The financial markets play a fundamental role in the modern economic system: to find resources for those who have none. Debt, therefore, is an integral part of modern capitalism. In the last twenty years, the expansion of debt has been a determining factor for the growth of income and per capita, but, today, after years of unstoppable growth, one wonders if we have not gone too far.
In itself, taking on a debt should not be seen as a "disgrace", but as a functional opportunity to achieve a goal that creates value, such as buying a house or investing in machinery. Beyond the level of debt, it is essential for investors to understand how that debt is used. Also because, as long as the expected return on the investment is higher than the cost of the debt, the debtor's solvency is not at risk and the creditor can sleep peacefully. However, the solvency of a debt, or the ability to repay it, can be jeopardized by the exogenous evolution of the markets. The Eurozone crisis is a good example.
In 2011, when market confidence in the Eurozone started to falter causing spreads to rise, countries like Italy, which until the day before were solvent - and in fact they were -, suddenly weren't anymore, at least in the eyes of investors. And that's when my legs started shaking. Low nominal GDP growth makes any debt reduction process long and complex. Apparently there are no "fixed" debt thresholds that should not be exceeded. But what is certain is that, when a crisis breaks out, the most indebted countries are the ones most at risk. Empirical evidence suggests that the excessive increase in private debt (ie of households and businesses) increases the risk of a financial crisis, and countries with an insufficiently robust fiscal position (public debt) are the ones that pay the heaviest price.
As economist Richard Koo of Nomura argues, when a debt crisis erupts, the economy can enter a balance sheet recession: the private sector prefers to minimize debt rather than maximize profit (this reduces consumption and the real economy) and those who do not have sufficient resources to offset private sector adjustment suffer a longer and deeper crisis. This partly explains the reasons why Italy was among the countries most affected by the crisis in the Eurozone and the collapse of the Italian banking system.
Bankruptcies are part of the capitalist game, and investors get paid for it. So far, yield compression has lightened the debt burden (and frozen default risk), while also reducing the risk premium. However, the start of the monetary policy normalization process opens a new chapter: what will happen to the next recession? This is what all analysts are asking, but it is a unique situation and there are no points of reference: the balance between risk and valuations is increasingly precarious.
