Despite its many failures, capitalism has been a tremendous engine of wealth creation and economic development over the past three centuries.
However, what classical economists and revolutionary theorists like Karl Marx called capital is actually what financiers call “equity.” Retained earnings sit in Shareholders’ equity A section of a company’s balance sheet. Technically, most capital accumulated in the eighteenth and nineteenth centuries justice.
traditional capitalism or “equality”
This does not mean that all of the equity created over time was produced in-house or that the companies were entirely self-financed. The UK’s railway mania in the 1840s, for example, was a classic stock market bubble fueled by bank intermediation using depositors’ money, but also directly by small public investors.
Since then, other people’s money has contributed to growth, although the “paid-in” capital coming from public offerings and rights issues has also been part of the shareholders’ ownership stake in the company.
Only from the middle of the nineteenth century onwards did debt, in the form of bank loans and public bonds, systematically help finance business. This prompted Max Weber to note the following:
In modern economic life, the issue of credit instruments is a means of rational accumulation of capital.
However, until the early decades of the last century, interest-bearing debt played a secondary role in corporate finance and a lesser role in consumers’ lives. With the exception of occasional speculative cycles, such as the frantic demand for American railroad bonds after the Civil War or the excess of household credit in the 1920s, stocks and individual savings were the primary sources of private financing in the first 250 years of capitalism.
This state first changed gradually after World War II and then changed more actively in the past half century.
Financial liberalization 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 cross-border mobile finance. Led by the creation of structured derivatives, deregulation immediately achieved notable focus. In 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 massive creation of credit inspired the junk bond mania and savings and loan failures of the mighty 1980s, the emerging market crises in Mexico, Southeast Asia and Russia in the 1990s, the proliferation of leveraged buyouts (LBOs) as well as the mortgage lending craze 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 fiscal stimulus took over. Every debt product — sovereign, emerging markets, financial and non-financial corporate, housing, consumer, student, and healthcare — is at or near all-time highs. Total debt was 150% of US GDP in 1980; Today it is hovering at 400%. During the worst of the Great Depression it was 300%.
Nowadays, debt plays a bigger role than property rights. Last year, bond markets totaled $130 trillion worldwide, up 30% in the past three years. Various sources have estimated the total capitalization of equity-backed securities between three-quarters and 80% of that amount, mostly due to the unprecedented quantitative easing (QE), which has led to a spike in stock valuations.
This is only part of the story. Even before the pandemic, credit was expanding much faster than stock offerings. In 2019, the securities industry raised $21.5 trillion globally. About $21 trillion of that capital has been raised in the form of fixed income. Only $540 billion came from common and preferred stock.
There is a strong underlying driver behind the recent popularity of credit.
According to the traditional rules of capitalism, debt is contractually due before or at maturity. From 30% of the Gross National Product (GNP) after the Revolutionary War, the US government’s debt was fully paid off by the 1840s. After rising to 30% during the Civil War, it fell to 5% by the end of the 19th century. It rose again to nearly 30% in 1917 due to World War I and then narrowed to 15% by the time of the Great Depression.
The combination of the New Deal and World War II pushed total government debt beyond 100% of GDP, a new measure introduced in 1934. By the 1970s, successive administrations, regardless of their political leanings, had lowered that ratio to 30%.
Even then, governments had displayed exemplary behavior simple enough to be emulated by citizens and businesses alike: debts had to be settled eventually. As the economist Wolfgang Streeck points out, within the Keynesian scheme:
“It is assumed that the debt will be repaid as the economy returns to an appropriate level of growth and public budgets generate an excess of reserves over spending.”
All that changed when Reaganomics replaced semi-permanent government borrowing with tax revenue. The model has gained acceptance not only in the United States or among center-right political parties, but around the world and across the political spectrum. Under Reagan, the US national debt nearly tripled from $700 billion in 1980 to nearly $2 trillion in 1988, rising 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, countries have rarely embraced the Keynesian principle of disciplined reduction, or what Strick calls the “state of consolidation,” in contrast to the current “debt situation” in which governments make little real effort to reduce spending. The US federal debt now exceeds 100% of GDP.
Businesses and consumers followed in their governments’ footsteps and made extensive use of credit. The danger is that the overuse of debt can cause bankruptcies, financial distress and recession. This was indeed the common scenario in past economic cycles. Recessions will force borrowers to stop spending and look for ways to reduce their obligations. Banks will stop lending and come up with solutions to their existing problem loan portfolios.
responsibility in eternity
This story is no longer popular. Religion is in fact so pervasive that the term capitalism has become a misnomer. We now live in an age of indebtedness. This model dictates that in the event of a crisis, borrowers and lenders renegotiate, modify and extend loans, i.e. transfer and reschedule loans. Debt contracts are more flexible than ever.
For all the intrinsic instability that leverage creates, governments encourage private lenders to keep lending to avoid a recession and kick the can on the road until the economy recovers. Lenders agree that they make money not from the interest charged on the loans—in a debt system, interest rates remain low—but from arrangement, prepayment, penalty, approval, and advisory fees, as well as joint fees derived from distributing the risk of default across the financial system.
Historically, governments have incurred debt to pay for wars and weather recessions, while the private sector—companies, homebuyers, and consumers—did so in boom times. But as Alan Greenspan points out, the period of relative economic stability between 1983 and 2007 – known as the Great Moderation – was “precisely the stuff that sparks the bubbles”. Two and a half decades of shallow stagnation and money encouraged everyone to take risks.
In the face of insurmountable demand for idleness, we are likely to be unable to sustain our debt burden. But despite the Biden administration’s commitment to student loan forgiveness, the debate over applying this policy to our group loan book may be missing the point. Few have raised the prospect of never redeeming this evergreen debt, but instead rolling it down continually in the face of adversity.
Although perpetual debt overhangs add chronic stress to the economy and may eventually require some form of financial relief, unless governments around the world team up to engineer a major deleveraging or write-down, the era of perpetual and extreme leverage is here to stay.
Aside from the moral hazard, such a system raises a philosophical question:
A loan that one neither intends nor is required to repay should be considered religion or justice?
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All posts are the opinion of the author. As such, it should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of the CFA Institute or the author’s employer.
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