Debt, a little like sex, is a two-sided relationship which, when used appropriately, pleases the partners and is good for society. But both are also intoxicating and can easily become excessive and anti-social.
The financial bubble of the 2000s was the financial equivalent of the 1960s enthusiasm for “free love”. The delights of nearly free debt set pulses racing. Since the financial collapse, the dangers of uncontrolled borrowing have been recognised, but the bad habits have hardly changed.
When debt is used as it should be, lenders receive a just return on their assets and borrowers pay a just price for the use of the fruits of other people’s labour. Loans finance helpful investments and assist governments and individuals to manage periods of adverse fortune. But debt can also be used for promiscuous pleasure-seeking, unaffordable consumption, unjustified corporate investments and excessive government spending.
In the recent debt party, the United States led the world. The ratio of total U.S. debt (private, corporate and government) to GDP increased from 256 to 373 percent between 1997 and 2008, according to Federal Reserve calculations. The whole country borrowed from foreigners to fund its trade deficit. The financial sector borrowed cheaply and invested dangerously to increase returns and remuneration. Homeowners borrowed more and more to buy more expensive houses.
At first, all this indulgence appeared to be beneficial. GDP growth was strong, consumption was high, unemployment was low and higher asset values – the other side of higher debts – made borrowers feel richer. But when Lehman Brothers failed in 2008, the dangers of frequent debt relations with multiple financial partners became clear. With everyone borrowing from each other, losses on bad loans, and the fear of further losses, spread rapidly around the world. A Lesser Depression set in, and there is no end in sight.
Despite much talk about the end of an era of hedonistic borrowing, financial rectitude remains a distant prospect. Governments have stepped up borrowing just about as much as the private sector has cut back. In the United States, debt remains an alarmingly high 359 percent of GDP.
What can be done to restore financial order? For irresponsible borrowing, a sudden outbreak of prudence would probably aggravate the economic problem. The economist John Maynard Keynes called it the paradox of thrift. If everyone tries to save more and spend less, the result will be a decline in total consumption, which leads to higher unemployment and then to more saving against rainy days. The desire to prevent such a spiral of decline lies behind the today’s low official interest rates, high government borrowing and generous support for banks.
These policies are supposed to spur enough GDP growth to reduce debts without economic pain. That sound like wishful thinking. As long as debts remain high overall, the whole financial structure will remain vulnerable and full recovery elusive. The euro zone crisis shows just how little it takes – a few small weak governments and some political wavering – to frighten lenders and deeply disrupt developed economies. With so much leverage about, other crises will be almost unavoidable.
What is needed is a large and fast decline in borrowing – a systemic deleveraging – to give over-indebted rich nations a fresh start. Sadly, there is no easy way to proceed. A gigantic debt write-down would do the trick, but creditors would be furious. Think of how the Chinese government would feel about being told that its $2 trillion dollars of U.S. government debt is now worth half as much, or how current and future pensioners would react to big losses in portfolios they thought were safe.
Mandatory inflation – say a law which doubled all wages tomorrow – would also reduce the ratio of debt to GDP, and would also infuriate savers and creditors. Alternatively, newly minted money could be used to stimulate economic activity through the creation of new jobs and the repayment of old debts. However, when governments feel free to create rather than to borrow money, they rarely stop before the rate of inflation rises dangerously high.
All of these techniques for deleveraging are risky. But I believe a clever and internationally coordinated combination of debt write-downs, inflation and controlled money creation is the best way to engineer a durable decline in leverage without destroying financial trust. Such radical techniques could work, given enough political support and sufficiently imaginative regulation.
The alternative to daring action along these lines is the continuation of something like the current policies. That amounts to persisting with the “nearly free debt” experiment, which will only lead to years of depressed economic activity and outbreaks of unpredictable financial losses. It’s worth trying something new and different to put debt back in its rightful place.