Issue #23, Winter 2012

Rethinking Debt

Washington refuses to understand that debt can be an essential tool for economic growth. Can we overcome this irrational and destructive fear?

Our national fear and misunderstanding of debt, deficits, and borrowing is understandable, given their role in the etiology of the Great Recession that continues to choke our economy. But such confusion is also terribly destructive. It helped lead us into the recession, and it’s preventing us from recovering from it.

Over the last decade, too many households, governments, firms, and banks borrowed recklessly, nudged by financial “innovations,” negligent underwriting, and pure disregard for their ability to meet the liabilities they were taking on. Then, in September 2008, the system snapped. One particularly overleveraged investment bank, Lehman Brothers, went bankrupt, and the global debt bubble popped. Millions of people lost, and continue to lose, their homes. Unemployment is rampant, and just under half of the unemployed have been jobless for more than half a year. The debt burdens of sovereign nations, Greece in particular, pose existential threats.

And yet policy-makers seem frozen in place, unwilling to take the necessary actions for one basic reason: doing so would mean deficit spending. Indeed, those at the helm in the advanced economies seem intent on shifting into reverse, pursuing austerity measures that, like medieval bleeding, only make the patient sicker. We recently inflicted more wounds on our already injured economy by arguing about whether or not to default on our own sovereign debt. This frustrating and destructive debate would have been a pitiful sideshow had it occurred during a period of full employment. For it to happen in the midst of the worst jobs crisis in decades amounts to malpractice by the policy-makers involved.

None of this was inevitable. A precious few economists warned of the housing bubble, which was the root cause of the recession. Had borrowers and lenders treated debt more responsibly, we arguably wouldn’t be stuck where we are today. Years ago, the economist Hyman Minsky warned about exactly the situation we were in before the bubble burst—the debt-driven instability of financial markets in economic expansions. Had we listened to him instead of Greenspanian notions of “self-correcting markets,” we’d also be a lot better off.

In other words, there are very high opportunity costs to misunderstanding and misusing debt, both in booms and busts. Economists have a solid understanding and story about the “identities” involved in public debt—the basic relations among deficits, savings, and debt. But we disagree on their implications. Financial market participants seem to regularly relearn lessons regarding the instability cycle associated with overleveraging, a cycle identified by Minsky years ago. Politicians deeply fret (and scaremonger) about deficits and debt, while neither exhibiting much of an understanding of their functions nor doing much about them. In some cases, these pols are motivated by an ideological strategy to shrink government, but in others, they fail to understand important nuances regarding the purpose, timing, and magnitude of public borrowing.

We clearly need a better understanding of the role of and threats associated with debt, which means internalizing a crucial point: Controlling for the state of the economy and assuming mature capital markets and the ability to service the debt burden (and those are not unrealistic assumptions—they exist in this and most other advanced economies), there’s little empirical evidence that we should be particularly alarmed at “high,” yet stable, levels of federal debt, such as the current U.S. level of around 70 percent of GDP. On the other hand, if you can’t effectively and reliably tax your citizens, as in Greece, any level of debt is a foundational threat. (Note that I distinguish between levels and trends here. The projection that under current policy the federal government will, year in and year out, spend a lot more than it takes in is obviously unsustainable.)

We need to take a “debt sobriety pledge.” We need the insight and wisdom to understand when borrowing is useful and productive and when it’s reckless. For governments, that means getting past irrational or ideological fear of borrowing, especially at a time like the present. For households, it means not substituting unsustainable borrowing for income growth. For financial markets, it’s recognizing the predictable tendency toward instability and the necessity of regulation.

I cannot emphasize enough the stakes of getting this right, and quickly. Global credit markets are behaving exactly as we would expect, offering historically low borrowing costs to finance the essential fiscal expansion that must take place if we are to avoid the mistakes of Japan in the 1980s and Europe now. But conservatives use debt aversion as a weapon in the ideological fight to shrink government, while too many liberals essentially agree, arguing for perhaps smaller cuts.

The First Step: Understanding Debt

The concept of debt is so poorly understood that it makes sense to start from first principles. Debt is what a person, firm, or government accrues when it borrows financial resources from a lender to be paid back over time. In the case of so-called sovereign debt—that of governments—there are a few wrinkles. When government outlays surpass receipts, the difference over the course of a year is known as the annual deficit. And when you add up all the deficits we’ve run since we became a nation and subtract the occasional surpluses, you’re left with the debt.

Personal and corporate debt are also straightforward. A family might borrow to invest in a child’s education. A startup needs physical capital—machines, offices, computers—and might borrow to finance those purchases, as does a factory owner upgrading aging machines. These are investments—that is, they are expected to return a stream of payments, a stream from which debt liability will be serviced. But households, firms, and governments also borrow to boost short-term consumption, to meet payrolls, or to pay the annual Medicare bill.

And there are different markets with different structures and prices to accommodate all of the above borrowing. Banks finance short-term credit card debt and long-term mortgage debt. Larger corporations often borrow short-term directly from investors, like money-market funds, through “commercial paper” loans. Governments borrow from anyone and everyone, including other governments, with the United States, China, and Japan the most prominent examples. (The Chinese and Japanese together hold more than $2 trillion in U.S. securities.)

I’m sure that if you could look at the electrical impulses in the typical person’s brain and say “debt” or “deficit” the synapses that fired would be ones associated with negativity. Yet debt has obviously been an economic mainstay since before money existed—members of bartering economies constantly owed one another goods and services. Without debt, very few people would own homes or go to college. But it has a bad reputation right now chiefly because there’s so damn much of it.

People have for centuries borrowed to buy homes, but in the 2000s, they overdosed. Three key factors combined to move people into homes they couldn’t afford (in economic terms, risk was underpriced, and underpriced risk is always the breath in the straw that inflates the debt bubble). The first was financial engineering, in which mortgage loans were bundled together and sold to investors, which led lenders to be less concerned about the borrower’s ability to service that loan. Second was bad underwriting—an unwillingness by lenders to realistically assess the amount of debt people can safely carry. And third was an often overlooked but crucial backdrop to all of this: the lack of middle-class income growth. The real median income of working age households fell 10 percent from 2000 to 2010, from about $61,600 to about $55,300 in 2010 dollars. And that isn’t just a recessionary story—it fell from 2001 to 2007 when the economy was expanding. These are middle-class, working-age households. And when earnings are flat or decreasing, their only recourse is to tap credit markets, especially when credit is cheap and easy.

The Deficit and Its Discontents

Along with the mortgage-debt overdose and the recession it caused, another reason debt has a bad rep has to do with the way politicians have talked about and managed deficits and debt for years now. We should not lose sight of the political and ideological motivation against deficit spending. In an era when tax hikes are verboten, deficit reduction can be achieved only through spending cuts, and it has thus become a way of arguing for less government.

One of the most common refrains in today’s debate is that the federal government spends too much. There’s little substance to this claim: For decades, federal outlays have hovered around the historical average of 21 percent of GDP. Ronald Reagan and George H.W. Bush averaged around 22 percent; Bill Clinton and George W. Bush came in around 20 percent. And President Obama’s somewhat higher outlays are a function of the deepest recession in decades—take out that spending and he’s in the same historical ballpark.

What’s different—what’s largely behind the structural deficits in recent years (controlling for the cyclical downturn)—is the decline in revenues from the Bush tax cuts and their extensions, not to mention the wars in Iraq and Afghanistan. Since their introduction in the early 2000s, the tax cuts have diminished the nation’s tax bill by hundreds of billions every year. Over the next ten years, they are expected to add $3.6 trillion to the debt. Without these cuts, our medium-term budget (say, over the next decade) would be sustainable.

As long as new revenues are off-limits, attacking the deficit is equivalent to attacking the functions of government. That gives the anti-deficit argument strong ideological support from small-government advocates. But there are others who are not motivated by anti-government ideology but are misguided nevertheless. These are the conceptual mistakes they make:

Little attention to what the borrowing is for: Earlier, I noted the distinction between borrowing to consume and borrowing to invest. While both are legitimate reasons for governments to accrue debt, their implications are quite different. Borrowing to invest in productive infrastructure, for example, is different from borrowing to support inefficient health-care spending. Or think about it on a more personal scale: Borrowing to send a kid to college is an investment that, on average, produces lasting economic returns. Borrowing to finance a weekend in Vegas does not. Our deficit comes from both types of spending: investments with longer-term payoffs and those that feed current consumption. But few deficit hawks make the distinction. They should, because in cost-benefit terms, there are times when borrowing to invest in infrastructure or education will leave the country with better growth prospects, while deficit spending to finance high-end tax cuts has little, if any, positive impact on growth.

Little understanding of time horizons: When borrowing is truly temporary, it has little impact on longer-term deficits and the growth of the debt. Even large deficit spending, if temporary, is quickly absorbed by economic growth. The Recovery Act, with a price tag of about $800 billion, was a historically large stimulus, and it was wholly paid for by borrowing. But by 2012 it will add less than 0.5 percent to the deficit-to-GDP ratio, and nothing to the growth in the debt (it does add to the level of debt, of course; in other words, it raises the share of debt to GDP, but it does not contribute to the growth in that share). The Bush tax cuts, on the other hand, which are essentially permanent in terms of ten-year budget windows, keep adding to both annual deficits and the growth of the debt—on the latter point, they add 20 percent to the debt-to-GDP ratio this year and, if they remain in place, 34 percent by 2019.

There’s another timing point here, made forcefully in recent commentaries by Yale economist Robert Shiller. Economists and official budget scorekeepers like the Congressional Budget Office judge the sustainability of budget plans by whether the debt-to-GDP ratio is rising or falling. Shiller points out, however, that this conflates an annual measure—GDP—with a debt measure that is decidedly non-annual. We don’t have to refinance government debt all at once in a given year. For example, it might seem intuitive that if public debt were 100 percent of GDP, we’d be insolvent, but of course that’s not the case. During World War II, that ratio exceeded 100 percent, and for good reason. A decade later, it was 52 percent.

Again, timing matters. Temporary deficits, say, to offset a downturn, make a lot more sense than permanent, or structural, deficits in a recovery (“structural” in this context means that even with a healthy economy, the deficit would persist). Seemingly large debt burdens in a given year can be dealt with over the course of many years. But while Keynesian stimulus (such as the Recovery Act) is temporary by definition, the aging of the population and the rise of health care costs are not. The problem, once again, is not borrowing—it never is. It’s what are you borrowing for, how long you will need to pay for it, and how you are going to pay it back.

Cost of borrowing: As I write this sentence, five-year Treasury bills carry an interest rate of about 1 percent, a near historic low. Why so low? Because the economy is so weak, inflationary pressures are low, stocks are volatile, Europe is a mess—all of which make hyper-safe securities like T-bills a highly desirable investment. That’s actually an important and salutary dynamic in an advanced economy with mature capital markets. It signals that government should borrow and deficit-spend on temporary measures to stimulate growth.

At such low rates and with so much economic slack, fiscal policy needs to focus on increasing the denominator of the debt-to-GDP measure, not lowering the numerator. If we borrowed 1 percent of GDP at the current interest rates to make investments in the economy, and assumed a (conservative) multiplier of 1.2 (meaning every dollar spent creates $1.20 of growth), debt-to-GDP would, under plausible assumptions, barely budge as the boost to growth would at least partially offset the increment to the annual deficit. And a lot more people could get back to work.

The point is that when borrowing costs are low because of a recession and all the slack it causes—which is precisely what we’ve seen in recent months—that’s an important signal to the government to engage in temporary fiscal expansion. To do so has the benefit of reducing unemployment and boosting growth at comparatively little cost to the federal budget. To fail to respond to this signal is to consign millions to joblessness under the false pretense of fiscal rectitude.

Issue #23, Winter 2012
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Ever hear of the agency problem of economics? Well, the government has it. In spades. So more debt to an incompetent government, who engineered the crisis, and to its venal and equally incompetent campaign contributing revolving door bank cronies, will do nothing whatsoever. Except maybe land you a cushy sinecure, you damn proto-wannabe bureaucrat.

Dec 13, 2011, 2:53 PM
Robert Walker:

Mizrahi -- your comments (well, actually, one posted twice) are quite substantive and important to a resolution to our problems.
(Sadly, the vitriol almost sent me running before I took the time to see what you're trying to say.)
It would be insane to keep expanding a government with a poor track record. At some point, drastic measures need be taken to change the way government operates.
We hope we can accomplish this without resorting to anarchy while waiting for a new government to evolve.

regards, common man bob

Dec 13, 2011, 5:42 PM
Steve Bannister:

I would add Evsey Domar to the wise troika. He formally and clinically defined debt sustainability.

Dec 14, 2011, 7:14 AM

I don't really see any validation here of your claim that debt is an essential tool for growth. You say "Borrowing from the future to invest in the present is one way to improve that future." Well if that's the measure for essentialness, then I guess saving for future spending would also qualify. What makes spending now better than not spending now? If we could claim that the spending bought us something that matters, that would help. Putting people to work would be nice, but if you want the economy to function those people need to be creating value. This essay appears to me to be a very long-winded way of screaming "Breathe!" at a dying patient.

Dec 14, 2011, 3:50 PM

Mizrahi never read Irving Fisher's accurate description of a debt/deflation cycle Jared, so you're wasting your talent on him.

Plus Mizrah's favorite political party, I'm thinking, invented crony capitalism a century ago, and in 2002 eliminated paygo so they could run up the debt bill in good times. Madness.

Run the bill up. They're paying us to take their money. Time to invest instead of dropping bombs on Muslims, or paying oil companies not to drill.

Dec 14, 2011, 3:55 PM

I think Modern Monetary Theory economists like Warren Mosler make a better case against debt and deficit panic by pointing out the fundamental fact that government debt = private sector savings to the penny.

Treasury securities are in essence savings accounts and "paying off debt" when they mature is as simple and pain free as moving balances from these savings accounts to checking (reserve) accounts at the Fed.

Dec 15, 2011, 10:43 AM

Lots of good points in this article... But it's worth pointing out that it's ridiculous to increase the level of debt as a substitute for our generation's unwillingness (esp. that of our generation's rich) to pay their way. Taxes in the US are at historic lows and that's the main reason we have deficits and a national debt.

Secondly, public spending in a recession makes sense in theory... but given the way that the US economy has changed in relation to the world (given our status as a huge importer), we should think twice before just throwing govt money at growing our GDP... even in a recession. The multipliers now appear in China even more than here. It's time to think differently (at least for us to think differently). We should be targeting govt investment to create sustainable jobs and exports... like Europe, Japan and China. We shouldn't be funding "shovel ready" jobs that disappear with govt funding.

The folks setting policy, including Bernstein, need to get smarter. Flying our economy according to the old flight plans "ain't cutting it. "

Dec 15, 2011, 4:42 PM

And btw, I'd say the govt bailout of Chrysler is a prime example of useful govt investment. Investing in green tech would be great too... but in light of a recent "scandal", we have to expect that' we'll sometimes pick losers as well as winners.

Dec 15, 2011, 4:51 PM

To say government engineered the economic crisis is not reality based thinking. It is fantasy. Did government create CDOs (collateralized debt obligations) that purposefully confused investors and cheated them? Did government gamble with Credit Default Swaps which still hang like death over credit markets? No. The government, shackled by ideology based thinkers in the Bush Administration and Congress, tied the hands of regulators that were prevented from doing the jobs that they were legally obligated to pursue. Republicans caused the economic crisis, then blamed in on government because government didn't let "bad firms fail." What a laugh. That was GW Bush and Wall Street's policy, pushed heavily by Republicans. That thinking is the cause of the economic crisis, not the government whose proper function is regulating the abuses of the private sector. It's time to let government do the regulatory job that it, and only it, can do.

Dec 15, 2011, 8:04 PM

"A precious few economists warned of the housing bubble, which was the root cause of the recession."
This is oversimplification to the Nth degree. The "bubble" was not a bubble until two triggers:
1. Job loss...can't pay the mortgage without a job, duh!
2. Effective default of the credit insurance sector...AIG, for example and the incorrectly rating junk derivatives as AAA with no reserves to cover real mortgage defaults. Buffett called them financial weapons of mass destruction for a good reason.

Dec 17, 2011, 7:42 AM
Lonnie Palmer :

Excellent essay. I am frustrated by President Obama's occasional comments that signal some level of agreement with the "We must shrink government and deficits immediately crowd." While these comments play well the political analysts who think they know what independents want (smaller government is their latest guess) these comments inadvertently help to spread harmful misunderstanding regarding when and how much the federal government needs to borrow. As the author has stated the US government should be paying down debt during good times and increasing borrowing to create missing demand during a slack economy. This isn't rocket science. It's Economics 101 in college.

Dec 17, 2011, 8:30 PM

... timing the market? Perhaps I can sell you some stock?

Dec 19, 2011, 1:25 PM
Li /Germany:

The problem about debts is, that they make you dependent on the loaner. Means, if the state borrows money from banks you have to do what banks want you to do. And this means that politics in made by banks and not by the government and the people of a nation.

If America wants to be a free nation, they have to be free of debts first of all.

Though, bankers will tell you the opposite, for obvious reasons.

Feb 1, 2012, 3:07 PM

People like that below me really discredit their own opinion with their anger, and also apparently didnt read the whole piece and completely deny the foundation of historical knowledge that support the basic ideas of public spending. Cronyism in our capitalism and an over concentration on incumbant economic power is a real problem, and legitimate concern, but the fear based reactionary criticism of strongly supported ideas is out of focus, a true rejection of all relevant information.

Feb 3, 2012, 10:46 PM

People like that below me really discredit their own opinion with their anger, and also apparently didnt read the whole piece and completely deny the foundation of historical knowledge that support the basic ideas of public spending. Cronyism in our capitalism and an over concentration on incumbant economic power is a real problem, and legitimate concern, but the fear based reactionary criticism of strongly supported ideas is out of focus, a true rejection of all relevant information.

Feb 3, 2012, 10:48 PM

I am curious about how GDP is mesuared. To me, it seems that our collective wealth as a nation that we all share is made up of goods and services. However, some "services" would be questionable as to whether to include in GDP. For example, any and all services that pertain to income tax, including IRS personnel, tax accountants, and tax lawyers. These services are needed only because we have an arcane tax system that IMO takes away from our collective wealth. If we did not have that ridiculously complex system, most of the people employed in that arena could make more productive contributions to our wealth in some other sector.More generally speaking, most government workers do not add to our real wealth. If those individuals were working for themselves or for companies that produce something useful, our collective wealth would be greater.So if the GDP has increased only because of the expansion of government, I would question the method of GDP calculation.(Over the weekend I read that Federal workers now receive pay that is 20 percent more than their counterparts working in private industry. If you include their benefits package, they receive 50 percent more than workers in private industry!)

Sep 22, 2013, 8:31 PM

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