Source: St. Louis Fed
A growing level of debt in an economy can be a good thing. By borrowing money to pay for capital, we can become more productive and everyone prospers. Think of the US borrowing massive amounts of money to build the interstate highway system in the ‘50s and ‘60s. The important thing to remember is that the return on investment has to be higher than the cost of the borrowing.
That’s why today’s persistently low interest rates are so puzzling. In normal times, low interest rates would spur investment spending on a host of capital projects. That spending would itself spur economic growth, as the money cycles through the economy. Capital spending makes an economy more efficient, making everyone better off. The borrowing is easily serviced by a growing economy.
But these aren’t normal times. Companies are reluctant to borrow to finance capital investments. They’re worried that there may not be enough final demand, and their projects may get stranded. Apple may be spending over $10 billion per year on research and development, but they’re funding this out of their massive cash flow. Corporate borrowing is being used for financial engineering: CFOs are borrowing money to finance stock buybacks. If they can borrow at 3% to buy their stock with an earnings yield of 5% (a PE of 20x), that’s positive for shareholders. But what are shareholders doing with the buy-back cash? They’re buying more stocks—and share prices are increasing.
Rising asset values may encourage some economic activity, but it’s not a very effective transfer mechanism. Ongoing subpar growth requires fundamental change—not just tweaks to monetary policy. Monetary policy can only shift growth around—from country to country, via exchange rates, and from one time period to another, through interest rates. Lower rates pull growth forward; higher rates push it back.
But there has to be growth to push or pull. That’s why fundamental change is needed. Regulatory reform can make it a lot easier to do business. There’s little need, as far as I can see, to make hair braiders get a license in cosmetology. But that’s what many states require. Tax reform can also level the playing field by eliminating special set-asides and lowering the statutory rate.
Debt can be profitable, but only if it’s used as a tool to become more productive. Otherwise, it’s just rearranging the financial deck chairs on an economic steamship headed into the fog.
Douglas R. Tengdin, CFA
Chief Investment Officer