Hung Over on Debt

American business appears to be hung over on a massive debt fest from before the financial crisis. Debt Overhang to be more specific. It's so bad, it's causing real investment which in turn generates real jobs for the real economy which generates real growth... to be muted. One problem, the declining values of assets, specifically commercial real estate.

Federal Reserve Bank of Cleveland researcher Filippo Occhino delves deep, complete with crayons, on how debt overhang is negatively impacting business investment.

The below video explains debt overhang in simple terms, real simple, must watch simple.



Turning to adult versions of crayons, here is Occhino's graph of assets to business debt. Notice the asset to debt ratio historic high. (To read las matemáticas version of the research, pdf here).



The debt-overhang distortion amplifies and propagates the effects of shocks to aggregate demand and supply. In addition to their standard contractionary effect, adverse macroeconomic shocks weaken firms’ balance sheets, increasing the debt-overhang distortion and diminishing firms’ incentives to invest. Because of this added effect, the impact of such shocks on the economy is much larger and more prolonged. For instance, the impact of a productivity shock on investment and production approximately doubles and extends for several years due to the propagation mechanism created by the debt-overhang distortion.

Given the large impact that the debt-overhang distortion has on firms’ investment, hiring, spending, and effort levels, debt overhang is likely to have been an important factor constraining the recovery. It is likely that it is still exerting a drag on hiring, investment, and growth.

Check out the correlation of asset depreciation to business investment:

Debt overhang decreases the level of investment by approximately 1 to 2 percent for each percent increase in the leverage ratio of long-term debt to assets. This estimate for the debt-overhang impact is impressively large: it implies that a 10 percent decrease in assets, which is of the same order of magnitude as the one that occurred during the last financial crisis, would cause a 10 to 20 percent decrease in the investment level.

Yoozer, a potential multiplier of negative growth (contraction). In a nutshell, two high of asset to debt ratios, along with reduced firm output (makin' and sellin' stuff) acts like a tax in effect, reducing the incentive to invest further.

One of the solutions proposed is that debt holders take a glorified hair cut.

The debt-overhang problem may be so severe that creditors can actually benefit from forgiving a portion of the debt. With excessively high levels of debt, the risk of default is large and the market value of debt is well below its face value. If the creditors forgive part of the debt in this situation, the lower debt burden helps realign the interests of the equity holders and the creditors. The firm’s effort and investment will rise, increasing the total value of the firm and the market value of the remaining debt. If this effect is strong enough, the market value of the remaining debt may be even higher than the market value of the total debt in the absence of debt forgiveness, in which case debt relief will ultimately benefit the creditors themselves.

How many times has this been mentioned on this site yet nary a person in power acts on the obvious. Also, when creditors know they will be bailed out 100% by the U.S. government, as recent past has shown, at least the mega ones, why would they bother to take a debt hair cut, even when it is in their best interests as well as the national interest?

On a side note, isn't this about the best video presentation of economic research ever? Economic researchers, more drawings please! Great job explaining dense findings and concepts for those who do not have an organic brain mathematics translator at their ready.



The question to ask is how

The question to ask is how American companies were able to get into so much debt. Why didn't creditors stop lending money?

American businesses have been running Ponzi schemes based on bubble-inflated asset prices. The formula was pump up assets prices, and borrow more money. Maybe, fake some income from operations for good measure. Next, you can use this cash pay yourself lots of money, pay nice dividends, or even create war chest. However, eventually you run out of money to keep this going. Now what?

over-inflating assets

I didn't read the paper enough (the pdf), to see specifically how CRE evaluations affected the asset bloat.

Bottom line, doesn't it seem that even with the great Enron/Dot Con/accounting scales corporations simply found new methods to super inflate their balance sheets?

i.e. nothing changed, it simply moved to real estate?

What I cannot also understand is why, when the entire real estate bubble is a glorified Ponzi scheme, cannot, never, doesn't happen, the debt holders simply take a hair cut. Everybody else is getting wiped, except for the mega banks.

Debt-Saturation: Negative Return on Investment

As we revisit the pro-cyclical effects of the debt-money system, we are well-advised to be clear on the implication of these horrendous insights.
Thanks, Nathan.
We also need to be clear on the counter-cyclical solution to the massive debt-saturation that is the inevitable result of debt-based money.
The solution to a stable-buying-power based circulating medium system, the money system, is laid out in the proposal of a prominent group of economists in 1939 and available at this link.

The debt-money system is broke, broken and insolvent.
And it's taking the national economy down with it.
So, our choice is monetary sovereignty or extended, debt-deflated, monetarily-contracted insolvency.