Mind the Gap

Story Notes:

• Current credit crunch fears play on Americans disdain for debt
• However, debt is a vital economic driver and isn't inherently negative as many assume.
• Easy access to credit helped drive the M&A boom earlier this year and will fuel a resurging boom.
• Cash-based M&A and stock buybacks reduce stock supply, which is a bullish feature.

Why does the fake credit crunch continue grabbing headlines? (Read "Best Credit Crunch Ever," 08/23/2007.) Possibly because credit crunch fears feeds on American's near-religious, Puritanical disdain for debt, as demonstrated in the following article:

Congress Grants Rise in Public-Debt Ceiling
By David Rogers, The Wall Street Journal (*site requires registration)
https://online.wsj.com/article/SB119094162976742119.html?mod=todays_us_page_one

A certain senator (we're not naming names, but he's the Senate Finance Committee Chairman) said, "What we're doing with our very high debt is essentially blowing out living standards." You can't see us right now, but our mouths are hanging open in dumbfounded shock. It's simply inexcusable the head of the finance committee—the FINANCE COMMITTEE, folks—doesn't understand the simplest financial premise. (He's not alone in this, by the way—it's a common affliction in nearly all politicians from both sides of the aisle. We're just picking on him because he made the asinine quote.)

But let's pretend he's right. Starting today, the issuance of any new debt is outlawed. No more debt! No more interest payments! No more irresponsible credit cards! Everyone pays cash for everything and no one owes anyone anything. Hooray!

But do our lives become more luxurious? Is it all puppy dogs and rainbows?

Suppose you're an average 35-year old back before we outlawed debt. You want to buy a house, but don't have enough cash on hand, so you get a mortgage. You live in that house for the next 40 years—maybe you trade up once or twice—but you have a mortgage the whole time. Heck, maybe you pay down some of it. But for the rest of your life, your standard of living is pretty nice. You are a homeowner—it's the American Dream! And, your house appreciates over time, and because you are leveraged, you experience even greater growth. Good times!

Now, suppose we outlaw debt. You can't get a mortgage. You have to save the full amount for the house. You're not insanely wealthy—just an average guy—so it might take until age 55, 60, or more. If ever! And, you're paying rent the entire time! That's not so nice. Seems like your standard of living is better with the debt. And—your net worth doesn't grow nearly as fast, because you don't have a big, leveraged, appreciating asset.

What else? Most people wouldn't buy cars. Forget about middle- or low-income kids going to college. Businesses wouldn't grow or hire more people. People wouldn't start businesses. How is this good for our economy? When we were kids, we loved the wholesome adventures on Little House on the Prairie, but that doesn't mean we want to live in a rough timber house and walk 6 miles to barter eggs for calico. Sheesh.

And even government debt is a net-positive. Yes, the government spends its borrowed money infinitely more inefficiently than you would. But still, the government spends the money—and that money gets passed to corporations and private citizens (and sometimes state and local governments, who also spend stupidly), who spend that money again. This phenomenon is called the "multiplier effect"—it means borrowed money gets spent and respent and respent, and each time it changes hands it drives our economy—which is good, not bad. So, while we wish our government wouldn't be such a stupid spender, it's overall better societally that the government has debt. (Pop quiz—Did the US ever not have debt? Follow up—was the outcome good or dreadful?) At some level, the government's debt will become a drag on our economy—but with today's very benign interest rates, we're nowhere near problematic levels.

Forget fake credit crunches. The greater risk is constant haranguing debt is inherently bad—politicians might begin believing this nonsense instead of simply parroting the fear to curry political favor. We don't see too many legitimate risks to the market currently—but aggressive legislation aimed at restricting access to credit could definitely whack the market and hamper growth.

But enough debunking silly fears that don't have the impact most think. What will drive this market higher? Easy—a resurging M&A and buyback boom. (We can't see you right now, but we assume you just did a spit-take.)

It's true. The fundamental driver behind the record levels of M&A and stock buybacks in 2007's front half was a historically unique phenomenon. Since 2002, the stock market's earnings yield was above the bond yield in the US and around the world. The positive yield gap makes it profitable for the average CEO to borrow and buy back stock—the same earnings over fewer shares makes earnings-per-share rise. Also, CEOs can borrow and acquire competitors—again reducing stock supply and making earnings-per-share rise. The wider the gap between the earnings yield and the bond yield, the more profitable this activity becomes. And currently, though everyone is too exercised over imaginary credit crunches and lecturing the evils of debt to notice, that gap is wider now than at the beginning of this year when M&A and buybacks accelerated.

The wider the gap—the more profitable it is and the more it should happen—shrinking stock supply. What happens when supply of something shrinks? That's right—prices rise. Lesson number one for our politician friends.

Answer. Yes. President Jackson paid off all of America's debt in the mid-1830s.
Follow-up. It was dreadful. His ill-conceived battle against debt culminated with the Panic of 1837 and the Depression of 1837-1843—one of the longest and worst depressions and stock market crashes in US History.

Have a great weekend.