By FERNANDO NOGUEIRA DA COSTA*

Cycles are influenced by the institutional structure of the economy, whether its financial system is characterized by bank debt or by the capital market

The co-evolution of personal, corporate, public, banking and international finance, in cycles of financial leverage and deleveraging, involves dynamic interactions between all sectors. These cycles are influenced by the institutional structure of the economy, whether its financial system is characterized by bank debt (fixed income) or by the capital market (variable income).

It is possible to model the typical sequences of interactive decisions of the so-called “institutional sectors” in each type of financial system and in each phase.

In the first, the cycle of financial leverage begins from the different points of view of economic agents. In the case of families, the poorest increase their consumption financed by bank loans, taking advantage of favorable credit conditions with low interest rates and easy access.

Decisions regarding financing for the purchase of housing and direct credit for purchasing durable consumer goods are different. Acquiring real estate requires commitment to long-term loans. In financing with chattel mortgage, until the total amount of the loan is paid off, the buyer enjoys the property, but the house or apartment is the guarantee for payment to the bank. If the buyer does not honor the debt, they will lose the property.

Vehicle financing tends to be a “youthful scam”. Before realizing the distant “dream of owning your own home”, it is easier to buy financed cars.

Many entrepreneurs have ideas but no capital. They create companies with investments in fixed capital financed through bank loans.

The successful ones, if they are in the expansion of operations and innovation phase, already have customer relationships with banks. They resort to loans to expand the scale of production and meet growing demand, whether from families or other non-financial companies.

The trigger for this phase is usually an expansive fiscal policy: the government increases public spending and investments in infrastructure, financing itself through the issuance of public debt securities. It adopts this policy to stimulate economic growth and employment.

Banks increase the supply of credit to families, businesses and the government, taking advantage of the demand for loans and the opportunity to profit from interest. Contrary to the a priori condemnation of credit by critics of “financialization”, all debtors make “voluntary servitude decisions” because they are beneficial or profitable!

In these favorable and/or optimistic circumstances, there is a reduction in loan requirements. Banks facilitate interest and guarantee conditions for granting credit.

In an economy with an underdeveloped financial system, which citizens distrust and commit capital flight, foreign creditors or investors are used. They are abused if debtors are unable to pay loans recorded in foreign currency (dollars).

Initially, due to the diversification of international or geographic risk, foreign institutional investors buy debt securities issued by the government and companies, attracted by the returns offered that are much higher than those of the “parent company”. The flow of capital with abundant inflow of foreign capital further encourages the leverage of local non-financial companies.

It occurs until the beginning of the financial deleveraging cycle. Given the high level of debt, families begin to reduce consumption to pay debts, facing financial constraints. They focus on increasing savings to reduce debt.

Divestment becomes widespread, when companies begin to cut costs, due to the drop in demand and the need to pay debts. The situation is made worse by the reduction in employment with staff cuts and hiring freezes.

Neoliberal ideologues, making the situation worse, contaminate economic journalism… with bad ideas. They push for the adoption of fiscal austerity.

An inept government, if elected by ignorant right-wing populism, adopts austerity measures to reduce public debt, cutting spending and increasing taxes. They claim that these policies are necessary for inflationary stability, in order to avoid “the euthanasia of rentiers” (when the inflation rate exceeds the fixed interest rate) and restore confidence.

As a result of the pessimistic scenario, banks restrict the granting of new loans, due to the increased risk of default. Provisions for doubtful debts are increased to cover the risk of losses.

Faced with this situation of reversal of optimistic expectations, creditors or foreign investors immediately arrange for capital to be withdrawn before the dollar becomes even more expensive. Foreign investors withdraw their investments due to increased risk perception. This flight (or repatriation) of capital leads to the devaluation of the local currency and “imported inflation”.

In the capital market economy (variable income), the cycle of financial leverage, from the microeconomic point of view of families, begins with investment in shares. In the US, around the richest 10% make direct purchases of shares and other variable income assets, taking advantage of the market rise. The rest invest in equity funds under the administration of professional managers.

During the boom, it is common for speculators to abuse the use of credit. They increase leverage to invest more in capital markets.

Taking advantage of the bullish phase, companies open capital in IPOs (Initial Public Offering) or make follow ons (subsequent offerings) when issuing shares to finance expansion and new projects. They are also justified by the increase in investments in Research and Development, financed by issuing shares.

The government offers the starter motor in case the private mechanism gets stuck. The Legislative Branch approves tax and regulatory incentives to stimulate the capital market. Financing occurs, in countries with mature capitalism, through the capital market, where the issuance of public debt securities competes with shares to attract investors.

Financial institutions provide third-party asset management services. Banks offer, via subsidiaries, brokerage and asset management services, expanding their operations in the capital market. Credit is usually granted for capital market operations.

In the bull cycle, foreign investors increase direct and portfolio investment in stocks and bonds. The inflow of foreign capital encourages leverage.

Everything is going well, giving reasons to demand smaller safety margins or guarantees. Suddenly, distrust in the face of the detachment of fundamentals explodes the asset bubble, triggering the deleveraging cycle.

The decline appears when families begin to sell variable income assets to liquidate positions, realize gains and reduce risks. They focus on savings, that is, on cutting consumption, to reduce debt.

Companies no longer open capital or reduce the issuance of new shares. This decrease occurs due to the drop in prices due to lower investor interest. They set out to cut costs by reducing financial, labor and supplier expenses. There is a freeze on new projects.

The government takes measures to stabilize markets and restore investor confidence. “Market regulation” is then accepted with the implementation of prudential measures to avoid excessively risky practices.

Banks restrict credit for speculation, that is, leveraged operations in the capital market. They take care to increase provisions for doubtful debts, that is, losses in investments and market operations.

Foreign creditors and investors are now “on their way out”. Capital outflow leads to the depreciation of the national currency. Worse is when the country has debt in foreign currency – and there is no exchange reserve to pay the debt.

The co-evolution of personal, corporate, public, banking and international finance, in cycles of financial leverage and deleveraging, depends on the dynamic interactions between these institutional sectors. In bank debt economies, bank credit plays a central role, while in capital market economies, the issuance of shares and other variable income instruments are the main drivers.

In both cases, leverage leads to growth and expansion, but subsequently to vulnerabilities and crises. These require deleveraging processes to restore economic-financial stability.

*Fernando Nogueira da Costa He is a full professor at the Institute of Economics at Unicamp. Author, among other books, of Brazil of banks (EDUSP). [https://amzn.to/3r9xVNh]

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