Few things as indispensable as debt are regarded with such dismay. Samuel Johnson called it a calamity and Ralph Waldo Emerson likened it to slavery. People are “saddled by” or “drown in” debt. Yet without debt, capital would be less mobile. The Industrial Revolution would not have been the explosion of growth that it was. Alexander Hamilton – who spent much of his life managing debt as the first US treasury secretary – famously said that “a national debt, if it is not excessive, will be to us a national blessing”. But at what point does debt change from a blessing to a curse?
Two new books on debt provide answers. Between Debt and the Devil, by Lord Adair Turner, and What We Owe, by Carlo Cottarelli, explore the exceptionally complex role of debt in modern society and shed light upon some of the more common areas of confusion. In some ways these books couldn’t be more different. Lord Turner’s probes both private and public debt whereas Cottarelli’s is limited to the latter. Turner’s is more technical and draws on a wide range of research whereas Cottarelli’s is shorter and more accessible. Both, however, are written by men who held significant posts immediately following the 2007-8 financial crisis, with Turner as chairman of Britain’s Financial Services Authority (abolished in 2013) and Cottarelli the director of the International Monetary Fund’s Fiscal Affairs Department. These are authoritative voices that ought to be heard.
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To understand the role of debt in modern society, a good starting point is to examine the view that all debt creation is inherently good. Turner begins his book by challenging this seemingly radical notion that wasn’t far from economic orthodoxy leading up to the financial crisis. The idea is simple: what economists call “financial deepening” – a rise in private sector debt – must be good because it ensures better “price discovery”, and ultimately more complete markets. The more debt, and the more accurately that debt is priced, the more transparent and efficient the economy because information is better utilised and capital better allocated. It follows that financial innovation – the development of complex derivatives, for example – is, in a favourite phrase of Turner’s, “axiomatically beneficial”.
This theory, though elegant, chafes with reality. Asset values are determined by more than just rational price discovery, or new information about how businesses will perform. Turner invokes John Maynard Keynes to argue that they’re also influenced by irrationality – the animal spirits and madness of crowds. A proponent of financial deepening would counter that irrationality tends to cancel itself out (there are likely to be as many irrational buyers as irrational sellers), and even if there was an excess of irrationality, rational arbitrageurs would discover this, exploit it, and thereby revert the market back to an efficient state. But while it’s true that arbitrage can accomplish this for individual stocks and bonds relative to others, Turner emphasises that this cannot be done for the whole market. In other words, the market may establish efficient prices relative to one another, yet still move, as a whole, in an irrational fashion.
This idea that something can be rational or efficient on a micro level yet irrational and inefficient on a macro level is one of two central arguments that Turner advances. His analogy of choice is pollution. While heating a home is socially valuable, the heating of many homes creates unsustainable carbon emissions. It’s the same with debt. Lending to a family to buy a house is socially useful, but a glut of mortgage debt can make an economy unstable. This holds even if all mortgages are good mortgages, and not subprime. So even if all outstanding debts were good debts, there is still such a thing as too much debt – there’s such a thing as “debt pollution.”
"Something can be rational on a micro level yet irrational on a macro level”
Turner’s other main argument is that there can be too much of the wrong kind of debt. He draws on data from the IMF, Bank of England, and French economist Thomas Piketty to demonstrate how, over the last century, there has been a massive increase in real estate debt, reflecting not so much a rise in the value of buildings that are constructed but rather a rise in the value of the land on which those building sit. (To illustrate the explosion of value in urban land, Turner shows that if the gardens surrounding central Tokyo’s Imperial Palace were available for building, the market price would be equivalent to all the land in California). The issue with land is that it’s finite. So banks are creating potentially limitless credit tethered to a limited commodity. Turner argues that this inevitably results in boom and bust cycles, which will always be a threat insofar as housing receives a disproportionately large share of total investment.
This problem is exacerbated when another sector’s share of total investment shrinks. Eric Brynjolfsson and Andrew McAfee of the Massachusetts Institute of Technology have argued that information and communication technology (ICT) is unique for two reasons: hardware prices are halving roughly every 12 to 18 months, and software, once developed, is replicable at virtually no cost. The result is rapidly falling prices in ICT. Turner draws on these findings to show how falling ICT prices equates to a higher share of investment moving to those parts of the economy where prices are not falling – construction and real estate – thereby aggravating the imbalances that lead to crisis. So when a company like Facebook creates “huge wealth with very little capital investment” – a 2014 valuation of $150bn with fewer than 5,000 employees – this isn’t necessarily a cause for celebration.
Cottarelli’s What We Owe is a different sort of book from Turner’s in that it explores just one class of debt: public debt, or what a country owes. Misconceptions abound about the difference between public debt and deficits, what counts towards public debt, when public debt becomes a problem, and how public debt can be reduced. What We Owe deftly clears the air on these topics in what amounts to a short primer on one of the most elusive issues for the interested layperson.
Cottarelli opens with an admonition: “Never trust those who tell you that a government’s budget is like a household’s budget.” Yet this is exactly what politicians imply when they urge the need to “fix the roof while the sun shines” or liken fiscal deficits to credit card debt. Many scholars will distinguish household from government debt by pointing out that the latter directly influences economic growth, which is why government spending can be used strategically to stimulate demand. Cottarelli makes a much simpler distinction: government debt is different because governments can tax people. And because of this unique power, lending to the government is widely regarded as safe.
“If the gardens surrounding central Tokyo’s Imperial Palace were available for building, the market price would be equivalent to all the land in California”
But it’s only safe until it’s emphatically not, at which point people lose all faith in whether a government’s debt can be repaid. Someone who dips into a book like Cottarelli’s is likely seeking clarity on when this tipping point occurs. The IMF, where Cottarelli was fiscal affairs director for six years, has established a “debt threshold” of 70% of GDP for emerging markets and 85% for advanced economies – beyond this red flags are raised. But the size of a country’s debt alone says very little about the risk of default. Other relevant metrics include the proportion of debt owed to foreign investors (the higher, the riskier), the amount of existing private debt, and whether public debt is rising. On this last point, Cottarelli has carried out econometric research showing that what prompts a government default “is not high debt but high and rising debt.”
Another important factor is how much debt is held by the central bank. This sort of borrowing is effectively free because central bank profits are returned to the government. Public debt statistics, however, don’t actually make a distinction between public debt held by the central bank and public debt held elsewhere. Yet Cottarelli points out that in the years following the financial crisis, the Federal Reserve bought about a third of the increase in the US public debt, the Bank of England offset more than half the rise in UK public debt-to-GDP ratio, and the Bank of Japan bought up nearly all the increase in Japan’s public debt. Japan is probably the best example of how the size of a country’s debt doesn’t tell the full story. While its gross government debt as a percentage of GDP is by far the largest in the world at 238%, 90% of that is domestic (lesser chance of default), much of it has been purchased by the Bank of Japan (effectively free), and the Japanese government holds large amounts of financial assets. This last point is important because, as Cottarelli explains, the interest receipts on these assets can be used to pay off the interest on public debt.
In some respects debt will always be intractable. It may forever remain difficult to have, to dispense with, to forgive, even to calculate. But it shouldn’t be difficult to understand. Thanks to books like Turner’s and Cottarelli’s, it doesn’t have to be.