March 4, 2021

High & Low Finance: Learning to Live With Debt

Seldom have those twin realities been as stark as they are now. It was excessive debt brought on by too-easy credit that brought down the American economy and allowed some European countries to borrow money they will never be able to pay back. It is fear of debt that threatens to keep the United States from doing much to prevent a double dip recession.

A considerable part of the current economic strain stems from the fact that the credit overhang continues to haunt borrowers around the world. The lenders may have been bailed out, but the borrowers were not — or at least not enough to return them to health. Millions of Americans remain underwater on mortgage loans. Countries that lack printing presses for their own currency find themselves unable to borrow from private lenders.

In the long run, inflation may be a significant part of the solution, enabling borrowers to pay back dollars and euros that are worth a lot less than the ones they borrowed. The soaring price of gold, now around $1,650 an ounce, makes sense only if you assume something like that is going to happen.

But for now, such inflation is not on the horizon. To get by, the sad reality is that those who can raise capital may need to do so for the benefit of others. Germany has grudgingly moved toward that with the latest bailout of Greece, but the United States — which now pays 2.4 percent to borrow money for 10 years, more than a percentage point less than it paid six months ago — seemingly has no desire to try to save its own economy, let alone anyone else’s.

The effort to slash spending with the possibility of a new recession looming may be foolish. Larry Summers, the economist and former Treasury secretary, pointed out in The Financial Times this week that tax receipts over the next decade would be about $1 trillion lower — and debt that much larger — if economic growth were shaved by half a percentage point a year. That is about the same amount that the bill passed this week claims it will save.

It appears that not much of that saving will be in the next couple of years, although the further cuts promised late this year could change that.

What is needed now is both a willingness to spend to offset the impact of the last debt debacle and a determined effort to ensure it does not happen again. But those efforts are stalling. Banks are lobbying with some success in both the United States and Europe to delay and weaken capital requirements.

And the American government shows no interest in doing anything about the incentives in current law that favor borrowing over equity. If you buy a house with the largest mortgage possible, you will pay lower taxes than if you borrowed less. Companies pay interest on loans out of pretax income, so the more they owe, the less they pay in taxes. But dividends are paid out of after-tax money.

“The U.S. tax system encourages household leverage and bank leverage, even though both are potentially destabilizing,” is the way Narayana Kocherlakota, the president of the Federal Reserve Bank of Minneapolis, put it in a recent speech. He offered a rather modest suggestion: lower the proportion of interest payments that are deductible.

There are, of course, claims that both tax policies produce greater good for the society, by encouraging homeownership and corporate investment. He suggested “replacing the mortgage interest deduction with a tax credit that offsets part of a buyer’s down payment toward a home purchase. Such a tax credit would encourage homeownership without simultaneously providing more incentives for households to accumulate more debt.” And lower corporate income tax rates, he said, could offset reductions in the deductibility of interest “without simultaneously providing incentives for corporations to acquire leverage.”

The fact that those suggestions have virtually no political support reflects one of the great political and economic challenges of this era: Governments now feel a need to encourage economic growth, but don’t want to spend money. Encouraging leverage seems like a good idea.

But it does have major risks. “A financial system with dangerously low capital levels — hence prone to major collapses — creates a nontransparent contingent liability for the federal budget in the United States,” said Simon Johnson, an M.I.T. economist and former chief economist of the International Monetary Fund, in Congressional testimony last week. “This can only lead to further instability, deep recessions, and damage to our fiscal balance sheet, in a version of what the Bank of England refers to as a ‘doom loop.’ ”

In plain English, he means Uncle Sam will get stuck with the debt when banks blow up. The fact that happened in the recent cycle is a major cause of the rising debt that seems so alarming to those who demand immediate cuts in spending totally unrelated to the financial crisis.

To hear banks tell it, every extra dollar of capital that they are forced to hold is one dollar less they can lend, and one dollar less of economic growth that the world desperately needs.

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