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Debt Overhang: Why Recovery from a Financial Crisis Can Be Slow* BY SATYAJIT CHATTERJEE particularly troublesome feature of the most recent recession has been the painfully slow growth in employment during recent recession has been the painfully slow the recovery. In order for employ- A ment growth to accelerate, economists growth in employment during the recovery. For believe that firms need to invest in employment growth to accelerate, economists new productive capacity. This view is believe that firms need to invest in new productive capacity. typically couched in terms of the need to absorb workers formerly employed This view is typically couched in terms of the need to in the sectors that were most adversely reallocate jobs away from crisis-depressed sectors into other affected by the financial crisis — namely, the construction and financial sectors. But doing so requires an expansion in productive sectors — into other sectors of the capacity in those other sectors. Tepid employment growth economy. The reallocation of jobs away from crisis-depressed sectors requires is a sign that this investment in new productive capacity an expansion in productive capacity has not been forthcoming. One reason for the reluctance to in other sectors. Tepid employment growth is a sign that this investment in undertake productive investment following a financial crisis new productive capacity has not been is debt overhang, a situation in which the existence of prior forthcoming. But it is not for a lack of resources. debt acts as a disincentive to new investment. There are Figure 1 displays the profits of the non- other explanations that, to varying degrees, account for the financial corporate sector and shows that profits rose strongly during this re- current reluctance of U.S. corporations to invest. In this covery. And if we examine the disposi- article, Satyajit Chatterjee focuses on the debt overhang tion of investible funds, we discover that the nonfinancial corporate sector problem. has dramatically reduced its invest- ment in productive capacity relative to the resources available for investment. In their widely read book, Car- their work is that economic recovery This is evident in Figure 2, which men Reinhart and Kenneth Rogoff from bad financial crises tends to be shows capital outlays of the nonfinan- have marshaled an impressive amount slow. On average, it takes an economy cial corporate sector as a percentage of of data on global financial crises going somewhere around seven years follow- funds that the nonfinancial corporate back eight centuries. One lesson from ing a crisis to get economic activity sector already possesses (without re- back to its normal trend path. In some course to any new borrowings or equity cases, the return to trend can take Satyajit issues — so-called “internal funds”) Chatterjee is a much longer — close to two decades! and can use for this purpose. This senior economic This historical experience reso- advisor and percentage fell precipitously during nates with our current situation. A economist in the recession and has since remained particularly troublesome feature of the the Philadelphia depressed. These facts indicate that Fed’s Research Department. the U.S. nonfinancial corporate sector This article is * The views expressed here are those of the au- possesses investible resources but has available free thor and do not necessarily represent the views chosen not to deploy these resources in of charge at www.philadelphiafed.org/ of the Federal Reserve Bank of Philadelphia or productive investments during the re- research-and-data/publications/. the Federal Reserve System. www.philadelphiafed.org Business Review Q2 2013 1 covery. Since our current slow recovery FIGURE 1 is partly attributable to the reluctance of businesses to invest in productive Domestic Nonfinancial Corporate assets, we need to understand why Profits Before Tax with IVA and CC financial crises have this effect on Adjustments investment.1 Economists believe that one Billions of USD (SAAR) reason for the reluctance to under- 1,200 take productive investment follow- ing a financial crisis is debt overhang. 1,000 Debt overhang is a situation in which the existence of prior debt acts as a 800 disincentive to new investment. When a firm has outstanding debt on which 600 the likelihood of default is significant, any investment that improves the 400 firm’s future profit potential also in- creases the value of outstanding debt. 200 All else remaining the same, an in- Last quarter plotted: 2012Q3 crease in the value of outstanding debt 0 reduces the value of equity in the firm; 1997 1999 2001 2003 2005 2007 2009 2011 that is, it results in a wealth transfer from equity owners to existing credi- Sources: BEA, Haver tors. Since equity owners are the ones who make investment decisions, the transfer acts like a tax on the return FIGURE 2 on new investment. This “tax” results in a drop in the rate of investment in business capital, which, in turn, slows Nonfinancial Corporations: Capital down the recovery. Outlays/U.S. Internal Funds (SA) There are other possible explana- tions for the reluctance of U.S. com- panies to invest. One oft-cited reason Percent of U.S. Internal Funds 160 is “increased uncertainty about the future.” When investment decisions 150 are costly to reverse, there is value 140 in waiting and learning more about 130 future conditions before committing 120 funds to a project. Thus, increased 110 uncertainty about the future may 100 90 80 1 One might think that the reluctance to add new productive capacity results from current 70 capacity utilization rates being low. If existing Last quarter plotted: 2012Q3 capacity is not being fully utilized, why expand 60 capacity? True, but it raises the question of why 1997 1999 2001 2003 2005 2007 2009 2011 utilization rates are low. If corporations as a whole were investing more, capacity utilization rates would go up right away. One must consider the possibility that low capacity utilization is a Sources: FRB Flow of Funds, Haver symptom of some deeper malady that is affect- ing investment – not the malady itself. 2 Q2 2013 Business Review www.philadelphiafed.org cause companies to delay investment. sis. The crisis caused the U.S. banking nancial corporate sector scaled by Aside from the increased uncertainty sector to deleverage. In doing so, banks the gross value added in the sector.4 that inevitably accompanies a deep cut off credit to the nonfinancial sector During much of the boom period, the recession, commentators have pointed — the now infamous “credit crunch.” liabilities of the sector shrank relative to uncertainty about the future path Because credit is a fundamental ingre- to its GDP. Nevertheless, it is true of U.S. fiscal (tax and expenditure) dient in the smooth operation of asset that whatever debt there was became policy as well as uncertainty about the markets, the crunch adversely affected much more risky following the onset of impact on businesses’ health-care costs the value of all types of tangible busi- the financial crisis in the fall of 2008. resulting from the recently enacted ness capital. The steep drops in the Figure 4 shows the difference in yields Affordable Care Act as factors holding value of assets owned by the nonfi- on medium-term industrial bonds and back investment and hiring. Another nancial corporate sector also lowered U.S. Treasuries. The difference is the explanation may be that the growth the sector’s net worth and raised the additional return required by investors rate of (multifactor) productivity has frequency of business failures.3 Both to absorb the default risk present in fallen back to its historical norm from factors made corporate debt appear industrial bonds but absent in Treasury the above-average pace experienced more risky to investors. bonds. As one can see, the compensa- during the decade preceding the onset It is worth observing that “exces- tion for default risk (the so-called risk of the financial crisis, causing the sive borrowing” by the nonfinancial spread) rose dramatically as the crisis rate of investment growth to decline corporate sector during the boom years unfolded and remains elevated today. in tandem. Finally, it is thought that is not part of this narrative. Figure Although risk spreads can go up retiring baby boomers may be holding 3 shows the liabilities of the nonfi- back business investment by depressing equity values as they sell stocks to fund their retirement. More fundamentally, 4 Scaling by sector GDP takes account of the 3 The net worth of the nonfinancial corpo- fact that borrowing is a natural complement a more slowly growing labor force re- rate sector is simply the difference between of economic activity and tends to go up with quires less growth in capital equipment the value of its assets and its liabilities. The it. Thus, to determine if the sector indulged in to productively equip new workers mechanism through which a drop in net worth “excessive” borrowing, it is important to look at amplifies a credit crunch is discussed in more its liabilities relative to a measure of economic joining the labor force, so there is less detail in my 2010 Business Review article. activity. growth in investment. Of course, all of these explanations, to varying degrees, FIGURE 3 account for the current reluctance of U.S. corporations to invest. In this Nonfinancial Corporations: Liabilities as a article I focus on the debt overhang problem.2 Share of Gross Value Added Ratio to Gross Value Added FINANCIAL CRISIS AND THE 2.2 GENESIS OF DEBT OVERHANG The genesis of the debt overhang 2.0 problem lies in the recent financial cri- 1.8 2 Following the onset of the financial crisis, a 1.6 number of researchers and many commentators have pointed to debt overhang as a reason for the drop in investment and its slow recovery.

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