Since the mid-1950s, global indebtedness has exploded to record levels.
At the beginning of 2019, the IMF reported global debt reached an all-time high of $184 trillion in nominal terms at the end of 2018, equivalent to 225% of 2017 GDP. On a per capita basis, the world’s debt now exceeds $86,000, which according to the IMF is “more than 2½ times the average income-per-capita.”
Further data show that the private sector’s debt has tripled since 1950 making it “the driving force” behind global debt growth according to the IMF.
In nowhere is this more apparent than the United States where the ratio of outstanding non-financial corporate debt to GDP has Risen from 40% in 2011 to 47% today, an all-time high. A decade of ultra-low interest rates has encouraged consumers as well as companies to borrow.
American consumers’ collective debt surpassed $4 trillion for the first time in February, and average UK household debt hit a record £15,400 in 2018.
These figures are concerning because, if there’s one thing that is responsible for more business and personal bankruptcies than anything else, it is debt.
Invert, always invert
Carl Gustav Jacob Jacobi was a German mathematician who believed that the solution to many problems could be found by inverting the question. For example, instead of asking “what makes a good company?” we should be asking “what doesn’t make a good company?” or to be more specific, “why do most companies fail?”
The answer to this inverted question is, as noted above, debt.
I do not think it is impossible to overstate the dangers of excessive leverage, both for companies and investors. Debt acts as a noose around the borrower’s neck, restricting movement and options. Companies with strong balance sheets can weather short-term problems. However, businesses with leveraged balance sheets depend on the kindness of strangers. All too often, these strangers are happy to provide liquidity in the good times, but when the music stops, they are the first to leave the party.
Warren Buffett, the Oracle of Omaha has warned about the perils of leverage many times during his lengthy career. Buffett notes that it is the low probability, Black Swan events that cause the biggest problems for borrowers. Because it is impossible to predict when these events will occur, borrowers cannot prepare for them and are, therefore, caught out when they happen.
Buffett cautioned investors about this at the 2004 Berkshire Hathaway annual meeting of shareholders.
“So we believe almost anything can happen in financial markets…And the only way smart people can get clobbered, really, is through leverage.”
He reiterated this stance in the 2018 letter to shareholders, calling debt “financially fatal” and a “Russian roulette equation” where borrowers “usually win,” but “occasionally die.”
The point Buffett is making here is that it is very easy to borrow money, and nine times out of ten, borrowers will be able to pay off their creditors (the global banking system would struggle to survive if a much higher proportion of borrowers failed to pay off their debts). However, there’s is always going to be a risk that you might not be able to repay creditors when the time comes.
If you’ve borrowed too much, this could mean it’s game over — that applies for both companies and consumers.
So, why play Russian roulette when you don’t have to? Staying away from businesses that have high levels of debt, as well as avoiding personal borrowing is the easiest way of staying away from this high-risk game.