I was listening to Megan McArdle on the EconTalk podcast the other day. (By the way, I recommend the EconTalk series for any real economics wonk. The subject matter is often not particularly investment related and it usually runs about an hour, but it's my clear favorite podcast.) The subject of the podcast was Megan's Atlantic article titled "Lead us not into Debt" and the subject of consumer debt generally. At one point in the conversation the question is raised, is debt inherently bad?
The host, Russ Roberts, made the point that recently many in the media have suggested that consumers need access to debt in order to finance current spending, lest we suffer some sort of economic disaster. It's not clear that the Fed agrees with this sentiment given how they've pushed the TALF for consumer asset-backed securities. Roberts questions whether this is really true, whether debt isn't, at least, more bad than good.
I'm a bond trader. Debt is my life. Granted, I'm more of a lender than a borrower professionally, but long-time readers will remember my defense of both the TALF and the bank bailouts as beneficial to main street primarily because I saw a functioning debt market as a necessary condition for a modern economy to function.
Roberts isn't the only one asking this question. Based on the comments and the e-mails I receive, I think many readers are sympathetic to this view. And its a great question, especially in light of the fact that our collective debts are what caused the financial crisis. Even further, the fact that our public debt is now growing at an alarming pace, potentially setting the grounds for another crisis. Isn't all this debt just bad?
After having mulled this over for three days, here is where I come out. First let's tackle debt for consumption. Specifically I'm thinking of any consumer product cheaper than a car. I'm also thinking in terms of pure positive economics, that is I'm not layering on my own judgement, merely what I think the laws of economics have to say.
First, I think there is a presumption among some that if consumer credit were tighter, there would be less aggregate demand. I don't think there is good economic evidence for this view. If a consumer buys some product, say a television, on credit, what's really happening? They are pulling forward demand. That same consumer later has to save to repay that debt. In the absence of credit, the consumer would have to save to buy the TV. I don't see what the difference is between saving to buy the TV in the first place vs. saving to repay the debt.
Let's put some numbers to this. Say its a $500 TV that the consumer puts on a credit card at 15%. Say that debt is repaid when the consumer gets a year-end bonus in exactly 6-months. Net of interest paid, the TV cost the consumer $537.50. If credit weren't available, the consumer simply waits until the year-end bonus hits and then buys the TV. As far as I can tell, aggregate demand is the same over time. In fact, since the consumer pays interest on the debt it would seem that the consumer's budget restraint results in lower demand over time the more debt is utilized.
I think some would argue that there is a multiplier effect, where more transactions are good economically. The spending turns into someone else's income which turns into someone else's spending which turns into someone else's income. Perhaps, but it's still necessary for the debt to be serviced. I have to think any multiplier benefit is offset by the negative effect future savings (or more specifically debt re-payment) has on transactions.
Let's take this multiplier theory further. If we assume a transaction today has a certain multiplier impact, call it x. So the TV purchase wasn't just worth $500 to the economy but $500 times x. If that's true, then wouldn't it be that the $37.50 in interest spent would have a negative multiplier effect of $37.50/x? If the consumer just saved and bought the TV at a later date, then the $500x multiplier would hold, just at a later date, without the debt service drag.
On the flip side, there are clear examples where debt is good. I think where consumers borrow to fund asset purchases that's basically good debt. Obviously it can go too far, as we've seen recently. But it's safe to say that without debt, there really couldn't be a housing market. People just wouldn't be able to lay out the kind of cash needed to purchase a home, and in most cases homes are a reasonable store of value.
I also think a lot of business debt is good. Businesses need debt to finance capital spending. Unlike the purchases of a television, corporations investing in new plant and equipment creates value for the economy. If their ability to create value is in excess of the interest cost of the debt, then I think the economy is better off.
Unlike consumer debt, business debt should tend to generate future cash flow rather, as opposed to simply pull forward demand for consumption. Thus there really is a multiplier effect to corporate leverage. Obviously too much leverage can be bad, but not enough leverage could be bad as well.
Now this next part isn't going to be popular but I'm going to say it anyway. Another area where we really need debt is on Wall Street. Here is the reality: without leverage, arbitrage-free prices won't hold. The market couldn't serve its function of properly allocating capital through the pricing mechanism. Don't believe me? What happens if two bonds deviate from their theoretical value. Maybe it's two Ford Motor bonds with similar maturities trading at wildly different yields. If dealer firms have access to short-term financing, they step in and arbitrage the differential away. If they don't, then the mis-pricing remains. Again, obviously leverage can become too great, so I'm not arguing that unlimited debt is good, but I am arguing that at the core, trading debt is good.
This brings us to public debt. I'm tempted to say it's always and everywhere bad because I'd really love to live in a world of zero public debt. But truth is if the Federal government basically operated like state and local governments, I would probably label public debt as good.
For the most part, local governments have to have balanced budgets. Despite some tricks governments pull (especially New Jersey and California, but that's another post), that's generally true. Where local governments issue debt it's for capital projects, like school construction. Rather than raise taxes substantially every time they need to build a new school only to lower taxes after it's complete, the government sells bonds to finance the construction. Where the government is acquiring a long-term asset, like a school, debt seems like a reasonable funding mechanism. Lord knows state and local government fund a variety of dumb spending. But compared to what the Feds finance? The states look like a bastion of responsibility.
Bottom line. Debt isn't bad. In fact, I still think keeping the debt markets generally open is a reasonable goal of government during a panic. However, the idea that debt-financed consumption is something that should be encouraged is highly questionable.