Pretty much all financial crises involve too much debt. The global financial crisis was triggered by excessive lending for US property purchase. The slow recovery from the crisis is probably because of too much debt. China’s successful plan to insulate its economy from the post-crisis recession has left it with its own debt problem. Those who believe that the US is stuck with “secular stagnation” (persistent low GDP growth) argue that only by excessive borrowing can US households return to previous levels of consumption growth. In sum, there seems to be too much debt around and it brings only temporary, illusory growth benefits at the risk of damaging crashes.
Lending at interest was banned for centuries by the Catholic church, which was the dominant religion in western Europe, because it was forbidden by the Bible. Debt became tolerated from the late Middle Ages, though arguments continue as to whether Christian doctrine still prohibits lending or only unfair and exploitative lending. Lending remains banned in Islam and there are arguments against lending in many ancient texts from other civilisations.
Yet it is hard to imagine modern economies without debt, both for companies and for households. It would be difficult for ordinary people to buy a house or even a car without a loan. Companies need additional funds if they are to invest more than they currently generate in profit. Unfortunately both types of borrower periodically take on too much debt and we have a crisis, often bringing a great deal of misery and economic damage in its wake.
Andrew McNally has produced a readable and admirably short book arguing in favour of a much greater use of the other sort of funding – equity. Debtonator: How Debt Favours the Few and Equity Can Work For All of Us goes beyond simply recommending lower leverage because it makes a financial system more robust. He believes that wider use of equity is a path to greater prosperity for the many, not just the few.
Debt is a fixed contract: I lend you money and you promise to repay it, usually on a fixed term at a set interest rate (sometimes linked to a market benchmark rate like LIBOR). There is a risk that you will not or cannot repay the loan, which is called credit risk. Otherwise, the contract is quite simple. Equity is a much more fuzzy arrangement. I invest in your company (only companies can issue equity, not people or governments). You promise to pay me a dividend, if you can and if you think it’s the best use of the money (you might decided to reinvest profits instead). In exchange for this fuzzinesss I get a vote at an annual general meeting or at a partnership meeting, to check that you aren’t just ripping me off or wasting the funds. I have an ownership stake in the business which (usually) I can sell.
When equity works well it’s a great success. Lending can only generate the return from the interest payment. Equity returns can come in two forms: the dividend payments, which might be higher than the interest on an equivalent loan; and the potential rise in the value of the equity if the business thrives. There is a reason why some long established branded companies are so valuable. Coca-Cola and Procter and Gamble have generated high equity returns from being persistently good at what they do (building barriers to entry) and from taking their business global. The combination of a high return and equity with growth opportunities offers real value creation.
My Cambridge Judge colleague Elroy Dimson is a co-author of the classic study of long term financial returns Triumph of the Optimists. It shows how investors in equities in the US and UK and several other capitalist countries saw high compounded annual returns (around 7% higher than from bonds) from holding stock market shares from the early twentieth century. If you get 7% a year compounded, you double your money in 10 years (using the rule of 72, where you divide the growth rate into the number 72 to get the period over which that rate leads to a doubling of value). Long term holders of debt didn’t do nearly as well, partly because periods of inflation badly hurt the real returns from lending which is usually done in nominal terms. The “optimism” lay in believing that businesses would thrive in the long run, which of course they didn’t do in all countries – long term returns in the countries which went Communist were of course not very good at all.
A bias against equity
Andy, previously the UK CEO at the very interesting Berenberg Bank (about which I wrote here), argues that a shift from debt to equity financing is essential to bring about a more equal distribution of economic gains. There are obstacles to the wider use of equity in business finance and a greater exposure to it by individuals. First, finance theory argues that debt is cheaper because it requires a lower compensation for risk than equity. Thus companies in the US borrow to buy back equity, the opposite of what growing companies are supposed to do. Second, the costs of owning shares through mutual funds discourage wider investment in equity. A pyramid of fees from market makers, brokers and fund managers makes the net return on owning shares much less than it should be.
(This is one area where Andy is not just criticising the system, he’s taking action. Together with my friend and former colleague Daniel He, and former strategist George Cooper, he is setting up a new fund management company, Equitile, which will offer an innovative and fairer fee structure, tiered according to the size of total funds under management. The new approach has already attracted favourable press comment).
But the largest bias in favour of debt against equity is the tax deductibility of debt interest payments. Andy tells how this was introduced as a temporary measure in 1918 only to become permanent. A strong lobby fights any suggestion of ending the tax bias towards debt. Tax reform is always difficult. In this case you’d have to either start taxing interest payments or make dividend payments (the return on equity) tax free. Neither looks very likely, and anything other than an internationally coordinated approach would invite complex corporate tax structures (which to some extent already exist of course). I think it more likely that this idea might gain traction in the EU than in the US but I’m not optimistic about either.
Depending on how markets work, the debt interest deductibility can actually show up as higher returns to equity owners. One example, which is the one most relevant to the equity experience of most Americans, is home ownership. The main form of wealth of ordinary Americans is equity in their own home. The US tax system systematically favours this form of equity by making mortgage interest tax deductible (up to a point). That benefits gets capitalised in the value of houses, so it benefits existing home owners even when they’ve paid off their mortgage. In the UK the mortgage interest benefit was abolished but home ownership still benefits from an exemption from capital gains taxation. This is one reason why people are incentivised to put their savings into their home, which is a source of some value but possibly discourages them from investing in other equity assets.
New approaches to using equity
The question of wider use of, and access to equity, overlaps with two interesting areas of financial innovation. One is Islamic finance, which is not exactly new but which has evolved in a modern context to offer mortgage-like services to households and methods of raising debt for companies, including for project finance, consistent with sharia law. The IMF’s research team has produced some fascinating reports recently on this subject, generally approving of the benefits that an equity-like approach brings. A former student of mine is doing a PhD in Cambridge currently on the systemic resilience of an Islamic finance based economy. Put very simply, an economy that can’t run up a credit bubble is less likely to get into crisis.
Secondly, the flourishing of crowdfunding – equity-raising through internet platforms that allow large numbers of people to invest relatively small amounts – shows that there is a wider appetite for equity investment, indeed it can be fun. It remains to be seen if crowdfunding is a permanent addition to corporate finance or something of a fad but it’s certainly popular at present. My colleagues in the Cambridge Centre for Alternative Finance are producing authoritative reports on crowdfunding and its cousin peer-to-peer lending. One of the most interesting and successful crowdfunding is Syndicate Room, based in Cambridge and founded by two former Cambridge MBAs. Syndicate Room addresses the fundamental challenge of all investing – how do I know if the business has a decent chance of success? – by only raising funds for companies that have already received investment from one of the Cambridge business angels. That doesn’t guarantee success but it might tilt the odds in a more favourable direction, given that all start up investing is risky.
There is a role for debt, even if it’s taxed properly. Small businesses might want equity investment but banks are loath to put equity in because it’s too costly to check what they’re doing with the money. Where there is asymmetric information, as is nearly universal in finance, an investor cannot verify whether a business has failed to make a return on the investment because of fraud, incompetence or bad luck. Knowing this in advance, the investor is unlikely to want to put equity in. A loan may however be worth making, because the lender doesn’t need to verify so much information. If the borrower defaults the lender can at least take some collateral. The effect is to make debt a sustainable contract in a way that equity is not, in cases where overcoming the asymmetric information is prohibitively costly, as it often is with small businesses.
Andy’s book covers a great deal of financial history, concepts and intriguing examples. Despite his introductory comments, he may leave the reader thinking that he wants to do away with debt completely, whereas he really just wants to redress the balance. I’m entirely in sympathy with this view. I’m not so sure that a greater use of equity alone would be enough to address the wider question of inequality, which I think requires more radical changes in income distribution away from the richest people. The likely acceleration of automation that risks putting millions of lower skill people out of work (e.g. automated vehicles that make truck drivers redundant, surely now only a matter of time) makes for an urgent question of how to give a stake in a more productive society to those who currently lack any ownership of it. This is likely to be a profound challenge in the next couple of decades and it will require us to think more imaginatively about what it means to own the productive assets (the apple trees in Andy’s example) of society. Andy’s book doesn’t claim to offer the answers but he rightly draws attention to the need for new thinking and attitudes.