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March 15, 1987

Federal Reserve Bank of Cleveland
1980s, but since have returned to, and even
have surpassed, the leverage ratios experienced in the early 1970s, despite the disinflationary environment that has prevailed
since 1980.7
A somewhat different way of looking at
this measure that is favored by financial
theorists is to use market values of debt
and equity. Also shown in chart I, this
series behaves quite differently than its
book-value counterpart. For instance, the
collapse of stock prices following the first
major oil price shock (in late 1973) sent this
ratio soaring. Investors systematically
reduced their assessments of the value of
the equity of American firms. In recent
years, this ratio has stabilized somewhat,
helped in part by rising equity prices,
though it remains far above levels prevailing before 1972.
Do either of these measures cause us to
infer that corporate capital structures have
degenerated to the point that their liabilities should be considered "junk" (that is,
below investment grade)? Or, rather, is
the trend towards debt-based financing a
natural response to the creation of the
economic stabilizers and expectations of
stability that have been developed since
the Great Depression?
There may, in fact, be many factors that
have led to the current appetite for debt
financing, none of which seriously contradicts the. principles set forth by the traditional prudent investor guidelines. As was
discussed above, it is considered perfectly
acceptable for industries with stable earnings to employ a higher proportion of debt
financing. The perception of increased stability of the overall economy, therefore,
should lead to an increase in the percent8. The corresponding means for the two periods are 9.5 percent and 6.6 percent, respectively.

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age of leverage that is considered safe for
all firms.
In chart 3, we present a time series
representation of the percentage change in
pre-tax corporate profits since 1910.
Excluding the Great Depression and the
Second World War, the volatility of the
growth of corporate profits appears to
have declined in recent years. Indeed, for
the period covering 1910 to 1928, the variance of the percentage change in corporate
profits is 7.1 percent. The same measure
for the years 1945 through 1985 is 2.3
percent."
The rational response to such a reduction, once it is regarded as permanent,
would be to reduce the cushion of equity
by taking advantage of the gains from
leverage. Among these gains is the tax
shield afforded by the deductibility of
interest payments by borrowing firms.
Seen in this light, the trend toward higher
debt levels and the emergence of markets
for low or unrated debt securities may
suggest that the perceived probability of
failure and/or bankruptcy costs (and the
associated stigma) have been reduced over
the past few years."
If today's economic environment is in
fact perceived to be less volatile, are rating
agencies reacting justifiably when they
downgrade the credits of firms that
increase their leverage? The rating agencies claim to consider many factors beyond
simple accounting ratios when assigning
ratings to corporate debt. They try to take

a broad view of the circumstances facing
the industry in light of overall economic
developments. By using criteria that
seemed appropriate in decades past, but
that no longer may be appropriate, rating
agencies may have failed to take account
of the possible reduction in certain business risks. Or, perhaps corporate debt ratings are intentionally biased downward
simply because the agencies want to avoid
the potentially high cost of a ratings
mistake.

ISSN 0428·1276

ECONOMIC
COMMENTARY

Debt-Deflation and
Corporate Finance
by Jerome S. Fons

Conclusion
The effectiveness of various programs
designed to protect against economic disruptions (both real and financial) have yet
to face a serious challenge. Many
respected analysts believe that the next
recession will provide that challenge, with
consequences potentially as severe as
those experienced in the 1930s.
If the public and private promoters of
debt-based financing have miscalculated
and overestimated the stability of the economy, then we may find ourselves being
pushed by bankruptcies into Fisher's debtexpansion trap. Keeping us out of the trap,
and protecting the economy from the debtdeflation syndrome, would require extensive governmental assistance that would
come out of the pocket of every taxpayer.
In any event, we appear to be dealing
with new rules of prudent borrowing
behavior that have been created and
shaped by the belief that we have developed a "stabilized" economy. Our nation's
corporations, as well as its households and
government, may be just beginning to test
these new rules.

9. See, for instance, Walker F. Todd,
"Aggressive Uses of Chapter IIof the Federal
Bankruptcy Code," in Economic Review, Federal
Reserve Bank of Cleveland, Quarter 3, 1986.

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Over the past few years, the rapid growth
in the level of public and private domestic
debt, and growth in the level of foreign
debt owed to American banks, has been a
major source of concern for our legislators
and financial regulators.
This concern centers on the possible
negative effects that debt buildup might
have on the economy as a whole and on
industry in particular.
In this Economic Commentary, we will
first discuss the theoretical dangers faced
by an overleveraged, debt-based economy.
Against this background, major economic
stabilizers and the effect that expectations
of economic stability may be having on
corporate financing decisions will be
considered.
First, the historical context. Probably
the first serious consideration of the
macroeconomic effects of excessive debt
accumulation was that of the distinguished
economist and author Irving Fisher, who
died in 1947.
In a 1933 paper, he notes that debt is a
complex phenomenon.' It is not a simple,
one-dimensional factor. In addition to the
total of dollars owed, one must also take
into account the maturity structure of the
debt-that is, the points in time at which
various payments come due. Moreover, the
concept of overindebtedness is a relative
one, which is dependent upon such factors
as total national wealth, national income,
and the availability of liquid assets.
Fisher thought that the severity of many
historical business cycles could not be
explained by the traditional theories used
by classical economists. Those theories

tended to focus on things like the relative
over- and under-production of various commodities, their relative prices, and the
effects of disturbances (fire, earthquakes,
pestilence, etc.) from "outside" the economy. Although certain forms of disturbance
might succeed in explaining much of the
cyclical expansion and contraction of business activity, he felt that major downturns
required something extra: namely, overindebtedness and deflation. The existence of
these conditions was considered sufficient
to cause a disruption in all other economic
variables. In particular, Fisher felt that
growing overindebted ness tended to exacerbate overspeculation, which would
increase until the following scenario began
to unfold.
First, asset liquidation by overindebted
borrowers would turn into distress selling.
The distress selling would cause a contraction in bank deposits as loans were retired.
In addition, asset sales would take place at
"fire sale" prices, leading to a fall in the
overall price level. Lower prices would
then reduce business profits, causing a
reduction in business net worth, thereby
leading to bankruptcies. The loss of confidence in the economy could also lead to
the hoarding of convertible currency and
to bank runs. In such a world, nominal
interest rates would fall, while real rates
rose. The overall effect would be a reduction in output, employment, and trade.
Fisher felt that, in these circumstances,
distress selling could cause the price level
to fall faster than debt could be liquidated.

This would result in real debts rising,
rather than falling as intended. Only
through some form of reflation could catastrophe be avoided. Moreover, he reasoned
that deflation resulting from any cause
other than overindebtedness would not
have the same devastating consequences.
Among the causes of overindebtedness
envisioned by Fisher was the existence of
new opportunities to invest at abovenormal prospective profits. The development of new inventions and technologies
provides incentives for such prospects.
The lure of large dividends, as well as
capital gains made possible by excessive
borrowing, contributes to the bubble effect
envisioned in his scenario. In addition, an
"easy money" or low-interest-rate policy
might have the same effects. Finally, the
reckless promotion of investment opportunities (which unnecessarily raise expectations), in combination with fraud, also
contributes to overindebtedness.
The failure of monetary authorities to
offset rapid deflationary forces by creating
more liquidity through open-market operations, currency issuance, or placement of
Treasury funds in the banking system,
may have been responsible for the severity
of past great depressions.f Indeed, Fisher
felt that the Roosevelt administration's successful reflation in 1932 was the chief
factor in arresting the economic decline
that would have otherwise continued unabated.f If the decline had gone unchecked,
the strain on financial institutions could
have eventually spread to the government,

Jerome s. Fons is an economist at the Federal
Reserve Bank of Cleveland. The author would like
to thank Mark Sniderman and Walker Toddfor
their helpful comments.
The views stated herein are those of the author
and not necessarily those of the Federal Reserve
Bank of Cleveland or of the Board of Governors of
the Federal Reserve System.

1. Fisher, Irving. "The Debt-Deflation Theory
of Great Depressions," Econometrica, vol. 1, no. 4,
Oct. 1933, pp. 337-57.

3. Another well-known factor was the simultaneous, large increase in federal spending. The
financing for this stimulus may have been aided
by Federal Reserve purchases of Treasury debt.

2. Most notably, 1837,1873,

1893, and 1929.

hart 1

Producer Prices

Index
3.5~------------------------------------------------'

3.0

Crude materials for further processing

2.5

2.0

1.5

1975
SOURCE: U.S. Department

1980

1985

of Labor, Bureau of Labor Statistics.

perhaps leading to some form of revolution. Fisher notes that uprisings in the
farm sector were already under way in
1933.

Lessonsforthe'80s
The parallels between Fisher's scenario
and today's economy, at least within certain sectors, are quite compelling. The
decline in the prices of agricultural and
mining commodities, in oil, and in some
sense steel, has led to a dramatic rise in the
bankruptcy rates of firms within these
industries over the past few years." Commercial and residential real-estate markets
in portions of the country in which these
industries have a significant presence also
have experienced similar problems. Heavily indebted, developing countries face
similar strains that, in tum, are transferred
to the U.S. banks that have made loans to
these countries.
Although Fisher's scenario appears to
be unfolding in certain areas of the economy, large portions of the economy, however; appear to be somehow insulated from
this distress. In view of this, it is reasonable to ask whether some economic sectors are more prone to the debt-deflation
syndrome than others.
Almost all of the affected industries are
involved in the production of basic or
primary commodities. These same sectors
witnessed very high investment returns in
the inflationary period that ended at the

4. Indeed, last summer's bankruptcy filing by
LTV Corp. caused 1986's corporate default rate to
reach one of the highest levels in postwar
experience.

beginning of this decade. Chart 1 plots
price indices for farm products and crude
materials for further processing. Note the
dramatic rise, especially in crude materials
prices, that occurred in the late 1970s. The
prospects for continued high returns may
have led to overcapacity in these industries
that, in hindsight, can be characterized as
excessive speculation. During this period,
there was no shortage of loanable funds for
firms engaged in the production of these
commodities. In tum, this may have contributed to their willingness to carry high
levels of debt, causing the banks and savings and loans (S&Ls) exposed to these
industries to suffer losses as prices fell.
The fact that our overall economy has
not experienced a major depression over
the past 50 or so years, however; may
indicate that Fisher's theory is no longer
relevant. Indeed, several major economic
"stabilizers" that have been created since
the Great Depression may be preventing the unfolding of Fisher's scenario.
Deposit insurance is one example.
Although bank failures are reaching
post-1933 record numbers today, no retail
depositor has suffered losses (on amounts
within the insurance coverage limits)." The
disastrous, cascading bank failures envisioned by Fisher have not materialized.
Other economic stabilizers that help maintain balance in the economy are unemployment insurance, social security, and a
progressive tax system.
Effective monetary policy can also counteract deflationary forces and help sta-

5. Bank failures have occurred at an annual
rate of nearly 200 per year in the first two months
of1987, versus 145 for all of1986.

bilize the economy. In some respects, for
example, the recent rapid increase in liquidity may be an important factor that has
helped to protect the overall economy by
isolating the problems of our troubled sectors. The growth permitted in the narrow
definition of the money stock, Ml, for
instance, has reached an annual rate of 12
and 15 percent in the past two years,
versus a 1974-1984 annual growth rate of
roughly 7 percent. An overly tight monetary policy designed to keep Ml within
lower limits could have spread contractionary impulses to other highly leveraged
portions of the economy with much more
serious consequences nationwide.
In a broad sense, the deflation scenario
has already manifested itself to some
extent throughout our economy. Fisher
himself pointed out that, since expectations of future inflation are usually part of
financial and wage contracts, problems
can result if the inflation rate doesn't meet
these expectations.
After reaching an annual rate as high as
13.5 percent in 1980, for example, inflation,
as measured by the Consumer Price Index,
declined to around 1.9 percent in 1986.
This disinflation probably was unanticipated, with consequences not unlike those
resulting from a deflationary environment.
In this disinflationary context, certain real
interest rates may have become almost
as high as nominal interest rates, closely
approaching the debt-expansion trap
outlined by Fisher.

Risk-Taking and Corporate Debt
Growth
The current tendency of society to accept
higher levels of debt may indicate an
increased tolerance towards risk-taking.
Institutional factors also may have
emerged recently that serve to spread or
otherwise shift certain forms of risk away
from the individual creditor. People are
less inclined, for example, to hold the debt
issues of firms directly. Increasingly, individual savers hold claims to large, welldiversified funds with managers who claim
to possess expertise in credit evaluation.
In addition, many funds take advantage
of hedging instruments to minimize the
exposure of investors to unexpected
economic events.
Because of the combination of monetary
policy, economic stabilizers, and diversified
investment opportunities, investors may
feel that they are somehow protected

6. Graham, Benjamin, and David L. Dodd.

Security Analysis: Principles and Technique, 3rd
ed., New York: McGraw-Hill, 1951.

against economic downturns, and thus
exhibit a readiness to accept higher levels
of debt.
The increase in the overall level of debt
may also have resulted from the abandonment of traditional risk-minimizing standards for corporate finance as a result of
expectations that the economy faces little
risk of a major depression.
Traditional wisdom held that high levels
of owners' equity, as a proportion of total
capital, constitutes the best strategy for
the prudent corporation. The role of equity
is that of a "cushion" that serves to protect
creditors in the event of an unforeseen
business disruption. The high-equity firm
can absorb a succession of periods of weak
(or negative) earnings without the need to
declare bankruptcy because it can always
suspend dividends or otherwise exploit
paid-in capital.
The credits of these high-equity firms
are invariably valued more highly by investors than those of firms with more leveraged capital positions. Because the
likelihood of bankruptcy (and the risk to
owners' equity) is somewhat lower for
high-equity firms, investors will generally
require a lower rate of return on their
equity shares, implying that, for a given
level of earnings, the stock prices of highequity firms will be valued more highly
than those of highly leveraged firms.
Using essentially common sense coupled with observation, Graham and Dodd
were among the first to establish what are
now considered the traditional guidelines
for the valuation of corporate securities."
Their rules of thumb were designed to
assist the individual in his choice of suitable investment opportunities. With the
spectre of the Great Crash firmly in mind,
they saw their mission as steering the
unwise away from speculative actions that
might lead to the misvaluation of financial
assets.
Through their recommendations, they
hoped that the wise investor would force
prudent behavior onto the management of
corporate America. Toward this end,
Graham and Dodd specified limits on the
financing arrangements of firms, though
they recognized that some variation should
be expected because of different circumstances faced by each company. As a result
of their efforts, the industry of ratio analysis was created.
Many of the Graham and Dodd guidelines involved accounting and operational
variables. In particular, it was their conviction that an industrial company should, in

7. Data collected and analyzed by Robert Taggart indicate that the use of corporate leverage
from the mid-1940s to early 1960s was unusually
conservative when compared to surrounding peri-

Chart 2

Debt-Equity Ratios

Percent
100
Market value debt/Market

value equity

SOURCE: Federal Reserve Board of Governors.

Chart 3

Percent Change in Corporate Profits Before Taxes

Percent
150
475%
100

o
-50

-100

-150
10
SOURCE: For 1910 to 1929-Doane, Robert R., The Measurement of American Wealth, New York,
Harper Brothers, (1933), p. 114. For 1935 to 1985-Data Resources, Inc.

fact, have long-term debt outstanding so
long as it did not represent more than 35
percent of total book capital (liabilities,
plus owners' equity). For firms in industries with very stable earnings, such as
utilities, a debt-to-total-capital ratio of 50
percent was acceptable.
In later editions of their classic book,
Graham and Dodd acknowledged, but
gave short treatment to, the growing body
of research that indicated that, except for
taxes and bankruptcy costs, the value of a
firm is invariant to its capital structure.
ods, implying that today's balance sheet ratios are
closer to "typical." See Robert A. Taggart, Jr.
"Have U.S. Corporations Grown Financially

They stressed instead the view that firms
with debt financing above recommended
levels constitute speculative enterprises
and are, therefore, not worthy of the
prudent analyst's attention.
Chart 2 is a plot of the ratio of the
aggregate book value of the debt of nonfinancial corporations to the book value of
equity. What emerges is a view of corporate America that conforms fairly closely
to the ideal world of Graham and Dodd.
Note that corporate balance sheets
improved during the late 1970s and early
Weak?" in Financing Corporate Capital Formation, edited by Benjamin M. Friedman, Chicago:
University of Chicago Press, 1986, pp. 13-33.