It is generally seen that the effect of financial leverage in firm investment is positive for large information asymmetric businesses. But no clear relationship exists between leverage and investment for large-scale companies. Instead it is seen that leveraged companies tend to have more short positions (in stock) relative to their assets and liabilities. This implies that a company increases its fixed capital without growing its balance sheet over time. The same is true for leveraged banks where the spread between loan and margin (the difference between the amount a bank borrows and the amount it can borrow) tends to be higher. Thus a bank with very high leverage has lower total asset value than a bank with low leverage.
There is one exception to this generalization. It is seen that firms listed in the stock market tend to increase their equity value as a result of market volatility. If the share price of such companies goes up, this implies that their capital is increasing and if it goes down, it means that the firm’s equity has come down. Thus the efficiency of leveraged capital structures depends on market prices of listed firms rather than aggregate efficiency.
Financial managers may argue that financial markets do not accurately reflect all aspects of capital structure efficiency. For example, it is difficult to determine whether a firm has efficient capital structure or simply has a lot of leverage relative to its competitors. Another concern is whether firms with high levels of leverage tend to adopt more risky policies. Finally, firms may argue that their panel data is incomplete because it does not allow for firm-specific inputs like board of directors, CEO selection, financial ratings, firm sales and operating costs, and other important inputs.
Most financial managers argue that although these arguments are true, they do not support the government intervention argument that they favor. They point out that government interventions in the form of subsidies and tax increases have occurred even during a period when the availability of firm investments is at its lowest since the Great Depression. Moreover, they point out that such government interventions were temporary and did not address the root causes of the crisis period, namely excessive leverage, excessive debt, and deficient financial management skills.
In addition, most financial managers argue that the real problem lies in the interdependence of banks and firms on credit and money. According to them, a return to more efficient policies will be accompanied by more rapid and durable recovery from the current economic crisis. The current recovery is likely to take longer as it is difficult to judge the effects of stimulus packages and trade wars on bank balance sheets. However, they argue, the overall effect of these factors on capital and credit formation processes is positive since it is boosting employment levels and economic freedom and reducing household debt.
In conclusion, the debate on investment efficiency continues. While there is general agreement that investment policy is one of the key factors behind sluggish economic recovery, differing views are highlighted on the extent of government intervention in the economy. Many also point out that fiscal policy is not the only means of promoting economic efficiency. A return to more flexible monetary policy may be needed to counter high levels of credit card indebtedness, excessive house purchase, and other forms of inefficient fiscal policy. In any case, effective capital allocation via firm purchase, firm ownership, and other forms of entrepreneurship continue to contribute to the economic stability and productivity growth of modern societies.
