DEBT good or bad

Can Debt Cure a Problem Created by Debt? One of the common arguments against fiscal policy in the current situation—one that sounds sensible—runs like this: “You yourself say that this crisis is the result of too much debt. Now you’re saying that the answer involves running up even more debt. That can’t possibly make sense.” Actually, it does. But to explain why will take both some careful thinking and a look at the historical record. It’s true that people like me believe that the depression we’re in was in large part caused by the buildup of household debt, which set the stage for a Minksy moment in which highly indebted households were forced to slash their spending. How, then, can even more debt be part of the appropriate policy response? The key point is that this argument against deficit spending assumes, implicitly,that debt is debt—that it doesn’t matter who owes the money. Yet that can’t be right; if it were, we wouldn’t have a problem in the first place. After all, to a first approximation debt is money we owe to ourselves; yes, the United States has debt to China and other countries,net debt to foreigners is relatively small and not at the heart of the problem. Ignoring the foreign component, or looking at the world as a whole, we see that the overall level of debt makes no difference to aggregate net worth—one person’s liability is another person’s asset. It follows that the level of debt matters only if the distribution of net worth matters, if highly indebted players face different constraints from players with low debt. And this means that all debt isn’t created equal, which is why borrowing by some actors now can help cure problems created by excess borrowing by other actors in the past. Think of it this way: when debt is rising, it’s not the economy as a whole borrowing more money. It is, rather, a case of less patient people—people who for whatever reason want to spend sooner rather than later—borrowing from more patient people. The main limit on this kind of borrowing is the concern of those patient lenders about whether they will be repaid, which sets some kind of ceiling on each individual’s ability to borrow. What happened in 2008 was a sudden downward revision of those ceilings. This downward revision has forced the debtors to pay down their debt, rapidly, which means spending much less. And the problem is that the creditors don’t face any equivalent incentive to spend more. Low interest rates help, but because of the severity of the “deleveraging shock,” even a zero interest rate isn’t low enough to get them to fill the hole left by the collapse in debtors’ demand. The result isn’t just a depressed economy: low incomes and low inflation (or even deflation) make it that much harder for the debtors to pay down their debt. What can be done? One answer is to find some way to reduce the real value of the debt. Debt relief could do this; so could inflation, if you can get it, which would do two things: it would make it possible to have a negative real interest rate, and it would in itself erode the outstanding debt. Yes, that would in a way be rewarding debtors for their past excesses, but economics is not a morality play.Just to go back for a moment to my point that debt is not all the same: yes, debt relief would reduce the assets of the creditors at the same time, and by the same amount, as it reduced the liabilities of the debtors. But the debtors are being forced to cut spending, while the creditors aren’t, so this is a net positive for economywide spending. But what if neither inflation nor sufficient debt relief can, or at any rate will, be delivered? Well, suppose a third party can come in: the government. Suppose that it can borrow for a while, using the borrowed money to buy useful things like rail tunnels under the Hudson, or pay schoolteacher salaries. The true social cost of these things will be very low, because the government will be employing resources that would otherwise be unemployed. And it also makes it easier for the debtors to pay down their debt; if the government maintains its spending long enough, it can bring debtors to the point where they’re no longer being forced into emergency debt reduction and where further deficit spending is no longer required to achieve full employment. Yes, private debt will in part have been replaced by public debt, but the point is that debt will have been shifted away from the players whose debt is doing the economic damage, so that the economy’s problems will have been reduced even if the overall level of debt hasn’t fallen. The bottom line, then, is that the plausible-sounding argument that debt can’t cure debt is just wrong. On the contrary, it can—and the alternative is a prolonged period of economic weakness that actually makes the debt problem harder to resolve. OK, that’s just a hypothetical story. Are there any real-world examples? Indeed there are. Consider what happened during and after World War II. It has always been clear why World War II lifted the U.S. economy out of the Great Depression: military spending solved the problem of inadequate demand, with a vengeance. A harder question is why America didn’t relapse into depression when the war was over. At the time, many people thought it would; famously, Montgomery Ward, once America’s largest retailer, went into decline after the war because its CEO hoarded cash in the belief that the Depression was coming back, and it lost out to rivals who capitalized on the great postwar boom. So why didn’t the Depression come back? A likely answer is that the wartime expansion—along with a fairly substantial amount of inflation during and especially just after the war—greatly reduced the debt burden of households. Workers who earned good wages during the war, while being more or less unable to borrow, came out with much lower debt relative to income, leaving them free to borrow and spend on new houses in the suburbs. The consumer boom took over as the war spending fell back, and in the stronger postwar economy the government could in turn let growth and inflation reduce its debt relative to GDP. In short, the government debt run up to fight the war was, in fact, the solution to a problem brought on by too much private debt. The persuasive-sounding slogan that debt can’t cure a debt problem is just wrong.