December 6, 2008

Debt as a Source of Short-Sightedness

As an addendum to the previous post, there is a reason for the increasing short-sightedness of businesses.

Shortening of the time scale of business decisions is a direct result from the overall increase in the level of gearing. When equity decreases in size compared to the overall level of debt in a company, the time scale is inevitably compressed. This is because creditors, unlike equity investors, are not willing to wait for profits. Interest must be paid on the debt at a predetermined rate, or a default is triggered. When the overall level of debt increases, time scales shorten and risk-aversion increases.

Below is a graph of the average rate of growth of credit/debt versus GDP in various industrial nations:

Here is the same thing as a graph over time:

There is no reason to assume that this statistic would not revert to a mean over time. Such relative measures can not keep developing in one direction forever. What is noteworthy, besides the huge level of the debt, is its remarkably monotonic growth. The developed world has not seen a real reduction in debt for over 30 years. Now we are finding out how painful that actually is.

No comments: