Thirty years ago Franco Modigliani, this year's winner of the Nobel Prize in economics, said that, even if a company were burdened with a lot of debt, it could still be attractive to investors if its shares cost less than those of a company with little debt. His colleagues quickly labelled him a heretic. In the early 1950s, when Modigliani was gaining prominence as a professor at Carnegie-Mellon University and, later, the Massachusetts Institute of Technology, debt was a dirty word. Businessmen found money for expansion or acquisition from internally generated profits or from selling investors the opportunity to share in anticipated profits—in other words, selling them shares in the company. Those who had fared worst in the Great Depression were those who had the most debt. Those who had survived best had acquired fewest debts.
The corporate world has changed since then, and Modigliani’s work may have had something to do with that. In a recent conversation with Baî'ron’s, the U.S. business weekly, Modigliani himself shied away from taking such responsibility. Still, in two decades since his articles became a major part of business administration theory, debt-financed takeovers and leveraged buyouts have become much more commonplace than the practice of raising money by issuing shares. Meanwhile, many bank lending officers have graduated from courses where they learned that the corporate balance sheet is in good shape if the company’s future cash flow does nothing more than cover the interest on its debt. And that is the very notion that has created the problems that both companies and nations now face.
Modigliani predicted investor and business behavior correctly but not even he anticipated one reason why going into debt has become so attractive: if the fallout is heavy enough, governments will come to the rescue. In the early 1980s the U.S. government did it with Chrysler and Continental Illinois, the eighth-biggest bank holding corporation in the United States. Now, Washington is planning further rescues—of the debt-encumbered federal farm credit system and of state savings and loans associations. In Canada, Ottawa has become lender to Dome Petroleum, Chrysler, the Canadian Commercial and Northland banks and several trust companies. Ottawa has even suspended collection of the mortgage debts that farmers accrued under the Farm Credit Corp.
Whether we can blame Modigliani for our recent love affair with debt, there are now signs that our ardor is cooling.
Our passion for debt began when inflation was rising but had not yet peaked. We learned that under inflation it is smart to take on debts because we could pay them back with ever-cheaper dollars. With inflation the price of tangible assets goes up. Throughout the 1970s real estate and commodity prices rose. By the mid1970s, when the Organization of Petroleum Exporting Countries quadrupled the price of oil, we got the idea that prices would always go up. As a result, everyone from farmers to oil explorers borrowed billions on the strength of rising prices and anticipated profits.
íOur profligate borrowing is catching up with us. It has become a danger to global financial stabilitg’
Now our profligate borrowing is catching up with us. Everyone talks about the dangers posed by the huge debts that newly developing countries owe to North American banks —but the truth is that our own internally generated debt has become an even greater danger to global financial stability, especially since Reaganomics has wrestled inflation to the ground.
That is because in the past three years the rate of inflation has declined from 10 per cent to eight per cent to four per cent. And that disinflationary environment where inflation grows more slowly has made it increasingly difficult for debtors to repay their debts.
The reason is the exact opposite of the reason why we loved debt while we had high inflation. Then, we were paying back our debts with ever-cheaper dollars. In a disinflationary world we have to repay debt with increasingly expensive dollars. One way of defining inflation is to say that money loses its value and tangible assets—things you can see and touch—become more valuable. By contrast, disinflation is a situation in which paper money is growing more valuable and commodities are getting cheaper.
That is certainly what has been happening lately: commodity prices, from corn to gold, are falling. The debt undertaken to farm or mine such resources becomes more difficult to service. Real estate prices stop rising at the rate they used to or actually decline, as they have in many parts of North America. And people who may be earning less at work must pay off mortgages on property that is no longer increasing in value. The debt incurred to acquire or produce assets becomes a hardship.
Look at the bankruptcies and bailouts of the past few years. If they are the fallout of disinflation, it should be clear that an outright deflation, defined as actually falling prices—the trend we are seeing in Alberta real estate, for example—is a prescription for global financial disaster.
There are good reasons to believe that Washington’s agenda no longer includes measures to foster disinflation. One sign is the efforts that the U.S. government initiated, before last month’s International Monetary Fund meeting, to devalue the U.S. dollar. Demonstrating a new flexibility, Washington acted on its newly-found wisdom that foreign debtors could no longer be asked to sacrifice at home to pay interest abroad.
Such moves strongly suggest that the world is on its way to reflation. That will surely be the effect of driving down the U.S. dollar: as it loses value, it will take more dollars to buy things with it. As companies and countries make more dollars from selling their products, debts become more easily serviced and can even be paid off.
Does this mean there will be another round of inflation in the near future? Not at all. The spectre of inflation still lives in recent memory. And with our newfound co-operation in monetary policy, the likelihood of much higher interest rates—and therefore much higher inflation—is remote. Still, we are going to have to unlearn the wisdom about debt that business schools have been teaching. And, while congratulating Prof. Modigliani on his Nobel, we may go back to shopping for shares in low-debt companies, just as we used to.
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