Which Type of Debt Drives the Business Cycle?

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A conventional view in business cycle theory is that secured debt (i.e., debt backed by collateral) drives fluctuations in economic activity. However, unsecured debt is a more important driver of economic activity than secured debt at the firm level, according to a recent Economic Synopses essay.

In explaining the conventional view, Assistant Vice President and Economist Yi Wen and Senior Research Associate Maria Arias noted that people borrow to buy houses and other assets during economic upswings. This increases leverage ratios and asset prices.

In contrast, people pay down loans and reduce leverage during economic downswings, when obtaining credit is more difficult. “The conventional view, then, implies secured debt is strongly correlated with gross domestic product (GDP),” Wen and Arias wrote.

They discussed a working paper by Wen and his co-authors Costas Azariadis and Leo Kaas in which these authors focused on secured and unsecured debt at the firm level.¹ Wen and Arias highlighted results from using Compustat data for nonfinancial publicly traded U.S. firms from 1981-2012.

In contrast to the conventional view, Wen, Azariadis and Kaas found that secured debt was only weakly correlated with GDP. On the other hand, unsecured debt was strongly and positively correlated with GDP.

They also found that unsecured debt tended to lead GDP by one year, which suggests that it might drive GDP, and that unsecured debt was a better predictor of economic activity than secured debt.

The authors of the working paper obtained similar results when using flow of funds data to measure secured and unsecured debt in the U.S. economy. Namely, they found that unsecured debt was a key contributor to fluctuations in GDP at least after 1980, while secured debt was not.

Wen and Arias noted that this finding contrasts with the conventional wisdom that the value of collateral is what allows firms to borrow. Instead, unsecured debt appears to be the important driver of economic activity.

“So, at the firm level, unsecured debt is more important than secured debt in understanding the business cycle,” they added.

How does the amount of unsecured debt at the firm level influence economic activity? Wen and Arias noted that the working paper included a model in which:

• A firm’s reputation plays a critical role in its ability to issue debt in the unsecured debt market.
• Reputation is a self-fulfilling behavior, whereby the desired future reputation influences behavior today.

Because of these two factors, the authors argued, a firm’s belief about future credit market conditions helps shape its current credit market behavior.

“As a result, the more confident firms are about future credit market conditions, the less likely they will choose to default and thus the more likely they will be able to borrow to finance investment, which in turn will strengthen credit market conditions in the future,” Wen and Arias explained. “Thus, firms’ confidence in the credit market will affect the size of the unsecured debt market, which in turn influences aggregate GDP.”

They pointed out that Wen, Azariadis and Kaas estimated that self-fulfilling shocks to firm confidence in future credit market conditions can account for about half of aggregate fluctuations in GDP.

¹ Azariadis, Costas; Kaas, Leo; and Wen, Yi. “Self-Fulfilling Credit Cycles.” Working Paper No. 2015-005B, Federal Reserve Bank of St. Louis, November 2015.

• Economic Synopses: Secured and Unsecured Debt Over the Business Cycle
• Working Paper: Self-Fulfilling Credit Cycles
• On the Economy: Auto Debt Growth Slowed in Q4, Delinquencies Rose