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Debt deflation and the company sector: the economic effects of balance sheet adjustment.

The debt-deflation theory of Irving Fisher has received renewed attention recently as analysts have attempted to provide an explanation for the behaviour of the UK economy over the current business cycle.(1)

Fisher (1933) asserted as part of his 'creed' on business cycle theory that 'in the great booms and depressions, each of |a set of other factors~ has played a subordinate role as compared with two dominant factors, namely over-indebtedness to start with and deflation following soon after ... . In short, the two big bad actors are debt disturbances and price level disturbances.' (Italics in original.)

Fisher's hypothesis is that booms are associated with over-indebtedness and the desire on the part of debtors to correct this situation causes distress selling, a fall in the level of prices, a rise in the real value of debt and hence a fall in the net worth of business, a reduction in output, trade and employment, pessimism and loss of confidence. This process leads back to further distress selling so that 'the very effort of individuals to lessen their burden of debts increases it, because of the mass effect of the stampede to liquidate in swelling each dollar owed'.(2) (Italics in original.)

The purpose of this note is to determine the extent to which industrial and commercial companies (ICCs) have been affected by over-indebtedness and to quantify the role that this has played in exacerbating the current business cycle. This is done by first looking at the evidence on the financial position of ICCs in aggregate and second by examining by model simulation the macroeconomic effects of their attempts to correct financial imbalances. It should be emphasised at the outset that this note is not attempting to quantify the effects of over-indebtedness outside the company sector nor is it trying to establish whether debt problems faced by particular companies have wider implications through their adverse effects on the balance sheets of financial institutions.

Evidence on indebtedness in the industrial and commercial company sector

Much of the relevant evidence was examined just over a year ago in this Review (see Young, 1992a). There it was shown that while the net debt of ICCs was historically high in real terms, it was not high in relation to their overall market value. It is useful to update this evidence.

Chart 1 displays the behaviour over time of four key measures of the burden of company sector debt: the ratio of net debt to the market value of capital (gearing) is a measure of the state of ICC's balance sheet, the ratio of interest payments to post tax company income (income gearing) is a measure of ICC's cash flow position, the ratio of net debt to company income after tax and interest payments and the ratio of net debt to GDP are hybrid measures capable of indicating cash flow and balance sheet problems. (A data annex describes the construction and sources for all figures described in the text.)

It is clear that while net debt remains at historically high levels in relation to income flows and interest payments are continuing to command a large share of company income, net debt is not high in relation to the market value of capital. In fact current levels of gearing are below the historical average. This is of considerable importance because it suggests that the market is confident that the future income flows generated by ICCs' capital are large relative to the future interest flows arising from current debt commitments: any financial difficulties experienced by ICCs are to do with problems of cash flow rather than doubts about its solvency. As such the typical company ought not to experience difficulty obtaining the finance to see it through any short-term cash flow difficulties.

The main reason for the relatively low levels of gearing observed at present is that the stock market valuation of capital has remained robust despite the recession and substantial declines in the price of certain physical assets. Chart 2 shows the valuation ratio (or Tobin's Q ratio) given by the market value of capital as a proportion of its replacement cost.

The market value of capital has remained broadly in line with the replacement cost of the capital stock in recent years. Lags in the publication of official statistics mean that information on the same basis as in the chart is not available for the past year, but it appears likely that the strong performance of the stock market and the general weakness of capital asset prices will have caused the valuation ratio to rise.

It is worth asking what is the effect on the financial position of companies of a fall in the price of capital assets when there is no change or a rise even in the value of the income expected to be generated by those assets. The most obvious adverse effect is that the value of the collateral for existing and future loans is reduced and this may make it more costly to raise new finance. But it is unlikely that the scale of the decline in the price of capital assets across all ICCs is sufficient for this to be of much importance in the aggregate.(3) Nor are the cost or availability of external finance highlighted in the CBI Industrial Trends Survey as important factors limiting capital expenditure.

A more serious problem would arise if, as envisaged by Fisher, the general price level falls, reducing both the market value of companies and the replacement cost of their capital. The fall in prices would reduce the ability of companies to generate the income necessary to service their debts. Companies in the UK are not currently in this situation.

This sanguine view of the burden of debt on the UK company sector is supported by cross country evidence presented in Davis (1992). This shows, on various measures, that corporate indebtedness in the UK (and the US) is lower than in Germany, France and Japan. Similarly others have noted that current levels of corporate debt do not appear to be imposing a large burden on business on average. For example, Congdon (1992a) has asserted that 'company finances are not completely out of line with previous historical experience'.

This does not mean that all companies are in balance sheet equilibrium. Certain companies are well known to be unhappy with their current levels of gearing and are making strenuous attempts to adjust their balance sheets. But when companies on average feel comfortable with their financial positions, the difficulties faced by certain individual firms need not pose macroeconomic problems: the business of firms in financial distress can be absorbed by others through purchases of their assets, through takeovers, or by competing away the customers of the distressed firms. Similarly profitable investment opportunities passed up by firms struggling to adjust their balance sheets are open to their less indebted competitors. This provides a rationale for examining the aggregate evidence on corporate indebtedness rather than focusing on the experience of individual firms when the purpose of the exercise is to determine the macroeconomic effects of debt. On this basis there is no cause for alarm.

A similar point has been made by Bernanke (1983, p. 267). In his analysis of the US Great Depression, he observed that 'most larger corporations entered the decade |the 1930s~ with sufficient cash and liquid reserves to finance operations and any desired expansion ... unless it is believed that the outputs of large and of small businesses are not potentially substitutes, the aggregate supply effect must be regarded as not of great quantitative importance.'

This argument is less applicable when whole sectors or regions of the economy are in financial difficulties so that those who might otherwise be interested in absorbing the business of financially distressed firms are themselves under pressure.(4) It is clear that there are certain sectors which are currently in this position. Chart 3 shows the value of the equity of the property and construction sectors relative to the value of the equity of companies in general. This pattern is consistent with companies in these sectors experiencing financial difficulties, although it is also likely to reflect considerable over-capacity.

With the caveat that the aggregate level of gearing may be disguising significant differences at the sectoral level, the analysis in this note uses aggregate gearing as one component of a measure of balance sheet disequilibrium. The fact that the aggregate level of gearing is not excessive by historical standards does not in itself contradict the debt-deflation hypothesis. This can only be the case if historical levels of gearing are a good guide to the level of gearing that companies would like now. If desired levels of gearing have fallen recently then the industrial and commercial company sector could still be in a state of over-indebtedness. To assess this requires some description of what it is that determines the level of indebtedness that companies choose. The difference between actual and desired gearing then provides a measure of balance sheet disequilibrium.

Optimum financial behaviour

The analysis of company financial decisions has been a subject of much controversy since the publication of the Modigliani-Miller (MM) irrelevance propositions in 1958 (Modigliani and Miller, 1958). They showed that in perfect capital markets (that is without taxes, bankruptcy and other frictions) the market valuation of a company and its cost of capital are independent of its capital structure (its choice of gearing). This implies that a company cannot increase its market valuation by increasing its gearing ratio even though the cost of borrowing might be significantly lower than the perceived cost of equity capital. The reason is that when a company increases its gearing ratio it is changing the composition of the income stream it pays out with more being paid out to those who hold its debt and less being paid out to those who hold its equity. But if investors in the market can borrow and lend at the same rate of interest as the company, then they can replicate any change in corporate capital structure by borrowing and lending themselves. As such, arbitrage considerations dictate that the overall valuation of the company should be independent of its capital structure. The effect is that the cost of equity capital rises (reflecting its greater risk when the company is more highly geared) to exactly the amount required for the weighted average cost of debt and equity capital to be unchanged by the change in capital structure.

By proving the irrelevance of capital structure in perfect capital markets, MM were able to draw attention to the circumstances where capital structure would be important: 'showing what doesn't matter can also show, by implication, what does' (Miller, 1988). Anything that means that investors are able to borrow and lend at different rates of interest to the firm falls into this category. The fact that companies and investors pay different rates of tax on interest income means that in post tax terms it is often cheaper for investors to achieve a particular flow of post tax income by holding the shares of companies with debt than by borrowing on their own account and holding the shares of companies without debt.

The influence of taxation forms the basis of the explanation of gearing decisions considered here. The evidence suggests that the configuration of corporate and investor tax rates observed in the UK has encouraged corporate borrowing. It is likely that in choosing the optimum amount of gearing, companies trade off these tax benefits against the greater risk of bankruptcy and its associated costs that greater indebtedness implies. In the empirical work to be reported below, the gains from leverage are measured by

|Mathematical Expression Omitted~

where |t.sup.m~ and |g.sup.m~ are the tax rates on interest income and capital gains paid by investor m, |t*.sub.c~ is the effective rate of corporation tax paid by the typical firm (this is a weighted average of the statutory rate paid by tax paying firms and an adjusted rate applicable to tax exhausted firms), |r.sub.t~ is the nominal interest rate, |p.sub.t~ is the expected rate of inflation, |D.sub.t~ is a dummy variable that takes the value unity when the base for capital gains tax is indexed and zero otherwise, |w.sup.m~ is the proportion of aggregate wealth owned by investor m. The different classes of investor considered are pension funds, life insurance companies and individuals. They are distinguished because of the different tax regime each faces.(5)

Expressions similar to (1) can be found in Miller (1977) and Modigliani (1982) and elsewhere. In the absence of capital gains tax (1) indicates that companies can improve their value by increasing their indebtedness when the effective rate of corporation tax is greater than the income tax rate of individual investors. In effect by borrowing at a low net rate of interest and paying out dividends early they are enabling investors to lend the proceeds at a more favourable rate thereby making a profit. When capital gains taxes are taken into account the incentives to corporate borrowing are greater because capital gains are reduced by paying out dividends early. Indexation of the capital gains tax base makes corporate borrowing less profitable in inflationary conditions because it reduces the incentive to have a highly geared capital structure to avoid paying tax on the purely inflationary gains on equity.

It should be noted that if the tax system is such as to encourage corporate borrowing then increases in nominal interest rates raise the incentive for companies to borrow: larger gains can be made by paying out greater dividends and allowing shareholders to lend the funds at a greater rate. This would be offset by a fall in personal borrowing.

Empirical evidence

A relationship between gearing and the tax incentive to gearing is not one that is well established in the empirical finance literature despite the fact that the theoretical relationship has been much discussed. For example, detailed studies at the firm level by Marsh (1982) and Titman and Wessels (1988) do not find significant tax effects and Myers (1984) stated in his Presidential Address to the American Finance Association that 'I know of no study clearly demonstrating that a firm's tax status has predictable material effects on its debt policy. I think the wait for such a study will be protracted'. More recently, MacKie-Mason (1990) and Givoly, Hayn, Ofer and Sarig (1992) do find evidence relating to the United States of significant tax effects at the firm level.

A statistically-acceptable quarterly time series relationship has been estimated between ICCs gearing and the gains to leverage over the period from the third quarter of 1967 to the end of 1991.(6) It indicates that in the long run, a rise in the gains to leverage of about 10 per cent from its sample average would raise the gearing ratio by about 3 percentage points (the long-run t-statistic on the coefficient on the gains to leverage variable is 2.63). Adjustment to the long run is slightly drawn out with a mean lag of 6.5 quarters.

Chart 4 displays the behaviour of actual gearing levels and the long-run solution to the estimated equation. This shows that desired gearing levels were highest in the late-1970s when the tax system discrimated most heavily in favour of corporate borrowing. Throughout most of the 1980s actual gearing levels have been below desired levels. The current position appears to be one of approximate equilibrium.

This evidence suggests that gearing is not currently excessive if it is determined by the estimated equation referred to above. This gives ground for confidence that the recession has not been exacerbated by attempts by companies to reduce expenditure to pay off debt (this can be contrasted with the position in the mid-1970s). However it is unwise to place too much reliance on aggregate time series equations of this type. Estimated relationships describing other types of behaviour (consumers' expenditure for example) have been misleading at various times. Falls in the prices of capital assets and hence collateral as described above may be having effects on desired gearing levels not picked up by the equation.(7) It is useful therefore to quantify what the effects would be if companies were in this position.

Adjustment to balance sheet equilibrium

The gearing relationship shows that companies adjust their indebtedness in response to changes in the incentive to corporate borrowing but it does not indicate how this change is brought about: because of the budget constraint impinging on companies, a change in borrowing implies a change in at least one other expenditure or financing flow. Adherents of the Modigliani-Miller view that company real decisions (on investment, employment and perhaps stockholding) are taken independently of company financial decisions, would expect adjustments to the stock of debt to be brought about by corresponding adjustments to the outstanding stock of equity by changes in dividend payments and net equity issues. A popular alternative view that applies particularly when companies have too much debt is that companies are forced to reduce their expenditure by cutting back on investment, employment and stockholding. This is because they are unable to reduce their dividend payments for fear of offending their shareholders and that the transactions costs in issuing new equity are too large for this to be a serious means of reducing debt.

The question of how balance sheet disequilibrium is corrected is empirical and may be tested. The approach that has been taken here is to examine whether a variable measuring excess debt is significant when added to any of the existing specifications of the equations representing company real and financial decisions in the National Institute's domestic macroeconomic model. A number of different measures of excess debt were tried. This was to allow the maximum opportunity for evidence in favour of debt effects in the expenditure equations to be found. In this way it is possible to place an upper bound on the size of the effect of excess indebtedness in reducing company spending. The variables used included:

a) disequilibrium gearing: the difference between the actual gearing ratio and the desired gearing ratio shown in Chart 4;

b) the ratio of net debt to company cash flow. This combines cash flow and balance sheet considerations. It tends to be high when both cash flow and balance sheet information are indicating that debt might be excessive. Trends in this series are shown in Chart 1.

This investigation indicated that significant debt effects could be found in all of the equations examined. The disequilibrium gearing variable (as in a) above) has significant effects of the anticipated sign in all of the equations except those for manufacturing investment, manufacturing employment and employment in the business services sector. In each of these equations a role could be found for the ratio of net debt to company cash flow (as in b) above) either in levels or difference form. A summary of the effects of excess debt in the individual equations is provided in Table 1.

The effect of debt variables on the financing and expenditure categories are not uniform. Relatively large effects are evident in the equations for dividend payments, investment in business services and employment in distribution. It is not clear why the effects in the latter two equations are so large. It should be pointed out that these equations are not the most reliable in the model. At the other extreme it was not possible to find a significant long-run effect in the equation for employment in the business services sector.

In order to assess the importance of these effects in the economy as a whole, the amended equations have been programmed onto the domestic model. This may then be used to quantify the effects in individual sectors and in the economy as a whole of shocks to the amount of debt with which companies feel comfortable.

Results of model simulation

The reported simulation assumes that the desired gearing ratio falls exogenously by 5 percentage points relative to what the model equation suggests. This is a large change(8) and from today's level would reverse most of the rise in gearing from its low point in the latter half of 1987. It is assumed that nominal interest rates and the exchange rate are fixed at their base levels throughout. The results are shown in Table 2.

The effect of the change in the desired gearing ratio is significant. The scale of the response is such that by the end of the third year output is 1 per cent lower and unemployment is 230,000 higher than they would otherwise have been. These changes come about because the fall in desired gearing raises the amount of disequilibrium debt and this feeds directly into the equations for stocks, dividends, net equity issues and some of the investment and employment categories. These then have second round effects through the usual multiplier processes.

The effects can be seen to be different in the different sectors. As noted above, the debt variable that appears to affect output and employment in manufacturing is the ratio of net debt to company cash flow. This behaves differently in this simulation to the disequilibrium gearing variable that acts as the measure of excess debt in other equations. In particular, as companies reduce their gearing levels so the ratio of net debt to cash flow starts to fall thereby boosting investment and employment in manufacturing. However, this is only apparent towards TABULAR DATA OMITTED the end of the simulation. In the first few years employment and investment in manufacturing are depressed by the reduction in activity in general.

The simulation brings out the sensitivity of the re-estimated equations for employment in distribution and investment in business services to the level of disequilibrium gearing. The very sharp change in investment in the business services sector means that employment there has to be higher than otherwise to produce the necessary business services output.

In addition to these changes in real expenditure there are also important adjustments to financial variables such as dividends and the amount of net equity finance. In effect this means that a higher proportion of investment (which is anyway lower) is being financed by retentions and new equity issues with less being financed by borrowing. The ICCs' sector financial deficit is thereby reduced significantly.

It is interesting to examine the effects of these changes on the capital structure of companies in the sector. Companies are able to reduce their indebtedness significantly by these changes in expenditure and its financing. At the same time their total market value, which in this model is ultimately related to the replacement cost of their stock of capital, is hardly changed. This means that the value of their equity rises by roughly the amount that the value of debt falls (the percentage rise in the value of equity is smaller because equity represents about 80 per cent of the balance sheet). This is illustrated in Chart 5. So despite the fact that dividends fall throughout most of the simulation, the market value of equity rises to reflect the fact that at the end of the simulation period the equity holders will have a much larger claim on the value of companies. Equity prices do not rise by so much because the claim of each share is reduced as new equity is issued.

Much of the reason for the fact that the market value of TABULAR DATA OMITTED capital is largely unchanged is that the price level is not ultimately affected by the depressing nature of the shock. This in turn results from the policy assumption underlying the simulation that the nominal exchange rate is fixed. With a fixed nominal exchange rate, the price level is anchored to overseas prices unless the shock changes the real equilibrium exchange rate of the model by a large amount. This is not the case in this simulation. Because of the relatively unchanging price level, the simulation does not exhibit all of the features of a debt deflation as described by Irving Fisher. In particular it does not allow the second of his 'big bad actors'--deflation--to come to centre stage. Prices do fall slightly to begin with, but never by enough to reduce companies' market value and therefore exaggerate the initial depressing impulse of excess debt.

An alternative simulation

The above simulation owes much of its effect to the reaction of various items of company expenditure to changes in measures of excess debt. It is of interest to examine what the effects of the same shock would be if company real expenditure were independent of excess debt. This can be accomplished easily by setting to zero the coefficients on the excess debt variables in the expenditure equations. It is assumed that stocks continue to be responsive to excess debt. The results are shown in Table 3.

It is clear that the effects of changes in the desired gearing ratio on the economy as a whole are much smaller when the effects of disequilibrium gearing are concentrated on the financial variables. This does not mean that there are no effects on the wider economy: the decline in stock holding and the effects of lower dividend payments on personal incomes both depress demand.


This note has presented evidence on the balance sheet position of industrial and commercial companies and provided some estimates of the consequences for the economy of adjustment by companies in response to financial disequilibrium. It remains to assess what effect the indebtedness of companies played in the recession.

The evidence suggests that the aggregate balance sheet position of the company sector is not unhealthy at present: debt levels are high in absolute terms but not in TABULAR DATA OMITTED relation to the market value of companies. Levels of gearing are not high either by historical standards or in relation to estimates of the equilibrium position. Nevertheless, accepting that company debt is not now at excessive levels in aggregate, some reasons remain for not dismissing entirely the view that the recession was exacerbated by debt problems in the company sector.

First it is likely that part of the expansion in the economy in the late-1980s can be explained by the response of companies to insufficient levels of gearing. The unwinding of this process can itself explain some of the downturn in demand. Second, the average position is not shared by all companies. In certain sectors of the economy it is likely that gearing is excessive. The efforts by such companies to restore their balance sheet position may have adverse consequences for the wider economy. Third, the estimates of equilibrium gearing are uncertain. An unexpected fall in the levels of indebtedness desired by companies at any time in the recent past will have prompted balance sheet adjustment. Fourth, there is evidence that certain components of company expenditure respond to measures of indebtedness such as the ratio of net debt to cash flow which have moved adversely over the recession.

Despite these caveats, there is no convincing evidence to suggest that debt levels in the company sector are currently excessive. Even where components of company spending might be expected to respond to the ratio of net debt to cash flow, the estimated effects do not appear to be large enough to have made a major contribution to the observed change in the behaviour of these components over the recession. But, to explore fully the effects of excessive indebtedness the model simulations in this note provide some means of quantifying them if this sanguine view is wrong.

The model simulations showed the effect of a permanent reduction in desired gearing of 5 percentage points. As noted in the text this is a large change and would be towards the top end of any range of possible values of excess gearing in the recent past. Its consequences were illustrated on two versions of the National Institute's domestic model. In the first version, estimated effects from excess indebtedness were allowed to feed fully into the company expenditure and financial equations. This showed there to be large effects on the economy as a whole with output falling by 1 per cent and unemployment higher by some 250,000 in the adjustment period. In the second version of the model, effects from excess indebtedness were prevented from feeding into company real expenditure. This was so as to produce a model consistent with the view that the real and financial decisions of companies are separable. Not surprisingly the effects on the wider economy of balance sheet adjustment in this model are very small.

It is important to note that the effects illustrated in the first version of the model are based on estimated equations whereas those in the second case use a version of the model where some of the estimated effects are over-written. This suggests that of the two cases considered more faith should be attached to the first case. However, it should be emphasised that the equations in which the estimated effects are largest are not those in which the most confidence is placed. As such these estimates are more likely to overestimate than underestimate the effects of excess gearing.

These arguments suggest therefore that problems associated with debt in the company sector might explain at most a fall in output relative to trend of 1 per cent and a rise in unemployment of about 250,000. Since output has fallen relative to trend by about 8 per cent and unemployment is about 1,250,000 above its level at the start of the recession it is not possible to attribute a very large proportion of the downturn to this cause.

These results should not be taken to mean that debt problems in general have not had an important effect on the UK economy. Rather they imply that to the extent that the economy is suffering from excessive indebtedness it is not in the industrial and commercial company sector that its effects are at their worst. The household sector faces well known problems associated with high indebtedness and the fall in house prices which might account for a large part of the weakness of consumers' expenditure. The banking sector has had to make substantial provisions for bad debts. As yet there has been little serious analysis of the effects of this on the wider economy. But it is important to note that Bernanke (1983) argues persuasively that failures in the process of financial intermediation made a substantial contribution to the US Great Depression. Finally it should be recalled that excessive indebtedness was only one half of Irving Fisher's hypothesis. The other essential half is falls in the general level of prices. It is difficult to imagine that the Great Depression would have been anything like as severe if the authorities had not allowed the price level to fall by about 30 per cent. A certain amount of comfort can be drawn from the historical record of the UK monetary authorities in this regard at least: a decline in the price level in the UK is not likely in the foreseeable future.


Bank of England (1992), Quarterly Bulletin, August.

Bernanke, Ben S. (1983), 'Nonmonetary effects of the financial crisis in the propogation of the Great Depression', American Economic Review, 73(3), pp. 257-276.

Congdon, Tim (1992a), 'The condition of the British financial system', Gerrard and National Economic Review, no. 40, October, pp. 3-12.

Congdon, Tim (1992b), 'How to beat the debt-deflation trap', Gerrard and National Economic Review, no. 42, December, pp. 3-12.

Davis, E P (1992), Debt, Financial Fragility and Systemic Risk, Clarendon Press, Oxford.

Fisher, Irving (1933), 'The debt-deflation theory of great depressions', Econometrica, October, 1, pp. 337-357.

Givoly Dan, Carla Hayn, Aharon R. Ofer, and Oded Sarig (1992), 'Taxes and capital structure', The Review of Financial Studies, 5(2), pp. 331-355.

MacKie-Mason, Jeffrey K. (1990), 'Do taxes affect corporate financing decisions', Journal of Finance, 45(5), pp. 1471-1493.

Marsh, Paul (1982), 'The choice between equity and debt: an empirical study', Journal of Finance, 37(1), pp. 121-144.

Miller, Merton H. (1977), 'Debt and taxes', Journal of Finance, 32, pp. 261-275.

Miller, Merton H. (1988), 'The Modigliani-Miller propositions after thirty years', Journal of Economic Perspectives, 2(4), Fall, pp. 99-120.

Milne, Alistair (1993), 'Financial problems and economic recovery', Economic Outlook, London Business school, 17 (5), February, pp. 39-47.

Modigliani, Franco (1982), 'Debt, dividend policy, taxes, inflation and market valuation', Journal of Finance, 37 (2), pp. 255-273.

Modigliani, Franco and M.H. Miller (1958), 'The cost of capital, corporation finance and the theory of investment', American Economic Review, 48(3), pp. 261-297.

Myers, Stewart C (1984), 'The capital structure puzzle', Journal of Finance, 39, pp. 575-592.

OECD (1992), 'Balance-sheet restructuring: economic impact and policy responses', OECD Economic Outlook, December, pp. 41-49.

Pepper, Gordon (1993), 'A policy for debt-deflation', Economic Outlook, London Business school, 17 (5), February, pp. 36-38.

Shleifer, Andrei and Robert W Vishny, 'Liquidation values and debt capacity: a market equilibrium approach', Journal of Finance, 47 (4), September, pp. 1343-1366.

Titman, Sheridan and Roberto Wessels (1988), 'The determinants of capital structure choice', Journal of Finance, 43 (1), pp. 1-19.

Tobin, James (1980), Asset Accumulation and Economic Activity, Basil Blackwell, Oxford.

Young, Garry (1992a), 'Corporate debt', National Institute Economic Review, February, pp. 88-94.

Young, Garry (1992b), 'The taxation of capital income in the UK: 1964/5 to 1992/3', National Institute Discussion Paper, New Series no. 27.

Young, Garry (1992c), 'Leverage and investment in the UK', paper presented at ESRC Money, Macro and Finance Conference, September 1992.


(1) Bank of England (1992), Congdon (1992a and 1992b), Pepper (1993), and Milne (1993) are recent examples which emphasise the problems associated with debt.

(2) It should be emphasised that Fisher considered this process self-limiting and hence a short run or cyclical phenomenon. In the long run, real balance effects following from the fall in the price level will dominate the cyclical effects described by Fisher (see Tobin, 1980, on this point). This does not make the downturn any less costly.

(3) The whole economy investment deflator fell by 3 per cent in 1992. The deflator for other new buildings and works fell by 9.3 per cent and that for plant and machinery rose by 0.8 per cent. The effect of the fall in the price of land, which is not included in investment in the National Accounts, may be more significant. But a comparison of the value of buildings and works, excluding land, in the CSO's estimates of capital stock with the value of commercial, industrial and other buildings, including land, in the CSO's estimates of balance sheets suggest that land represents a relatively small proportion of the tangible assets owned by ICCs (less than 10 per cent in 1987).

(4) A discussion of this type of situation is contained in Shleifer and Vishny (1992).

(5) Detailed information on the weightings used and the calculation of marginal tax rates for each group of investors can be found in Young (1992b).

(6) Further details of a similar relationship are contained in Young (1992c).

(7) Tobin's Q ratio was included in the original specification of the gearing equation but was not significant so that there is no evidence that this is important.

(8) Levels of disequilibrium gearing in excess of this have only been observed (not continuously) in the period from 1974 to the beginning of 1977.


This annex indicates briefly the sources and definitions of variables used in the paper and drawn in the charts. (Mnemonics in parentheses are central database identifiers.)


Data on ICCs balance sheets are published in Financial Statistics Table 14.7.

Net debt is the sum of net short term and net long term debt.

Net short-term debt (|Pounds~ billion) is constructed as:

Bank lending, sterling (AZBQ) + Bank lending, foreign currency (AZBR) + Identified trade credit, domestic (RICG) + Other lending by financial institutions (RIKB) - Deposits with banks, sterling sight (RIBU) - Deposits with banks, sterling time (RIBV) - Deposits with banks, foreign currency (AYSI) - Credit extended by retailers (AXCH) - Identified trade credit, domestic (RIBY)

Net long-term debt is estimated as the difference between UK debenture and loan stock issued (ALCP) and that held (RDXO). Unfortunately, these series are no longer published in Financial Statistics. The last observations are for 1990Q4. Estimates after this assume that UK debenture and loan stock issued and held are constant proportions of total debt issued and held.

The value of net equity issued by ICCs is given by:

+ UK company securities issued (RICJ) + Overseas direct and other investment in the UK (AZBP) - UK company securities held (RICA) - Direct and other investment abroad (RICB).

The total market value of ICCs' domestic capital is given by the sum of net short term debt and net equity issued (which includes long term debt within UK company securities). The total market value of their global capital is the sum of the market value of their domestic capital and the value of their holdings of overseas capital (RICB).

The format of the tables in Financial Statistics has recently been changed. The definitions used for data before 1980 are as in Young (1992a). The series are spliced at 1980q1.

The definition of the capital stock used is the net capital stock at current replacement cost. This is interpolated from annual figures given in Table 14.7 of the 1991 Blue Book.

The gearing ratio is defined as the ratio of ICCs' net debt to the market value of their global capital.

The valuation ratio is given by the ratio of the market value of ICCs' domestic capital to the net capital stock at current replacement cost.


The information on financial flows is taken from Tables 8.1 to 8.3 of Financial Statistics.

Income gearing is defined as interest payments (AIAV) divided by total company income (AIAN) less UK taxes on income (AIAY). Company cash flow is defined as Total income (AIAN) less interest payments (AIAV) less UK taxes on income (AIAY). This is used to define the ratio of net debt to cash flow drawn in Chart 1.
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Author:Young, Garry
Publication:National Institute Economic Review
Date:May 1, 1993
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