Sunday, 18 January 2009

More debt please

While the amount of net debt across the world is always zero, the amount of gross debt is not. And gross debt has reduced substantially in the last year as firms and consumers are deleveraging.

An interesting post from Steve Waldman at Interfluidity praises this trend. I'm not convinced by his conclusion but he does contribute something rarely visible in economics commentary - a good philosophical understanding of what debt is.

"Credit, also known as debt, is one of several arrangements by which a party with the power to command resources but lacking aptitude or interest in managing a productive enterprise delegates wealth to another party who is capable of creating value but unable to command sufficient resources."

I would put it slightly more generally: Debt is a promise to give resources to another party in the future. On this view, the gross amount of debt in the world is a representation of the number of promises we have made to each other.

A promise is a restriction on your future freedom, but one that you have voluntarily entered into to increase your freedom in the past. It could certainly be argued that this restriction on freedom is not a good thing - presumably freedom in general is beneficial. But we do accept all sorts of restrictions on freedom because they benefit us - we agree to obey laws, submit ourselves to an elected government, drive on the correct side of the road, and make general social accommodations with the people around us.

The restrictions must be measured against the benefits gained. The network of promises embodied in debt are a powerful factor binding together humans in a common enterprise where we agree to make life better for each other.

Indeed, debt is not an absolute loss of freedom - it is a promise that you can break, though there are usually consequences to doing so. Throughout our lifetimes, past and future, actions and consequences, interact in complex ways, and debt is one of the integrating structures for our lives.

As Steve points out, it's not the only one:

"You would be forgiven for not noticing, given how habitually we misuse credit, but supplying credit is really just a subspecies of the practice that used to be called "investing". There are a variety of other arrangements that serve the same economic function. Perhaps you have heard the terms like "common stock" and "cumulative preferred equity"? In fact, credit is to investing what heroin is to painkillers: Unusually appealing, in a certain way. Hard to kick once you're on it. Almost certain to, um, cause problems, eventually."

He rates equity as preferable to debt (for investment purposes) which is a view I'm sympathetic with because it makes the economic system less brittle. However he doesn't much like consumer debt. That I'm not so sure about. I'm not yet ready to defend it strongly but I don't feel Steve makes a convincing argument against it:

"Credit availability creates winners (self-today) and losers (self-tomorrow), while interest payments reduce the size of the overall pie available to the time series of selves."

However, total utility generally is increased when wealth is transferred to a poorer party (self-today) from a richer one (self-tomorrow), because the marginal utility of money is greater when you have less of it. Does this outweigh the cost of interest? That question has a case-by-case answer, but in general why shouldn't it?

Finally he argues for transfers from wealthy to non-wealthy people as an alternative to debt. Of course, this is happening anyway as part of the fiscal stimulus that most countries are implementing - but I assume he would like to go further.

"The world is full of human want, which we should strive to meet by working to increase our capacity to produce. Problems arise when want and purchasing power are misaligned. We can improve that by redistributing some of the purchasing power from those with lesser to those with greater use for current consumption. If that sounds Commie to you, note that is precisely the function that consumer credit traditionally serves, just without all the residual claims, a large fraction of which will prove to be illusory (at least in real terms). That is, transfers are just a more honest way of doing precisely what a credit expansion does, except without the trauma that comes from learning that much of the money lent to fund current consumption will never be repaid."

Politically I see the appeal of this as an aspiration, but I don't think it is very realistic. The amount of resources that could be forcibly transferred, in any democratic political system, is small compared to the amount that people can borrow when they promise to pay it back. In addition, transfers only make sense as a mechanism to move money from rich people to poor people. Debt allows people of similar wealth also to exchange their wants through time - lots of debt, perhaps most, is held by middle-class people and comes from the savings of other middle-class people.

The amount of consumer debt that will "never be repaid" even in a crisis like 2008's is surely less than 5% of all outstanding consumer debt, which makes this quite a radical fix for a system which is not really broken.

I even believe it's plausible that the optimal amount of debt could be much higher than today's level (though I'm not sure). Quick thought experiment:

If someone could make a transformational difference in your productivity or quality of life, wouldn't you be willing to commit (say) 10%, 20% or even more of your income to them in return? (If you say no, you have presumably never been married or had children.) If you think that borrowing money can't make that kind of difference in your life, then I say you need to be more imaginative. It undoubtedly can, when invested well; and as Nick Rowe pointed out to me, the line between investment and consumer spending is far from clear.

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