The problem is not debt in itself. It is instead that debt might be highly concentrated, and is part of leveraged exposure to risky assets.
Put it this way. In the 2007-09 crisis, US banks lost $550bn. Those losses triggered the worst recession since the 1930s. But in the tech crash of 200-03, investors in US equities lost $6.3 trillion yet these much bigger losses led only to the mildest of recessions. Why the difference? It’s because losses on mortgage derivatives were concentrated in a few, leveraged firms. By contrast, stock market losses were dispersed among mainly unleveraged investors.
This warns us that concentrated, leveraged losses can be fatal. We saw this last week, when the Swiss Franc’s 20 per cent rise triggered the closure of FX broker Alpari and Everest Capital’s global hedge fund, both of whom had borrowed lots of francs.
This means that, after a fall in any asset - oil, copper, emerging market equities and so on - the questions arise: who has leveraged exposure to this? Are they in danger of failing? Such questions matter because of two risks. One is counterparty risk - the danger that the other side of one’s trade will be unable to fulfil their obligations. The other is fire sale risk: a distressed firm might need to sell other assets quickly to raise cash. Such risks mean that otherwise good trades by sound firms might turn bad. The mere risk of this is enough to prompt them to reduce exposure to other risky assets. In this way, falls in oil or copper or whatever can lead to falls in equities.
This problem will not go away. In a financialized world, losses on pretty much anything will raise doubts about counterparty risk.
Paradoxically, investors’ response to such uncertainty might even exacerbate the problem. In uncertain times, people want assets that feel familiar – which are often US dollars. However, Hyun Song Shin at the Bank for International Settlements pointed out recently that emerging market companies have increasingly been borrowing US dollars even though they don’t have equivalent US cashflows. This, he warned, means that “a stronger dollar constitutes a significant tightening of global financial conditions” - and hence the risk of defaults.
My point here is not that we are on the verge of a financial crisis. It’s simply that a small increase in the risk of a crisis, or concerns about heightened counterparty risk, can lead to day-to-moves in share prices of one or two per cent. Uncertainty about the distribution of debt is sufficient to generate stock market volatility.
And herein lies yet another reason for negative index-linked gilt yields. It’s often said that high debt puts a brake on global growth, and that low growth is a reason for low bond yields. But high debt can reduce bond yields in another way - because it increases uncertainty and counterparty risk, and thus increases demand for safe assets as insurance.
