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Rethinking Debt
Washington refuses to understand that debt can be an essential tool for economic growth. Can we overcome this irrational and destructive fear?
Minsky proceeded from two key insights, both of which diverged sharply from the orthodoxy of the day (he died in 1996): first, the centrality of debt to a functioning economy, and second, the tendency of financial markets toward instability. As I stressed at the beginning of this essay, the basic idea of debt is not only sound but essential to growth. Borrowing from the future to invest in the present is one way to improve that future. And some of the economic gains that flow from the investment will be used to pay down the debt.
Minsky’s second insight, about instability, was once nicely summed up by the great game theorist Yogi Berra, who pointed out, “It’s tough to make predictions, especially about the future.” So uncertainty and risk must be accounted for, and in a rational market, the rate of interest would put a price on the loan that accurately reflected its risk. And in fact, that’s often the case at the beginning of economic recoveries. Growth is newly back on the scene, businesses and households start to get active again, and lenders tend toward a reasonable degree of caution in evaluating their loan prospects.
However, as the recovery ages and growth picks up speed, risk aversion diminishes. Loans that didn’t seem creditworthy a year ago start looking pretty good. Minsky also recognized that new forms of lending often begin to sprout up at this stage—“innovations” that enable their inventors to lend into the accelerating cycle ahead of their competitors. These innovations may be poorly understood, and not just by the borrower, but by the lender as well. They may involve gambles that can’t possibly end well, such as loans whose repayment is wholly dependent on a price bubble in the underlying asset, or even outright fraud, like what came to be called “liar loans,” where lending intermediaries ignored or falsified documentation to create the appearance of credit worthiness.
Minsky’s model could be viewed mistakenly as simple common sense: a) Debt financing is pro-cyclical, and b) lenders get sloppy (or cryptic) as the cycle proceeds. But his model says more than this. As Cassidy puts it, “At the risk of oversimplifying, Minsky’s argument can be reduced to three words: stability is destabilizing.” Under this model, debt can be like a virus in the body of a business cycle. It starts out supporting the organism in ways salutary and safe, but is unable to modulate its growth, and it ultimately infects the system under the weight of leverage.
Our failure to understand this dynamic has led to our current pass: a fixation on debt when the system needs more of it, and complacency about debt when we need vigilance. Minsky would have recognized the signs that something was amiss as the 2000s debt cycle shifted into overdrive. The underpricing of risk, financial innovations, leverage ratios that were multiples of their historical averages, and the shadow banking system—all signaled that the virus had been activated and would soon destabilize the system.
Where Does This All Leave Us?
As I’ve stressed throughout, debt is not just important—it is an essential tool of economic growth. Neither families nor firms nor governments can adequately help themselves or their constituents without the ability to borrow from the future to spend or invest in the present. Yet market and political failures have undermined this essential function, and the politics of budget deficits have devolved to the point where, at least rhetorically, any debt is bad debt. It is impossible to overemphasize the lasting harm done by this anti-deficit fervor.
The good news is that—putting politics aside—all of this is fixable. The United States still hosts mature, flexible, adequately capitalized credit markets. In fact, credit markets are working exactly as they should be right now, with interest rates signaling us—if not screaming at us—to borrow and apply fiscal stimulus. Over at the Federal Reserve, the interest rate has been stuck at zero. But households are still deleveraging and still on insecure economic ground, so they’re not much moved by the low rates. It’s the same with firms that are flush with cash reserves but not moved to use them unless they see a profitable reason to do so.
What’s needed is more demand, more customers, more factory orders. Absent those, monetary stimulus—the Fed’s Operation Twist, quantitative easing—risks “pushing on a string.” But if more folks could get back to work and increase their hours and paychecks, then businesses would see more foot traffic and investors could see some profitable openings. As Vice President Biden’s chief economist, I saw up close that the Recovery Act helped significantly in this regard. Upon its passage, the loss rates of both GDP and jobs began to diminish; GDP turned positive in mid-2009 and employment began to grow in the spring of 2010. But while the Recovery Act (along with aggressive monetary policy by the Federal Reserve) arrested the decline, it only helped shift the economy from reverse into neutral. We’re stuck in the doldrums with deep excess capacity, and monetary policy alone can’t get us out. We need temporary measures that would borrow a lot more; I liked the President’s jobs plan but I’d have gone twice as large (though truth be told, in today’s climate it’s actually an ambitious plan). But we won’t do it because we’re too damn scared of deficits and debt.
We also have the means to take a solid stab at fixing the instability cycle in financial markets. That’s the purpose of the Dodd-Frank financial reform legislation, which I view as the first real attempt at “Minsky insurance”—that is, of protecting against the next financial instability cycle-debt bubble—in decades. It’s not perfect, but it has the right attributes, all of which could be fine-tuned if we can only fight back against the amnesiacs who can’t remember what happened a few years ago.
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 PMMizrahi -- 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 PMI would add Evsey Domar to the wise troika. He formally and clinically defined debt sustainability.
Dec 14, 2011, 7:14 AMI 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 PMMizrahi 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 PMI 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 AMLots 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 PMAnd 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 PMTo 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.
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 PMThe 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 PMPeople 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 PMPeople 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 PMPost a Comment
Jared Bernstein is a senior fellow at the Center on Budget and Policy Priorities and was formerly chief economist to Vice President Joe Biden.
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