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June 30, 2014

The problem of debt

"The only man who sticks closer to you in adversity than a friend is a creditor." -- Anonymous

Robert Samuelson has a piece up on RCM today talking about a proposal by the Bank of International Settlements (BIS) for governments to move away from traditional business-cycle centric monetary policy and towards a "financial-cycle" monetary policy. It's an interesting idea, but Samuelson lays out the basic problem:

All this will prompt pushback. Mainstream economics still commands the intellectual heights. How can we ignore the business cycle? Optimism - consumers' and firms' willingness to spend - presumes that governments respond to economic weakness. This seems especially relevant now with a fragile global economy. Even if we agree with the BIS, do we have the tools to adopt its advice? Within limits, debt is desirable. It aids economic expansion and allows families and firms to invest in the future. Do we know when debt is "excessive"?

Before we start talking about debt, I want to define what debt is, at a conceptual level. Basically, debt is a mechanism whereby I can pay for present expenses or purchases with future earnings (and that includes things like building factories or hiring more workers). And since money I haven't earned yet doesn't exist (which is to say that the value has not yet been created), I have to use someone else's money, and they'll charge me a premium to do so. Why? Because a creditor incurs a cost by loaning me the money. If I have the money, the creditor doesn't have it, and thus they can't use it for their own purposes. Interest is the price we put on the opportunity costs incurred by loaning money.

There are good reasons to take on debt. But accrual and management of debt also requires a great deal of discipline, and it's a kind of discipline many people find it hard to exert.

In the days of the early internet, John Gilmore said "[t]he internet interprets censorship as damage and routes around it." I sometimes wonder if we should start treating debt-financing the same way, of treating debt as damage and routing our financial institutions around it.

The main objection is that this is not possible in the modern world, that the world economy simply cannot function without debt. There is some truth to this; it's important to remember that debt is the obverse of investment -- it's hard to have one without the other. Money invested by me is money borrowed by someone else. Abolishing debt entirely (even if we could do such a thing) would also abolish most kinds of investment. But this means that "excessive debt" is also a problem of excessive liquidity, which in turn is often associated with loose monetary policy.

The basic truth is that debt is a tool, a very ancient one (perhaps a primordial one). It is probably inseparable from a functional economy. But like any tool, it can become a terrible hazard when misused, and there is mounting evidence that excessive debt is becoming a systemic risk from the level of world governments all the way down to individual households. Some economists think that this is caused by monetary policies followed by American and European governments in the post-World War II era which have preferred high rates of GDP growth driven by debt-financed spending.

The upside of this expansionist policy is in the enormous rise of the standard of living in most western countries; the downside is the enormous and growing pile of debt. It's becoming terribly clear that debt-financed spending at the levels we've been maintaining are not sustainable. Debt-financed spending only works, it appears, when the growth of the larger economy outpaces the servicing costs of the debt that's driving it.

American household debt has been increasingly concerning to many economists, because the pattern of family debt has been changing. Credit cards have become a way for Americans to spend as their government does: as a short-term income supplement rather than an extraordinary expenditure. Many Americans now use credit cards to cover basic expenses --- groceries, clothes, even mortgage payments and university costs for the kids (thus using one kind of debt to cover another kind of debt). And just as with the debt-financed spending conducted by the government, this kind of spending is not sustainable -- the costs of servicing the debt will almost inevitably outstrip the debtor's ability to pay down the debt. This problem is especially acute in a stagnant economy where wage-growth isn't growing as fast as the debt.

I'm not sure there is a solution to this specific problem without going back to some hard-money standard. The extreme level of debt we currently carry is bound up with our fiat-money regime -- remember, excess debt and excess liquidity go hand in hand. The Fed's dual mandate of keeping inflation low and employment high are completely at odds with each other at this point in time, and this is also to some extent an artifact of a fiat-money regime. But many of the problems facing our economy are deeper and more intractable than mere monetary policy: changing demographics, a globalized workforce, a highly-asymmetrical international trade structure, and so on.

Extreme levels of debt pose a systemic risk not just to our government, but to our very culture and social fabric. If we think of economics as a kind of technology (which it is, among other things) then it's clear that we need to develop a better and more robust technology to solve the problem of debt.

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posted by Monty at 09:00 AM

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