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Implications of Corporate Indebtedness for Monetary Policy

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  • Benjamin M. Friedman

Abstract

The extraordinary increase in reliance on debt by U.S. business in the 1980s has generated widespread concern that overextended borrowers may become unable to meet their obligations and that proliferating defaults could then lead to some kind of rupture of the financial system, with ensuing consequences for the nonfinancial economy as well. The thesis advanced in this paper, however, is that the more likely threat posed by a continuing rapid rise of corporate indebtedness is instead a return to rapid price inflation. In particular, a review of recent developments lead to four specific conclusions: First, problems of debt service within the private sector are more likely to arise among business borrowers, not households. Because businesses, and especially corporations, have used much of the proceeds of their borrowing merely to pay down their own or other firms' equity, their interest payments have risen to postwar record levels compared to either their earnings or their cash flows. Second, despite these high debt service burdens, debt default on a scale large enough to threaten the financial system as a whole is unlikely in the absence of a general economic downturn. But the sharp increase in indebtedness has made U.S. businesses crucially dependent on continued strong earnings growth. Third, the consequent need to prevent a serious recession -- so as to preclude the possibility of a systemic debt default -- will increasingly constrain the Federal Reserve System's conduct of monetary policy. The Federal Reserve's reluctance to risk a situation of spreading business (and LDC) debt defaults, especially with the U.S. commercial banking system in its current exposed position, will increasingly prevent it from either acquiescing in a recession or bringing one about on its own initiative. Fourth, over time this constraint will severely limit the ability of monetary policy to contain or reduce price inflation. Episodes of disj in the United States since World War II have invariably involved business recessions, including declines in business earnings and increases in bankruptcies and defaults. If the economy's financial system has become fragile to withstand any but the shortest and shallowest recession, it is unlikely to be able to support a genuine attack on inflation by monetary policy.

Suggested Citation

  • Benjamin M. Friedman, 1990. "Implications of Corporate Indebtedness for Monetary Policy," NBER Working Papers 3266, National Bureau of Economic Research, Inc.
  • Handle: RePEc:nbr:nberwo:3266
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    References listed on IDEAS

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    1. E Philip Davis, 1996. "The Role of Institutional Investors in the Evolution of Financial Structure and Behaviour," RBA Annual Conference Volume (Discontinued), in: Malcom Edey (ed.),The Future of the Financial System, Reserve Bank of Australia.
    2. Bindseil, Ulrich & Winkler, Adalbert, 2012. "Dual liquidity crises under alternative monetary frameworks: a financial accounts perspective," Working Paper Series 1478, European Central Bank.
    3. Benjamin M. Friedman & Kenneth Kuttner, 1993. "Why Does the Paper-Bill Spread Predict Real Economic Activity?," NBER Chapters, in: Business Cycles, Indicators, and Forecasting, pages 213-254, National Bureau of Economic Research, Inc.
    4. Adalbert Winkler, 2012. "The Financial Crisis: A Wake-up Call for Strengthening Regional Monitoring of Financial Markets and Regional Coordination of Financial Sector Policies?," Chapters, in: Masahiro Kawai & David G. Mayes & Peter Morgan (ed.), Implications of the Global Financial Crisis for Financial Reform and Regulation in Asia, chapter 7, Edward Elgar Publishing.
    5. Winkler, Adalbert & Bindseil, Ulrich, 2012. "Dual liquidity crises under alternative monetary frameworks," VfS Annual Conference 2012 (Goettingen): New Approaches and Challenges for the Labor Market of the 21st Century 62032, Verein für Socialpolitik / German Economic Association.

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