The Economics of Debt

By Kelvin Tai - Economics and Management Student @ Harris Manchester College, Oxford

At a basic understanding, debt can be understood to be an economic liability owed to another party. Debt is an instrument of the financial system, where those who have a more efficient use of capital can borrow from those with idle cash. In this article, I will explore how debt affects firms and individuals, along with why they might choose to use debt financing as opposed to other means.

According to the Modigliani-Miller (MM) Proposition, the value of a company does not depend on the amount of debt held by a company but instead the cash flows generated by the company. As such, taking on debt to fund investments that increase the cash flows would raise the value of the firm unambiguously. Unfortunately, this is not the case in real life, as the MM proposition relies on the unrealistic assumption of perfect capital markets. This suggests that there are no transaction costs and entities can borrow at the same rate at which they can lend. Furthermore, by taking on debt, many firms in the USA are able to reduce their taxes unlike the issuance of equity, so issuing debt can in effect cause the government to pay some of the interest.

In addition, the taking on of debt increases the risk to the debtholder, since a change in economic conditions could leave the debtholder unable to repay the principle or even the interest. The adjustable-rate mortgage in particular is one of the alleged culprits of the 2008 Great Financial Crisis, where homeowners were lured to take up loans at low interest rates, only for the rates to increase when the period of lock-in for interest ended. Firms too have gone insolvent when a black swan event caused their revenues to plummet and render them unable to repay their debts. The costs of implementing restructuring are an added burden which decrease the value of the firm. Furthermore, the risk of bankruptcy is likely to raise the cost of capital (the interest rate at which the firm can acquire cash) for the firm.

However, raising debt can be a wise strategy even if the firm does not urgently need the money, despite the higher financial risk and need to pay interest. A firm that waits until it faces a cash crunch before borrowing is likely to face difficulty securing credit from others if the ability to repay is in doubt. Those willing to lend would likely demand a higher interest rate too. Airbnb quickly raised a billion dollars in debt at the onset of the COVID-19 pandemic, a move that created a cash buffer before the full impact of the pandemic on travel was revealed.

Debt has also been exposed as a means by which high net worth individuals can avoid paying taxes. The modern age tycoon now sees a large proportion of their wealth increase in the form of company stock instead of cash. Propublica revealed a leak of tax returns where they detailed how some individuals would pledge their shares as collateral to borrow money for spending at low interest rates, since taxes only have to be paid when the shares are sold. Elon Musk is reported to borrow tens of billions in this manner.

Entire markets have sprung up around debt, with the size of debt markets around 119 million USD dwarfing that of the equities market. Although debt might appear simplistic when applied to the everday life of the layman, the diverse world of debt is definitely more highly interesting and varied.

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