The Western world is suffering a crisis of excessive indebtedness. Governments, corporations and households are groaning under unprecedented debt burdens. Average household debt has reached 141% of disposable income in the United States and 177% in Britain. Worst of all are the banks. Some of the best-known names in American and European finance have liabilities 40, 60 or even 100 times the amount of their capital.
Saturday, 7 February 2009
Another article (this time by Niall Ferguson, of whom more later) on the too-much-debt theory. The subtitle is: "Governments cling to the delusion that a crisis of excess debt can be solved by creating more debt".
Well, this isn't a crisis of excess debt. To the extent that credit problems are responsible for the recession, it is a reduction in the availability of credit that has triggered it.
Ferguson may think that companies and individuals owe too much. But who do they owe it to? Er, other companies and individuals!
He doesn't present much evidence for the "too much" theory, except an assertion:
Ferguson obviously thinks these numbers sound high. But who knows? What is the correct number? What should our target amount of debt be? Government debt in the past has reached 200% and 300% of GDP (after major wars) and been paid off. So has private debt. Why shouldn't bank liabilities be 100 times their capital - after all, their assets are 100 times too.
While building up my company, I've certainly had much more debt as a percentage of disposable income than the numbers Ferguson cites. I don't any more. If I hadn't taken on those loans, I wouldn't have the business now. The loans were an essential part of coordinating current and future activities in order to create a productive business. And my ratio of liabilities (or assets) to capital? At its peak, maybe 2000 or so. It just doesn't take that much capital to run a software business.
This attitude arises from forgetting the difference between me and us. It's a useful aspiration for individual people, as they go through life, to build up financial assets. Not perhaps as useful as it is to build up income, but still, the two numbers are partially correlated. Few 20-year-olds have much in the way of investments to draw on, but the average 55-year-old (in the developed world) has a reasonable sum. This is usually what enables us to retire around 60 (and withdraw our productive skills from uses that can make people better off - but that's a different argument).
But this does not mean that the whole world can build up financial assets. Every asset I have (that is, each pound I have invested or lent) is a liability of someone else. It's only someone else's debt that enables my credit.
Does it feel tragic to realise that, for all the saving, investing, profits and dividends that people and companies have built up over the years, the whole world's financial asset base has a value of: zero! It shouldn't. These assets are just a promise for one person to pay money (or resources) to another person in the future. Every promise has two sides, the giver and receiver of the promise; and thus every debt has an asset.
So these figures - 141%, 177%, 500%, whatever - are simply measures of how many promises people in the world have made to each other. Nobody has a useful theory (that I've seen) of the number or strength of promises that people should make to each other; Ferguson does not propound one in that article, except the implied idea that "if I had that much debt I wouldn't feel comfortable". Well, that's a statement about someone's feelings, not economic reality.
Incidentally, Ferguson does have a few reasonable policy proposals in the article. But they come from a flawed premise, and thus the chain of reasoning seems likely to be incorrect too. Funny how our instincts can keep us on track in building an argument, pulling us back from the obviously-wrong conclusions that our premises may logically imply. But this is just a newspaper article; no doubt in an academic paper one would argue more clearly from premise to result.
Back to the recession. Each reduction in a debt is also a reduction in someone else's asset. And if they both shrink faster than the holders desire, both will be unhappy; and their ability to carry on the productive work that they were previously doing, will be reduced.
This withdrawal of credit and the dislocations that result have led to people and resources sitting idle, and output falling. The reason governments are trying to boost the debt in the economy is to counter this fall. Excessive debt did not cause this crisis - the problem with debt is that we can't get enough of it any more.
Update: Brad DeLong comes to similar conclusions about Niall Ferguson's reasoning, though for slightly different reasons.