June 07, 2019
The Washington Post had another column telling us about the run-up in corporate debt and how this is going to be 2008 all over again. This is a popular one with the media. William Cohan has a regular feature in the New York Times telling us how a collapse of the debt bubble is imminent, giving us another financial crisis.
While excessive corporate debt can pose problems, nothing we see now, or will plausibly see in the near future, looks anything like 2008. The fact that ostensibly knowledgeable people can say this shows that they not only missed the housing bubble as it was growing, ten years after it burst, they still don’t have a clue as to what happened.
So let’s try our Econ 101 lesson once again.
The reason the economy collapsed in 2008 was that the housing bubble that had been driving the economy collapsed. The financial crisis was lots of fun (always good to see billionaire types sweating), but it was very much secondary. The issue was that the housing bubble created a massive amount of demand in the economy, which disappeared when the bubble collapsed.
Most economists probably didn’t recognize the impact of the bubble because you would need access to GDP data, as in the data that is readily available on the Commerce Department’s website any time anyone cares to look. Those who did think that GDP data are useful in understanding the economy would see that residential construction, which had averaged a bit more than 4.0 percent of GDP in the 1980s and 1990s, soared to a peak of 6.7 percent of GDP in 2005.
This surge in construction spending was not associated with any developments in the fundamentals of the housing market. After all, the baby boomers, the largest demographic group, were seeing their children move away from home and downsizing. Rents were not sharing in the upswing in house prices, moving more or less in line with inflation. And, vacancy rates were hitting record highs.
All of this should have suggested that the surge in residential construction was transitory and likely to end when house prices came back down to earth. In fact, construction was likely to over-correct since the construction boom meant there was a lot of overbuilding. Construction ultimately bottomed out at 2.4 percent of GDP in 2010 and 2011. (It is 3.8 percent in the most recent data.)
In addition to the construction boom, surging house prices also led to a consumption boom. This is based on an economic concept that is probably at least a hundred years old, known as the “housing wealth effect.” The idea is that when people see the price of their house double from $200,000 to $400,000, as many did in the bubble years, they will look to spend more based on the $200,000 in additional equity.
This could mean borrowing against their new equity to do renovations on their home, take a vacation, pay for their kids’ college, or it might just mean putting less money in a 401(k). (Saving less, means spending more – it is definitional, saving means not spending.) To know about this bubble-induced consumption you would have to had been paying attention to some guy named “Alan Greenspan” who wrote a number of papers on the topic in these years. (I have more of the details in a ten-year anniversary piece from last fall.)
Anyhow, the bursting of the housing bubble meant that the demand generated by it disappeared as well. The 4.3 percentage points of GDP drop in residential construction from peak to trough would translate into more than $860 billion in annual demand in today’s economy. Add in a couple of percentage points of GDP from lost consumption demand, due to the massive disappearance of housing wealth, and we’re talking about a loss of almost $1.3 trillion in annual demand. This is an amount that is almost nine times as large as the Trump tax cut.
What did economists think would replace this massive loss of demand? Was there a plausible story where some component(s) of private sector demand could just jump up by six percentage points of GDP? Had we ever seen anything like this happening in the past?
The point here is that there was no plausible story whereby the demand generated by the housing bubble could be readily replaced by other forms of demand in the private sector after it burst. We could, of course, replace it by additional public sector spending, but we would need a stimulus that was two to three times as large as the one pushed through by President Obama.
Even if a much larger stimulus might have been politically plausible, the point is that massive government intervention would have been necessary because the collapse of the housing bubble meant that the private sector was not keeping the economy anywhere close to full employment. The collapse of the housing bubble would have meant a deep recession, barring a strong government response, even if the financial sector had been just fine.
I realize that economists and economics reporters like to focus on the financial crisis. After all, it is pretty embarrassing to admit that they somehow hadn’t noticed the huge upsurge in residential construction and consumption that were plainly visible in the quarterly GDP data. It’s much less embarrassing to say that they didn’t know the liabilities and poor quality of assets held by many financial institutions, especially since much of this data was not public.
But moving beyond the misconceptions about the Great Recession, the question is what risk does the current buildup of corporate debt pose? The first point to note here is that just looking at debt levels, or even debt as a share of GDP, is misleading. Interest rates are considerably lower today than they were before the Great Recession. The interest rate on high-quality long-term bonds, which had been in the 5.0 percent to 6.0 percent range before the downturn, has been under 4.0 percent for the last seven years. The rates on high-yield bonds are correspondingly lower.
This means that a larger debt can still mean a lower interest burden. In addition, the profit share of income has increased considerably. This has been partly at the expense of wages, as the profit share soared in the weak labor market following the Great Recession, and partly as a result of the Trump tax, which radically reduced corporate tax burdens. Therefore, the ratio of debt service to after-tax corporate profits is not especially high.
But carrying this a step further, let’s suppose investors suddenly lost confidence in the corporate bond market and interest rates soared, especially on high-yield debt. What would be the devastating consequences in the real economy?
With the housing bubble, it was easy to answer that question. When house prices plummeted, so did residential construction. Consumption also took a nose dive. But what component of GDP do we expect to see crash following a flight from corporate debt?
Anyone who answers “investment” has not been looking at the data. Investment has been very mediocre in this recovery. Even after the Trump tax cut last year, investment only grew modestly. It would be very difficult to make the case that there is some big investment boom that will come to an end if the market in corporate debt takes a plunge.
Of course, this doesn’t mean that there will not be some firms that have to cut back investment if they lose access to credit. Many firms are highly leveraged. This is especially true of firms that are owned by private equity companies.
As my colleague Eileen Appelbaum and Rose Batt have pointed out, most of the big retail chains that have failed in recent years have been owned by private equity (PE) companies. Invariably, the PE owners load up the companies they buy with debt and strip them of assets. This makes them especially vulnerable to any downturn in demand. While this is not the sort of thing that gives you another Great Recession, it certainly is bad news for the workers at companies owned by PE firms.
The PE companies use the debt incurred by their portfolio companies (not the PE companies) to pay themselves large dividends. The PE companies then treat the heavily leveraged company as a longshot bet, with a potential for a very high payoff and little downside risk.
If the company manages to survive in spite of its debt and lack of assets, they can have it go public again, and have a really big payday. In the event it goes bankrupt, they have typically already covered the cost of the purchase with the dividends they paid themselves.
It’s a great game for the PE companies, although not for the workers at the companies they control or their creditors. The latter includes not just banks and other investors, who explicitly lend them money, and should understand the risks, but also suppliers, landlords, and other businesses that may find themselves owed money at the time of a bankruptcy.
Anyhow, in the event of a downturn, there will be many heavily leveraged companies, including many owned by PE firms, that will face bankruptcy. This will be very bad news for lots of workers and creditors. This won’t give us another financial crisis, with cascading bankruptcies, nor will it give us a Great Recession, but it is not a pretty picture.
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