Despite its many failings, capitalism has been a formidable engine of wealth creation and economic development over the past three centuries.
Yet what classical economists and revolutionary theorists like Karl Marx called capital was actually what financiers call “equity.” Retained earnings sit in equity part of a company’s balance sheet. Technically speaking, most capital accumulated in the 18th and 19th centuries has been equity.
Traditional capitalism or “equityism”
This is not to say that all equity generated over time has been generated internally or that the companies have been entirely self-financing. The Railway Mania of the 1840s in the UK, for example, was a classic stock market bubble fueled through banks using their depositors’ money, but also directly by small public investors.
Since then, other people’s money has guaranteed growth, even though ‘paid-up’ capital from public offerings and rights issues was also part of a shareholder’s stake in a company.
It was not until the middle of the 19th century that debt, in the form of bank loans and public bonds, systematically contributed to the financing of companies. This led Max Weber to observe:
Yet until the early decades of the last century, interest-bearing debt played an ancillary role in financing businesses and an even lesser role in the lives of consumers. With the exception of occasional speculative cycles, such as the frenzied demand for U.S. railroad bonds after the Civil War or the glut of household credit in the 1920s, stocks and individual savings have been the main sources of private sector financing during the first 250 years of capitalism.
This state of affairs first changed gradually after the Second World War, then more rapidly over the last half century.
Financial deregulation and innovation
President Richard Nixon’s decision to end the Bretton Woods international monetary system in the early 1970s opened a Pandora’s box of mobile cross-border financing. Deregulation, led by the creation of structured derivatives, immediately took center stage. The following decade, under President Ronald Reagan in the United States and Prime Minister Margaret Thatcher in the United Kingdom, a wave of product innovation ensured that the “box” could never be closed again.
This colossal credit creation inspired the junk bond mania and savings and loan failures of Roaring 80sthe emerging market crises in Mexico, Southeast Asia, and Russia in the 1990s, and the proliferation of leveraged buyouts (LBOs) and subprime mortgage lending frenzies before and after the turn of the millennium.
Private credit supply has been particularly pronounced in recent years after a hiatus during the 2008-2010 credit crisis when financial stimulus took over. All debt products – sovereign, emerging markets, financial and non-financial corporations, housing, consumer, student and health care – are at or near historic highs. Total debt measured 150% of US GDP in 1980; today it is hovering at 400%. During the worst stages of the Great Depression, it was 300%.
Nowadays, debt plays a more important role than equity. Last year, bond markets totaled $130 trillion globally, up 30% over the past three years. Various sources estimate that the total capitalization of equity-backed securities is between three-quarters and 80% of this amount, and this is mainly due to unprecedented quantitative easing (QE), which has fueled a rise in stock market valuations.
That’s only part of the story. Even before the pandemic, credit was growing at a much faster rate than equity offerings. In 2019, the securities industry raised $21.5 trillion globally. About $21 trillion of this capital was raised in the form of fixed income securities. Only $540 billion came from common and preferred stocks.
There is a powerful underlying engine behind the modern popularity of credit.
According to the traditional rules of capitalism, a debt is contractually due before or at maturity. From 30% of Gross National Product (GNP) after the Revolutionary War, the American public debt was fully repaid in the 1840s. After rising to 30% during the Civil War, it was reduced to 5% in the end of the 19th century. It rebounded to nearly 30% in 1917 due to World War I, then fell to 15% as the Great Depression hit.
The combination of the New Deal and World War II pushed total public debt past 100% of gross domestic product (GDP), a new measure introduced in 1934. By the 1970s, successive administrations, whatever their political orientation, had reduced this ratio to 30%.
Until then, governments had shown exemplary behavior that was easy enough for citizens and businesses to emulate: debts had to be paid eventually. As economic sociologist Wolfgang Streeck points out, following the Keynesian scheme:
That all changed when Reaganomics replaced near-permanent government borrowing with tax revenue. The model has gained acceptance not just in the United States or among center-right political parties, but around the world and across the political spectrum. Under Reagan’s watch, the national debt of the United States nearly tripled, from $700 billion in 1980 to nearly $2 trillion in 1988rising from 26% to 41% of US GDP.
Since the 1980s, public debt has increased in all OECD countries. Except for a brief period under US President Bill Clinton, nations rarely embraced the Keynesian principle of disciplined reduction, or what Streeck calls a “consolidation state,” unlike today’s “debt state.” today in which governments make little real effort to cut spending. . US federal debt now exceeds 100% of GDP.
Businesses and consumers followed in the footsteps of their governments and used credit massively. The risk is that the overuse of debt could lead to bankruptcies, financial difficulties and recessions. This was indeed the common scenario in past economic cycles. The downturns would force borrowers to stop spending and look for ways to reduce debt. Banks would stop lending and find solutions for their existing distressed loan portfolios.
Liability in perpetuity
This scenario is no longer fashionable. Debt is in fact so widespread that the term capitalism has become a misnomer. We now live in the age of indebtedness, or indebtedness. This model dictates that in a crisis, borrowers and lenders renegotiate, modify and extend, that is, convert and reschedule loans. Debt contracts are becoming more and more flexible.
Despite all the inherent instability brought about by leverage, governments encourage private lenders to keep lending to avoid a recession and to quit until the economy recovers. Lenders agree because they make money not from interest charged on loans – in a leveraged system interest rates stay low – but from arrangement fees, prepayment fees, penalties, of consent and advice, as well as syndication fees derived from spreading the risk of default throughout the financial system.
Historically, governments have taken on debt to pay for wars and stave off recessions, while the private sector – businesses, home buyers and consumers – have done so in times of prosperity. But as Alan Greenspan explained, the period of relative economic stability between 1983 and 2007 – known as the Great Moderation – was “precisely the tinder that ignites the bubbles.” Two and a half decades of shallow recessions and financialization have encouraged everyone to take risks.
Faced with stubborn and sluggish demand, it is more than likely that we will not be able to add to our debt burden. But despite the The Biden administration’s commitment to student loan forgiveness, the ongoing debate over the application of this policy to our group loan portfolio may be missing the point. Few have spoken of the prospect of never redeeming this evergreen debt, but rather continually reversing it in the face of adversity.
Although permanent over-indebtedness adds chronic stress to the economy and may eventually necessitate some form of financial catharsis, unless governments around the world work together to engineer the Great Deleveraging or Great Write-off, the Age of he perpetual and extreme leverage is here to stay.
In addition to moral hazard, such a system raises a philosophical question:
Should we consider a loan that we neither intend nor are required to repay debt Or equity?
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All posts are the opinion of the author. As such, they should not be construed as investment advice, and the opinions expressed do not necessarily reflect the views of the CFA Institute or the author’s employer.
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