It’s fundamental – if you want a higher return on your capital you have to take more risk.
The risk-return tradeoff in financial markets has been around forever. What many in today’s global markets may have missed is that this fundamental principle doesn’t go away when you take on debt. Individual investors and government policy makers alike seem to think you can put borrowed capital to work without any additional risk.
The financial markets always find a way to correct this misunderstanding. Market volatility in Greece, China, and the United States points to the additional risk of using borrowed capital.
To understand the principle consider two businesses that are identical in all aspects except one. Firm A uses only investor’s capital to operate, while Firm B uses 50 percent debt. When Firm A earns 10 cents, each investor makes a 10 percent return on each dollar of their capital. Investors in Firm B, however, earn nearly 20 percent because they have less capital employed.
The problem arises when these businesses face a downturn. A 10 percent decline in earnings reduces Firm A’s capital by 10 percent, but reduces Firm B’s capital by more than 20 percent because the debt holders still need to be paid their interest.
What’s true for the investors in these hypothetical businesses is also true for entire economies that take on debt. The economic and investment outlook for the remainder of this year is heavily dependent on how the debt situations in Greece, China, and the United States play out.
At the end of June the Greek government failed to make a scheduled debt payment to the International Monetary Fund. The government in Athens has clearly overextended itself, running excessive budget deficits for decades and promising generous pension benefits for its workers.
Historically, governments addressed debt problems by devaluing their currency. This is the biggest risk of the Greek crisis for all investors. If Greece decides to no longer use the Euro currency it should precipitate a fall in the value of the Euro and a corresponding rally in the value of the US dollar. Such exchange rate changes will likely lead to declines in both commodity and world stock prices.
The end of the June also saw financial market turmoil in China. The run-up in Shanghai stock prices over the past year was fueled in large part by borrowing on the part of small, individual investors who wanted to invest in the stock market. Then, when the market started to sell off in late June and early July the Chinese government responded with more cash for the state-backed margin financing entity — China Securities Financing Corporation (CSFC). The CSFC lends funds to brokerage firms for the specific purpose of lending to investors for stock purchases.
China’s overall debt load is now nearly three times its annual economic outputiii. The country could also try to devalue its currency in response, but the Chinese government has officially stated otherwise. The government announced earlier this year it would like its currency, the Yuan, to become what is known as a reserve currency. When more institutions around the world hold a currency in reserve that country benefits from more trade and lower interest rates.
The United States continues to have its own debt problems. In response to the housing crisis the US federal government took over the large mortgage financing entities and the US Federal Reserve embarked on unprecedented government and mortgage bond-buying spree. There is now more than $23 trillion of US government-sponsored debt outstanding[i], which amounts to 130 percent of our annual output. The burden of this debt stays low if interest rates are also low.
That could be changing soon. Policy makers at the US Federal Reserve began discussing in June the potential for raising interest rates. Minutes from the Federal Open Market Committee meeting show that at least one member was ready to raise interest rates now, but “expressed a willingness to wait another meeting or two.” [ii] Higher interest rates will make the government debt burden harder and raise the value of the Dollar. Just as with the Greek situation above, the effect should be declines in both commodity and world stock prices.
The debt problem is not limited, however, to just these three countries. According to the McKinsey Global Institute, global debt has grown by $57 trillion since 2007, with most major economies having higher levels of borrowing relative to their economic output than they did before the financial crisis of 2008.[iii] As with the US, most of this debt is government-issued.
Some economists have argued that government debt is not a problem and that we should issue more to finance government spending. Paul Krugman, for example, has argued that we should not worry about government debt because it is “money we owe to ourselves.”[iv] Not true if future generations (not us) have to pay it back to others (again, not us).
Government budget deficits and increasing debt is more like taxing ourselves, and higher taxes reduce economic growth and lower financial returns. Economists Robert Barro and James Buchanan, among others, have shown that increasing government debt increases the likelihood of financial crises and reduces long-term growth.
It’s fundamental – societies have increased the risks in the economy and financial markets by using debt with the hope of generating better returns. It hasn’t worked. Economic growth is slow, bond returns are anemic, and annualized stock-market returns over the past decade are still below historical norms.
Expect slow growth and low financial returns unless government spending and debt declines.
The views expressed here are those solely of the author and do not represent Northwest Nazarene University or Rathbone Warwick Investment Management.
Peter R. Crabb, Ph.D.
Professor of Finance and Economics
Department of Business and Economics
School of Business, Northwest Nazarene University
Dr. Crabb holds a Ph.D. in Economics from the University of Oregon and an MBA in Finance from the University of Colorado. His research in economics and finance is published in the Journal of Business, the Journal of Microfinance, and the International Review of Economics and Finance, among others. Dr. Crabb lives with his wife, Ann, and their four children in Canyon County, Idaho. Dr. Crabb’s regular Financial Economics column is published by the Idaho Statesman. Previous work experience includes international trade, banking, and investments.