More Money, More Debt
Minsky and others before him recognized that debt also arises from central banks lowering interest rates and printing money. Indeed, debt expansion due to lower interest rates is one of the explicit aims of monetary policy. Central bankers reason that lower interest rates will induce people to borrow in order to fund entrepreneurial endeavors and expand existing businesses. They also figure that interest rates are the discount rate at which investors value their investments. If an investor can buy a government bond that yields 5% annually with very little default risk, then she might demand a 10% annual return from a stock since the stock investment entails more risk. Based on the fundamental financial model known as the “dividend discount model,”²¹ demanding a 10% return implies that the stock will trade at a multiple of 100% / 10% = 10x cash flow, assuming no growth in cash flows over time. But if the government bond yields only 2%, then the investor might demand only a 5% annual return from a stock, which would imply 100% / 5% = 20x cash flow. This 20x cash flow valuation implies the stock doubling in price as compared to a 10x cash flow valuation implied by the 10% demanded return.
The same logic applies to real estate and other risk assets. Such increases in asset prices allow investors to take out more debt secured by those investments. Thus a business owner might seek to borrow money in order to grow her business more quickly since the interest rate is low, and the bank might be willing to lend her the money since in a lower interest rate environment, her business is worth more. Likewise, a homeowner might seek to take out a mortgage at a lower rate to improve her property, and the lender will be willing to lend since the property is worth more in the low interest rate environment.