Intellectual groundwork for a debt bubble

In The debt bubble legacy of economists Modigliani and Miller, FT's Robin Wigglesworth explains how Franco Modigliani and Merton Miller's academic work led to a four-decade decrease in corporate creditworthiness.

"Their initial findings [that whether companies funded themselves with debt or equity was irrelevant] only held in a world without "frictions" -- such as taxes, imperfect information and inefficient markets. But a later revisitation that incorporated the tax-deductibility enjoyed by interest payments showed that the value of an indebted company is actually higher than that of an unleveraged one. It eventually helped lay the intellectual groundwork for a dramatic erosion of corporate creditworthiness."

By focusing on efficiency in a theoretical economy rather than resilience in a real one, Modigliani and Miller (as well as later economists who argued that debt could ensure corporate discipline and therefore increase economic dynamism) laid the intellectual groundwork for companies to leverage up and increase returns to shareholders at greater risk to the economy as a whole.

It's reflected in corporate credit ratings. In 1980, Standard & Poor's gave 65 companies (6 percent) a AAA rating, with the majority of companies in the A range. Today five companies out of 5,000 have a AAA rating, and only 14 percent are in the A range.