Resilience has become the watchword for governments around the world. It is primarily applied to healthcare systems and manufacturing supply chains that are at risk of being overwhelmed by Covid-19. But a new approach to corporate finance is also needed: a preference for debt over stocks has made economies more fragile than they should have been at the start of this crisis.
The ability of debt to generate instability has been exhaustively demonstrated twice in just over a decade. The 2008 financial crisis was originally caused by excess debt. The destructive power of the financial innovations that sparked the moment of crisis itself was magnified by the leverage of the banks. A long decade of weak growth followed in the wake of the crisis, in part as banks and governments tried to get their finances back on track.
While the current crisis is not caused by debt, the side effects of foreclosure are compounded by strained corporate balance sheets. Companies that have used cheap loans to increase and optimize their profits are now struggling to pay interest rates during a forced shutdown. Borrowing which in good times keeps costs down can become a touchstone in bad times.
Debt is, after all, a promise, but circumstances change and promises made in good faith in a situation cannot always be ruthlessly fulfilled when the world changes. It can be destructive for businesses and investors; over-indebtedness and technical failures can push otherwise viable companies to the demise. When promises are broken, the question becomes how to share the pain; equity has this built-in capability.
Yet the existing infrastructure to manage failures and bankruptcies is not adequate to cope with such a large and rapid wave of restructuring. Bankruptcy courts are concerned with ensuring contracts are honored and disentangling competing claims from creditors rather than protecting economic activity. Extrajudicial renegotiations are difficult at the best of times, an era of social distancing and massive uncertainty making them even more difficult.
Incentives to get into debt rather than equity should be removed after the crisis. Corporate taxes fall on profits distributed to shareholders and not on bondholders’ interests. Business leaders respond rationally to the incentives offered to them when they use bond markets rather than stock markets. Central bank policies, such as quantitative easing, reduce the cost of financing in general, both debt and equity. The use of borrowing reflects the incentives companies face.
For now, governments should consider reorientation of the bailout programs ranging from loan guarantees and cheap credits to equity injections. The taxpayer is already taking the kinds of risks that shareholders take: many of these companies will go bankrupt and the loans will never be repaid. Yet taxpayers fail to reap the potential benefits of a share of the profits at the end of the lockdowns. More equity prevents the kind of over-indebtedness – where high borrowing levels prevent companies from investing in profitable ideas – which could hamper a possible recovery.
Credit is an extremely powerful tool: in the months and years to come, it will allow many individuals, businesses and governments to survive an economic decline that would otherwise be devastating. However, recent experience shows that it can also be fraught with pitfalls and amplify slowdowns. A resilient economy is a flexible economy. Effective bankruptcy procedures are essential. But the most flexible form of financing is equity. The greater the shocks to which we are exposed, the greater the real loss-bearing equity becomes.
