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Published: January 20, 2014

 
 

Efraim Benmelech on Financial Contagion

When there is a lot of debt, the immune system is weak. And when there is less debt and more cash, the firm is more resilient. If you think about a contagious disease, the disease spreads most easily to people with weak immune systems.

S+B: It seems sort of obvious that a company (or a person) shouldn’t take on too much debt. Why have these situations occurred?
BENMELECH:
In fact, it’s not clear that firms should not take on a lot of debt. Debt is not as negative as some people try to portray it; it is actually very useful. Why do firms have debt? Some firms need to invest in capital and may not see the profits until a few years later. If they have fantastic projects and good ideas, why shouldn’t they take on debt? That’s the only way in which one can grow and invest. We need debt.

All firms will have debt, but they need to get the balance right. What’s the optimal level of debt? No one knows. Economics is not only about giving numbers; it’s also about describing trade-offs. Companies must weigh the value of debt against the need for strong immune systems. Our research helps lay out the issues for consideration.

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