both borrowers and lenders might come under intolerable strain. That would be bad news for an economy already struggling to grow at a meager 2 percent annual rate.

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