Nothing is more expensive than a missed opportunity. The tangled schema of underinvestment could be simplified by the wise words of H. Jackson Brown Jr (in his successful “Life’s Little Instruction Book”).
Debt overhang indeed, is a debt burden that is so large that an entity cannot take on additional debt to finance future projects (including entities that are profitable enough to be able to reduce indebtedness over time). Firstly, we can consider a firm which has an outstanding debt due at the end of the year so that its managers wants to undertake a new investment to steer the company into a new business. For its initial investment, the firm will realise a certain return. Dividing the difference between the gain from an investment and its cost by the cost itself we can determine a rudimentary gauge of an investment’s profitability: the so called “Return On Investment”. But let’s take a step back.
Could our firm raise the required sum for the plan by issuing new equity? Before jump on board, equity holders will probably try to evaluate investment’s future prospects with the “Net Present Value” rule. Let’s suppose our project has a positive NPV: it means a profitable investment and more benefits than costs in the future. It might be thought good news are about to rise, but, unfortunately, something is still missed. The load of the initial debt could be so hard to carry, to make the profitability of our new project insufficient. Therefore, equity holders, without any gain, will choose not to finance the project even if that was a profitable one. Sacrifices related to debt finance are the so-called “costs of financial distress”. The pressure of debt issue, if unendurable, could indeed force the firm to take the opposite direction, redirecting capital. In other words, when facing financial distress, some firms may choose not to finance project with positive “Net Present Value”. Moreover, a firm facing debt overhang cannot issue new junior debt because boosting leverage could be dangerous, especially when default is just around the corner. Leverage results from using borrowed capital as a funding source when investing to expand the firm’s asset base and generate returns on risk capital. It can be used to generate shareholder wealth, but if it fails to do so, the interest expense and credit risk of default destroy shareholder value. This investment strategy is strictly connected with the value of the firm; in particular, it exist a specific point where the firm value decreases if leverage is increased any further: the reason is that expected costs of financial distress could become too large to be tolerable.
Therefore, oversized debt induces a behaviour where positive net present value projects do not get undertaken due to the fact that parts of future earnings from projects goes to creditors in the form of promised payments. As a consequence, management may be unable to raise new capital for positive-NPV projects when the firm’s existing debt holders have a senior claim to the proceeds. So just to make a comparison with the “real world”, the IMF in 2015 published a chapter on corporate leverage in emerging markets, reporting that corporate debt of non-financial firms across major emerging market economies quadrupled between 2004 and 2014.
Shifting the focus from firms to private debt, the similarities are unsettling; but in this case, squandering an opportunity has more perturbing consequences. US case deserves our attention. The New York Federal Reserve reports that younger people are so crippled by debt that they are forming household later and they neglect other productive investments for their future. Since 2000, educational courses are up 132% (same reports). The overhang of educational debt is pernicious both for the individuals and for the economy as a whole. A large, unbearable amount of initial debt “crowds out” people’s productive potential. This kind of system is clogged by its own rules and should be a priority to break the fetters, although the economy does not look in obvious need of stimulus, with unemployment at just 4.1% and an unrivalled technological progress.
Thus, the American economy may be booming, but not everyone is participating in the bonanza. Robert Reich, professor of economics and former Secretary of Labor under the presidency of Bill Clinton, in his documentary film “Saving Capitalism” focused his attention on the connection between capitalism and democracy, arguing that “a crony capitalism is getting richer at the expense of the small guy”. The blatant effect of a widespread underinvestment is a profound inequality among the required skills for different jobs. Inequity is a key factor in steering debt towards a vicious cycle. Gertjan Vlieghe, a member of the Monetary Policy Committee, during a very thoughtful speech in 2016, stated: “a rise in inequality could itself reinforce the rise in debt, as households at the lower end of the income and wealth distribution try to maintain consumption growth despite weaker income growth”.
Fig: Data from the Federal Reserve Bank of New York
The graph above makes clear what we are talking about. It analyses the household debt (expressing it in trillions of dollars) in US for a range of 10 years, since 2007 to 2017. From 2007 the debt increased to reach a pick in 2008, during the financial crisis. Then it steadily decreased from 2009 to 2013, starting then another growth, to get to nowadays at a higher level then 2008.
Some could argued our conventional macroeconomic measurements are lurching facing with reality. According to them, analytical data ought to be disaggregate by geography and income group in order to get a more granular sense of whose being hurt by the economic environment. That is the view expressed by Eugene Ludwig, CEO of Promontory Financial Group, interviewed by Bloomberg. Even Robert Kennedy, during a speech at University of Kansas in 1968, dealt with the issue: “Gross National Product measures neither our wit nor our courage, neither our wisdom nor our learning, neither our compassion nor our devotion to our country, it measures everything in short, except that which makes life worthwhile”. Hence, the way to take into account the economic granularity is to position citizens at the heart of the big picture. During the Lindau Nobel Meeting on Economic Sciences in 2014, Edmund Phepls (Nobel prize winner in 2006) affirmed: “when opportunities to exercise creativity fall off, then there’s less innovation, less investment activity and less job creation: this whole other side of employment determination is under recognised”.
Creativity and innovation have acquired a voracious appetite for money and the play of younger, debt ridden America is a matter of concern: if the stifling portion of debt is recoverable, a some sort of consumer debt restructuring will be achievable.