Does this question make sense: "Is debt too high?"?
It certainly makes sense for me to ask whether my debt is too high. Should I try to earn more income, reduce my consumption, or sell off some assets? And if a friend asks me whether his debt is too high, I could offer him advice in the same way I would advise myself. Would it be in his best interest to reduce his debt?
I could think about government debt in a similar way. As a citizen, the government is my government, and as a taxpayer, the government debt is my debt. So government debt is my business in the same way that my debt is my business. Also, the government might ask for my advice. Or I might just offer it anyway, in the same way I would advise a friend. Would it be in the national interest for the nation's government to increase taxes, reduce spending, or sell off some assets?
But can I talk about the debt of strangers in the same way? Is private debt too high?
First, there's the obvious point that for every dollar borrowed, there's a dollar lent. Total debts minus credits, or net debt, must be zero as an accounting identity. Since governments are net debtors, and me and my friends are too small to matter, the total net debt of strangers must be negative. So if anyone says that the debt of strangers is too high, he must mean that some strangers have too high a debt, and other strangers have too low a debt (too high a credit, their debt is too negative).
Second, there's another point, that ought to be equally obvious, that follows directly from the first obvious point. If anyone says that the debt is too high, and says that some people (the debtors) should earn more income, reduce consumption, or sell assets, he must also say that other people (the creditors) should earn less income, increase their consumption, or buy assets. It ought to be obvious. But I have never heard anyone say that debt is too high and so (some) people should earn less, consume more, or buy more assets. [Update: OK, "never" is too strong; I've even said it myself. But why does debt reduction usually get framed in terms of debtors saving more rather than creditors dissaving more?]
Third, even if we understand the first and second points above, what exactly are we hoping to accomplish when we say, in public, that debt is too high? To whom are we speaking? We might just be issuing a general warning; if I say the rainfall is too high, I might just be warning people to watch out for floods, rather than trying to reduce the rainfall. That's OK. But I think that most people who say "debt is too high" do want people to reduce debt. They are not just complaining about the weather. So how do they plan to accomplish this?
Maybe they are giving advice to strangers in the same way that I would give advice to a friend, even perhaps if he didn't ask for my advice. "Watch out! Some of you have too high debt, and it would be in your own best interests to earn more, consume less, or sell some assets". They are speaking from the perspective of a financial advice columnist, which is just the personal finance version of a consumer report on what's the best car to buy. That's OK too. But good personal advice normally looks at the circumstances of the individual. And that must be true in this case. It might make sense in very rare circumstances to advise everyone to buy the same car; it could never make sense to advise everyone to reduce debt by saving more and selling assets (remember my first and second points above).
But I don't think that all people who say "debt is too high" are merely giving personal financial advice. They sound like they are making a public policy statement, in the same way that someone who says "pollution is too high". It makes sense to say that pollution is too high because the individually optimal level of pollution is not socially optimal; and that's because there's an externality. You might try moral suasion, but most economists who say that pollution is too high will go on to advocate some sort of policy, like a Pigou tax, to correct the problem. Otherwise they might as well be whining that Ottawa winters are too cold.
So, if you think that debt is too high, and you have understood my first and second points above, and you are not giving personal financial advice, and you are not just issuing a flood-warning:
1. What's the externality?
2. What public policy would you recommend to correct that externality?
(Those are not intended rhetorically, but I think the answers aren't obvious.)
[Too much Fed: this one's for you ;-)]
Worthwhile Canadian Initiative 
Nick,
I’m not sure on this point, but doesn’t your argument hinge on the assumption that the money supply is fixed (or controlled)?
If we accept that some money supply is endogenous, isn’t it reasonable to ask whether debt is too high?
I could be way off on this. Let me know where I’m wrong.
“But I have never heard anyone say that debt is too high and so (some) people should earn less, consume more, or buy more assets.”
Obviously, you have been talking with the wrong people. 😉
I think that some people should earn less, consume more, or buy more assets. I mean, isn’t that what we need right now? It’s just that the people who can afford to do so are not, darn it. 🙂
“Third, even if we understand the first and second points above, what exactly are we hoping to accomplish when we say, in public, that debt is too high? To whom are we speaking? We might just be issuing a general warning; if I say the rainfall is too high, I might just be warning people to watch out for floods, rather than trying to reduce the rainfall. That’s OK. But I think that most people who say “debt is too high” do want people to reduce debt. They are not just complaining about the weather. So how do they plan to accomplish this?”
If the people who can afford to earn less or spend money won’t do so, then the government should give, or (preferably) pay other people so that they can pay down their debt or (preferably) spend money. Only politics is in the way. 🙂
Liberals like myself complain about people earning too much all the time. The problem when people complain that “debt is too high” is that a small number of people have accumulated far too much in savings because they earn far more than can be reasonably justified. It’s a problem that results from extreme and increasing concentration of income at the top end.
The obvious externality is the extent of deadweight losses from bankruptcies. These, however, will always be small in the scheme of things, and to look solely at them and assume that other effects “net out” between creditors and debtors is too use a too-static mode of analysis.
Rapid, outsized growth in credit creates signals about the real returns to projects that are self-reinforcing, transient, and that also work in reverse.
Think of consumers borrowing 500% of GDP in expectations that their assets will appreciate in value and provide the funds to service that debt. The impact is rapid consumption and asset price growth, which then leads to enormous investment in the sector, which in turn raises employment, incomes, and AD. In short, the borrowing has a large impact on velocity.
If consumers are right about the trajectory of asset prices, then there is no problem. If they are following “false” signals, self-created ones, about future prices, then its likely that they will have to service that same debt out of income in the form of higher savings. Where AD ran higher than was justified, it now runs lower, which in turn becomes another self-reinforcing signal about the attractiveness of investment projects, which further depresses velocity and AD.
Why should such a “boom/bust” process not net out to zero over time? Why should the “busts” be bigger (which implies an externality)? One obvious reason is that, in large busts, governments put at risk future expectations about the value of the currency. This can depress investment over long periods of time, as happened in Latin America over large portions of its history.
Asymmetry (loving booms, hating busts) in economic policy can create the externality of chronically low investment or chronic malinvestment (as in the case of Japan’s last two decades of public investment). There are many examples of this in history, and economists love to take exception to these as not applying to large developed economies.
And public policy wise – a new tax bracket charging a significantly higher marginal rate on incomes over, say $1.5m. It would affect less than 0.1% of the population, and would do a world of good to reduce the wealth accumulation of a very small number of people. The government could then use their redistributive powers to put that money back into the hands of demographics more likely to be debtors.
Brandon: if we consider money as a liability, then it is either a liability of the government (and comes under what I said about government debt), or it is a liability of the private sector (and comes under what I said about the debt of strangers). In any case, whether the money supply is too high is a question about the composition of debt, not the total size of debt.
Min: “Obviously, you have been talking with the wrong people. ;)”
Yep, I know! And I have actually said myself that creditors should save less in order to reduce debt! But most people who encourage (some) people to save less and buy assets are wanting to increase aggregate demand, not reduce debt. That’s how the argument is usually framed.
“If the people who can afford to earn less or spend money won’t do so, then the government should give, or (preferably) pay other people so that they can pay down their debt or (preferably) spend money. Only politics is in the way. :)”
Yep, but that sounds more like an aggregate demand externality, rather than a debt externality per se.
Neil: where’s the externality of debt? You sound as if it’s the distribution of income you don’t like, rather than debt per se. Indeed, your proposed policy (extra income tax on high earners) is directed at the distribution of income, not at debt. If you thought that debt was the problem, you would instead be proposing a tax on borrowing and lending.
David: “The obvious externality is the extent of deadweight losses from bankruptcies.”
That’s not obvious to me. Aren’t those costs borne by the borrower and lender?
“Rapid, outsized growth in credit creates signals about the real returns to projects that are self-reinforcing, transient, and that also work in reverse.”
Why? Would rapid, outsized growth in the consumption of apples create false signals about the benefits of eating apples?
In any case, suppose the investment boom were financed by equity rather than debt? Or suppose each person financed out of his own pocket. Why would it be any different? (I can see us going off into ABCT here!)
Nick,
Apples are a great example. Outsized growth in the consumption of apples fueled by credit would induce investment in orchards but no immediate increase in production. Prices would rise, apple growers would borrow more to plant more, and consumers would borrow more and hoard apples (in the form of jam!) as their value increased. Eventually, the new orchards would start producing, the price of apples would fall, consumers would dump their jam, producers would dump their orchards, the price would fall further…
A classic boom/bust cycle.
Except in this case, the government decides to print money and buy apples to keep the price of apples and orchards from falling. Not knowing either what 1) real demand for apples is; or 2) what real returns on orchards are: producers would refuse to invest in more orchards, holding down growth for years.
This is not my personal opinion, but I hope some people have this coherent opinion:
1. Too much debt leads to financial fragility, higher bankruptcy costs with associated supply-side problems, higher probability of monetary policy errors
2. Taxes on equity financing (on dividends etc.) should be reduced and taxes on debt financing should be increased
“Yep, but that sounds more like an aggregate demand externality, rather than a debt externality per se.”
Well, unlettered as I am, I do not see any particular level of debt as being too high, per se. I suppose that you can argue that if debt is higher than it used to be, that it is too high, but I only find that plausible. OTOH, it seems to me that debt is too high when we see a lot of defaults and bankruptcies. (Yes, I know. What’s a lot?) Don’t defaults and bankruptcies and reduced aggregate demand go together? Frankly, when we are talking about complex human systems, the words “per se” don’t usually mean much to me. 🙂
David Pearson: “Except in this case, the government decides to print money and buy apples to keep the price of apples and orchards from falling. Not knowing either what 1) real demand for apples is; or 2) what real returns on orchards are: producers would refuse to invest in more orchards, holding down growth for years.”
You are going a little fast for me. I thought that over-investment in apple orchards was part of the problem. Not that gov’t stockpiling of apples is the solution! 😉 But it does seem to be helping to reduce investment in orchards.
Leverage increases the risk of recession due to an unexpected shock, and adds rigidity to the economy making it more difficult to deal with the result. Leverage is often the symptom of other serious problems such current account imbalances due to mercantilism, or an unwillingness to face the real risk of investing for the future, or subterfuge in submerging real risk beneath the surface. Investors may prefer a lower exchange rate, or saving to investing, or the illusion of risk avoidance, but these are not necessarily in the interest of the country or the economy as a whole. Investor preferences are often the result of government policies themselves, so we need to make sure what we encourage is what we want.
Leverage is a tool and not good or bad in itself. One should expect leverage to grow with more productive opportunities and the income to support it and diminish with fewer of them and reduced prospects. One must be extremely cautious of leverage for other purposes, such as for currency manipulation, or to increase consumption or speculation. Increasing leverage is expansionary while decreasing leverage is contractionary. There can be real dangers to our economic financial well-being due to leverage and risk.
Sharply increasing leverage demands negative real interest rates to combat it, more inflation, but increasing asset prices can cause bubbles and keep real interest rates too high until they burst. Trying to avoid risk by shoving it onto government isn’t avoidance at all. Unless we really want the socialist paradise where government is the only equity owner and everyone else can be debtors, it is in public policy to discourage it.
Lord: “Unless we really want the socialist paradise where government is the only equity owner and everyone else can be debtors, it is in public policy to discourage it.”
What kind of paradise is it where the government is the only debtor?
😉
Oh come now! This “update” disclaimer is completely inadequate; your voice is merely one among millions, a snowflake lost in a howling blizzard. There was a long-winded piece about “the paradox of thrift” complete with giant diagrams printed in the Globe and Mail, you know. Also, just about every second Krugman blog post refers to this issue.
And no externalities to default! That is so egregiously absurd a contention that I have to ask whether you were kidding? Or will you seriously undertake to defend the position that Lehman’s default damaged nobody except Lehman and its creditors? Good luck with that.
It’s cash flows that matter, well, in the short term anyway. It’s the effect of defaults on cash flow that can cause cascading defaults. Say I am a business owed $1000 dollars, due on the 15th of the month. I NEED that $1000 or I can’t meet my obligations due on the 30th. If I don’t meet my obligations on the 30th, I can’t get the materials, labour, etc I need to operate. I maybe solvent on paper, but I’m out of business. The cascade of destruction continues until it hits someone who has sufficient liquid capital or credit to absorb the loss and keep going.
Now imagine all debts are ‘callable’ (sorry I don’t know the real term), but which I mean: if you default on a payment the entire principle becomes due immediately. If everyone along the line is dependent on the payments to meet the obligations to the next creditor in the chain, a single default causes the whole mess to explode.
All this to say that I think it’s the interplay between interconnectedness, liquidity, and debt structure that matters. Gross debt stats might give hints that something is amiss, but it doesn’t capture the really essential points.
Well, for the record, the last time we covered this ground here, I commented that,
“If we want to reduce debt levels, they have to be tackled more directly [than via interest rate manipulation]. Some options:
1) Trigger inflation
2) Increase the number of defaults (increasing interest rates would ‘help’ here)
3) Increase debtors incomes (higher minimum wage, stronger unions, trade barriers that prevent global wage arbitrage, etc.)
4) Transfer money directly from creditors to debtors (progressive taxation, easing of bankruptcy rules)”
So I don’t think I could have been much clearer about creditors having to pay. As for why people focus on debtor behaviour more, it is debtors who create the debt, not lenders. As we’ve covered here probably a dozen times now, loans create deposits. Trying to convince creditors to reduce their holdings while debtors keep going to the bank to borrow more money is an accounting impossibility, so focussing on debtor behaviour is logical. And I don’t think anybody is trying to convince entrepreneurs and business people not to borrow money to make productive investments (at least not in general, some folks like Canwest may have wished to indulge in a little moderation on this front), it is the non-productive borrowing that people wish to discourage.
I don’t follow your statement that, “it could never make sense to advise everyone to reduce debt by saving more and selling assets.” In fact I would indeed offer that advice to everyone who, for example, is paying interest on credit card debt and most people who pay interest on personal non-mortgage debt and a lot of people who are paying mortgage debt as well. OK, that’s not everyone, but it’s a heck of a lot of people.
I’m not sure why you are looking only for externalities either. At the transaction level the problem is negative internalities (in the sense that the transaction works to the detriment of those who agree to it, not third parties).
At a macro level, the primary problem caused by debt is volatility/fragility, as David and Lord and Patrick have all said. People, companies, and the monetary system itself all become more prone to failure as the level of leverage increases. To the extent that the debt is applied to non-productive investments, the increase in debt levels just increases the cash flow drain from the debtor class to the creditor class. Debtors can only escape via reducing their consumption (thus causing a recession) or by defaulting (thus threatening financial intermediaries and risking debt deflation)
In terms of solutions, at the micro level public policy is a poor substitute for morality, as the similar case of the war on drugs has shown. Still, generous bankruptcy laws, restrictions on predatory lending, usury, credit counselling and education, credit bureaus and limitations on the level of competition in the lending market will all help to limit the damage caused by ill advised borrowing/lending.
At the macro level, it would have been better to prevent debt levels from getting this high in the first place but it’s too late for that and now there are no solutions which are both effective and fair (to be fair, creditors must be paid what they are owed, to be effective, creditors must not be paid what they are owed). Solutions all involve reducing the flow of interest payments on non-productive debt from debtors to creditors and reducing overall leverage. So, printing money, lower interest rates, progressive taxation, loan forgiveness, easier rules for bankruptcy, etc. would all help.
I think David Pearson is right about the deadweight loss of bankruptcies, although it’s getting late for me so I’m not following the apple analogy.
I think bankruptcies do have a negative externality in that they raise the price of loans for borrowers without affecting the expected returns for lenders. If lenders knew with certainty that there would be no bankruptcies or defaults on loans, borrowers would get a lower interest rate from lenders. But since borrowers tend to spread the risk of default over all their loans, I’m going to pay a higher price for a loan as more people default, regardless of my circumstances (this assumes, of course, asymmetric information in the lending market).
I suppose a policy solution would be to make it more difficult and/or unpleasant to go bankrupt.
Nick:
Count me as believing in a difference between debt and equity. Surprisingly, the right way to think about this is in terms of debtor’s prisons. Debt and equity differ in the same way that slavery and liberty differ.
Moreover, I think its interesting that bankruptcy is essentially a formalized process of turning debt into equity. Again for the same reason.
My third point is that debt creates a curious decoupling between yield and depreciation. There is a very true sense in which a country, a firm, or an individual can consume capital.
My final point is that there can be too much debt when its denominated in a foreign currency. All foreign debt is effectively real not nominal. Consequently, it is possible to incur liabilities in excess of yield and spiral into poverty–wherein a nation consumes more and more capital to discharge its debts which in turn means less and less true yield and consequently an accelerating rate of capital destruction.
Only a debt arrangement has that animus. An equity arrangement–almost tautologically–implies a preserved interest in preserving capital over achieving present income.
Consequently debt has a social book-keeping risk. Namely that the yield of productive assets discharge debt payments. Those debt payments are then consumed rather than reinvested in capital because the lender in inured against the capital depreciation underwriting the collection.
Its been argued that this latter relationship is actually exacerbated by an unexpected inflation which cannot repair the capital depreciation that has come prior but does conceal that depreciation from account which encourages the cycle to begin anew, and capital destruction to resume.
Certainly there are cases where there are no externalities in defaults, but there are two important exceptions. First, in some complex cases, imperfect bankruptcy laws prevent the preservation of going concern value, creating many problems not only for the owners of defaulted instruments, but also for the third parties (Lehman clients in London had/have to wait more than a year for a return of their assets). Second, if there is a sudden spike of bankruptcies, courts may not be able to process all the bankruptcy cases in a timely manner. This was the supply side reason why IMF did not require a currency devaluation during the bailout of Latvia in 2009.
In a world with strong income guarantees for people over 65, the not-saving of strangers matters for anyone paying for those income guarantees.
Does the pain of watching people do stupid things count as an externality? I’m talking here about credit card debt – people who can’t afford it paying 19.75% on outstanding balances. (this echoes some of what Declan says).
@Frances
“In a world with strong income guarantees for people over 65 …”
Yes. In my opinion, Nick’s mental model is far too narrow. The economy is not divided into borrowers and creditors because it is too common to be both. It is not unusual to have both a pension and a mortgage, for example. When A owes B who owes C, the default of A will always result in externalities to C even though at the 10-million foot level “everything balances.” Also, there are political fault lines between creditors and borrowers that have real-world consequences. The legions who are saying “China should appreciate the Renminbi” are in effect saying “Americans should save more and Chinese should spend more.”
“I’m talking here about credit card debt …”
There is a very interesting post about this subject from the perspective of behavioral psychology here: http://www.psyfitec.com/2010/03/putting-down-credit-cards.html. The connection to your remark is the observation that those who are comfortable with the situation because they enjoy being subsidized by stupid people are too complacent. One can have too much a good thing, and we passed that line long ago. The consequence is the prospect of a protracted reduction in AD.
I don’t think it makes sense to count loans as negative debt. Suppose you have two people in the economy, one is a lender and the other is a debtor.
Situation 1: No loans made, debt is too low.
Situation 2: Lender lends debtor $1,000. Debt is just right.
Situation 3: Lender lends debtor $10,000. Debt is too high.
In each case, it balances out to 0, but each situation is different. To say debt is too high is to say that people are making too many loans.
In terms of public debt/government debt the implication of having a ‘too high’ debt is that it leads to ‘diminished capacity’ on the part of Government which inhibits their ability to fund existing obligations to citizens and have the resources to react to new challenges. The short term impact of the Govenrment taking on more debt in our current circumstances may not be particularly significant. However, the failue to discharge that debt during the next business cycle will diminish the government’s capacity to fund healthcare, education, etc. and that may become more pressing as the population ages in the years ahead. And if government cannot competently manage its debt then you and I, as taxpayers, will be paying more of our tax dollars out and receiving less services for it. The Govenrment is not so very different than a household or a company except it capacity to issue sovereign debt means it has a lot more time before it creditors get fed up. Government may be too big to fail but it is not too big to be anemic and increasingly marginalized by too hight debt. Government’s challenge is to always avoid be part of the problem – something it has difficulty managing in the best of situations.
“If anyone says that the debt is too high, and says that some people (the debtors) should earn more income, reduce consumption, or sell assets, he must also say that other people (the creditors) should earn less income, increase their consumption, or buy assets.”
I think that what you’re leaving out here is the fact that we have a financial system designed to create money by lending/creating deposits. “Debt is too high” is a statement that financial institutions have issued too much debt relative to the real assets — and cash flow from them — in the economy. It’s essentially a statement that the private sector has created too much money and is causing asset price inflation that will either lead to more general inflation (so incomes can catch up with debt) or to bankruptcies (if income doesn’t catch up with debt).
I read “debt is too high” as a statement that there is a monetary disequilibrium in the economy that will need to be resolved one way or another. This view is clearly related to David Pearson’s and Lord’s comments.
Well said, csissoko, I agree 100%.
James, a minor quibble perhaps, but I think your scenarios are misleading. If in scenario 3, the lender can lend $10,000, then this means in scenario 1 and 2 the lender has $10,000 and $9,000 respectively that is held as cash (loaned to the central bank) or loaned to other people.
My scenario was deliberately simplified. I didn’t intend to include banks, including central banks, nor fiat currency (which some people consider government debt). Money sitting as reserves in banks doesn’t need to be loaned out, although it usually is. Money loaned to the central bank is not used to purchase things, so is conceptually different from a home or car loan. I don’t want to get tangled up in the details of how banks operate and create money by making loans.
While my example may have been misleading, the point I was trying to get at is that the total loans made in society does fluctuate. If you count the loan or bond as negative, and then sum it up, you arrive at Nick Rowe’s conclusion that net debt never changes. Since people comment on debt levels all the time, they simply can’t be talking about net debt, they must be talking about something else. I would like to posit that that “something else” is the amount of loans made.
Andrew F: But if the lender is a bank (and therefore able to create money), there is a 5% minimum capital ratio and reserves can be borrowed, then all James was assuming in scenario 2 is that the bank has a $450 capital cushion. In other words, as long as the lender is a financial institution there is no need for $9000 “cash”, because banks create cash in the form of new deposits every time they make a loan.
Aren’t at least some of what is being referred to here as externalities really pecuniary externalities, i.e., external effects that show up in the price system, and that thus do not distort resource allocation (or something)?
Nick, thanks. I will try to post some more tomorrow with something similar to a Michael Hudson response.
Some thoughts:
James Oswald: yes, net debt is always zero. I am talking about gross debt.
Phil Koop: “Oh come now! This “update” disclaimer is completely inadequate; your voice is merely one among millions, a snowflake lost in a howling blizzard. There was a long-winded piece about “the paradox of thrift” complete with giant diagrams printed in the Globe and Mail, you know. Also, just about every second Krugman blog post refers to this issue.”
There’s a difference between the paradox of thrift and what I am talking about. The paradox of thrift says we should all try to save less in order to increase income. What I am talking about is that creditors should save less in order to decrease debt.
On the externalities question: I am not saying there are no externalities to debt (or the increased bankruptcies that debt leads to). I do want us to clearly identify what those externalities are. Let me pose this question: suppose we lived in a hypothetical world in which information on everybody’s debts were costless (to acquire and process). Would those externalities then disappear? In other words, are the externalities informational in nature? In other words, if A borrows from B, does that impose an extra informational cost on a third party C, that is not taken into account when A and B decide how much to borrow and lend?
Because so far, I tend to agree with David Stinson: “Aren’t at least some of what is being referred to here as externalities really pecuniary externalities, i.e., external effects that show up in the price system, and that thus do not distort resource allocation (or something)?”
For example: suppose B lends to A. Then subsequently C lends to A. You might say that C’s lending to A imposes an external cost on B, since it reduces the chance that B will be repaid. But in a world of costless information it would be easy for B to take this into account. Either make sure his loan gets first dibs on A’s assets, or else put a clause in the loan that says A may not undertake subsequent debts without B’s permission.
csissoko (I hope I spelled your name right; my eyes or computer creen aren’t good enough for me to read it clearly)
“I think that what you’re leaving out here is the fact that we have a financial system designed to create money by lending/creating deposits. “Debt is too high” is a statement that financial institutions have issued too much debt relative to the real assets — and cash flow from them — in the economy. It’s essentially a statement that the private sector has created too much money and is causing asset price inflation that will either lead to more general inflation (so incomes can catch up with debt) or to bankruptcies (if income doesn’t catch up with debt).
I read “debt is too high” as a statement that there is a monetary disequilibrium in the economy that will need to be resolved one way or another. This view is clearly related to David Pearson’s and Lord’s comments.”
That’s interesting. I don’t have my head clearly around it yet, but my hunch is you are onto something. It’s money, not debt; it just so happens that (most) money is also debt. (And, if you are a monetary disequilibrium theorist like me, you believe that you can create an excess supply of money in a way that you can’t create an excess supply of debt.) But I don’t think that this is what most people say when they say “debt is too high”. Nevertheless, it’s worth thinking about.
Frances: “In a world with strong income guarantees for people over 65, the not-saving of strangers matters for anyone paying for those income guarantees.”
True. A nice clear externality there. But really one created by the tax/transfer system. It’s very similar to the externality created by someone who earns less income than they could, so they might get transfer payments from me, or, at least, won’t be helping me by paying for their share of public goods.
Declan: “As for why people focus on debtor behaviour more, it is debtors who create the debt, not lenders.”
That seems false to me. It takes 2 people to create a debt: one to borrow; and one to lend. You can’t have one without the other.
“I’m not sure why you are looking only for externalities either.”
I’m working on the assumption that all “market failures” (or cases where individual self-interest does not coincide with an efficent equilibrium) can ultimately reduced to externalities. I (and perhaps a second party) do something that benefits me (and the second party) but harms a third party.
Nick said:
“On the externalities question: I am not saying there are no externalities to debt (or the increased bankruptcies that debt leads to). I do want us to clearly identify what those externalities are. Let me pose this question: suppose we lived in a hypothetical world in which information on everybody’s debts were costless (to acquire and process). Would those externalities then disappear? In other words, are the externalities informational in nature? In other words, if A borrows from B, does that impose an extra informational cost on a third party C, that is not taken into account when A and B decide how much to borrow and lend?
Because so far, I tend to agree with David Stinson: “Aren’t at least some of what is being referred to here as externalities really pecuniary externalities, i.e., external effects that show up in the price system, and that thus do not distort resource allocation (or something)?”
For example: suppose B lends to A. Then subsequently C lends to A. You might say that C’s lending to A imposes an external cost on B, since it reduces the chance that B will be repaid. But in a world of costless information it would be easy for B to take this into account. Either make sure his loan gets first dibs on A’s assets, or else put a clause in the loan that says A may not undertake subsequent debts without B’s permission.”
Yes, externalities are informational in nature, and it seems that when gross debt is large, markets process information less efficiently. EMH is especially false in credit markets. Have you seen any studies that say otherwise? Excess volatility that is unexplained by volatility of fundamentals is much stronger in debt instruments than in stocks. So yes, when debt is too high capital markets are too far away from EMH.
For example, clients of Lehman could have arranged their contracts with Lehman so that client assets held in custody would not be frozen if Lehman fails, but alas…
Nick Rowe: “I’m working on the assumption that all “market failures” (or cases where individual self-interest does not coincide with an efficent equilibrium) can ultimately reduced to externalities.”
What about the bubbles and busts that occur in the toy economies of experiments? Any externalities there?
Nick,
A question: What’s wrong with this logic?
If household debts are high and climbing it increases the likelihood that we will reach a cultural shift where many citizens in phase scale back consumption. The banks and credit card companies are not going to buy consumer goods with the money they are not lending. So the economy will shift and for many months to a year people who produce stuff that ordinary people buy will by on trouble and banks don’t buy stuff, but sit on money in case the ordinary people can’t pay their mortgages and banks need the case because their income is down.
Cheers.
TMDb: “Yes, externalities are informational in nature, and it seems that when gross debt is large, markets process information less efficiently. EMH is especially false in credit markets. Have you seen any studies that say otherwise? Excess volatility that is unexplained by volatility of fundamentals is much stronger in debt instruments than in stocks. So yes, when debt is too high capital markets are too far away from EMH.”
That’s interesting. I wonder what the underlying theory is? I wonder if liquidity is at the root of it? (I find it easier to imaging externalities in liquidity.)
Min: “What about the bubbles and busts that occur in the toy economies of experiments? Any externalities there?”
Dunno. No externalities that are obvious to me. Except pecuniary (but they cancel out).
Chris J: I think that might be similar to David Pearson’s argument. Debt increases the volatility of aggregate demand, and so makes business cycles more severe. But then there may be too versions of that appoach: 1. A high average (over time) level of debt makes AD more volatile; 2. A volatile level of debt makes AD more volatile.
(In either case, I am willing to believe that AD volatility can be a bad thing, since monetary policy cannot always counteract it and keep AD stable. And I do think the business cycle matters, and that booms and busts don’t cancel out on average. (For one thing, I think a more volatile business cycle reduces long run investment and growth.)
Nick said: “Does this question make sense: “Is debt too high?”?”
For the current situation, the question needs to be expanded to “is currency denominated debt too high with little to no price inflation in most goods and most services?”
I’m going to try to condense down the Michael Hudson argument. The one variable almost all economists are missing is retirement date changes for the lower and middle class vs. the rich. The few are accumulating assets, the very, very few are accumulating most assets (positive real earnings growth), and a lot of people are “losing” assets (either from currency denominated debt or outright asset sales). This is because of negative real earnings growth for most people due to a globally oversupplied labor market. Next, the few will start “losing” assets if the many have to go into their jobs (to oversupply those labor markets).
Eventually, the very, very few will own all the assets and just want to “rent” them out using currency denominated debt. Welcome to neofeudalism or debt slavery. The very, very few rich can retire at any time but won’t, and everyone else may never be able to retire.
The rich and the fed especially like to use housing as “rent tool” except they want the people making the interest payments to pay the taxes and maintenance. The rich just want to collect the interest payments. If the rich and the fed can keep housing prices going up and the people experiencing negative real earnings growth borrow with a home equity line (or other means), the rich and the fed can “trick” them into spend now along with working more later. People expect to retire at about 60 to 65 but can’t because they still have a mortgage to pay.
The fed and the rich then give us what I consider to be excuses for this like the goods market is supply constrained now and in the future so all spending problems are aggregate demand problems not due to an increase in aggregate supply and people are living longer so they should work longer.
However, if the markets go from supply constrained to demand constrained, the workers won’t be getting the hours they expected and probably won’t be able to make the interest payments and maintain their standard of living (the labor market is oversupplied so they won’t be getting raises either). Now there is a problem with spending in the present.
IMO, there will be fewer and fewer lenders (banks mostly). These fewer lenders will want a subsidy to lend to the more people who will be less qualified. The fed will provide them with a subsidy if they lend to prevent price deflation, to debt enslave the borrowers, and are “connected” (like too big to fail).
Nick said: “But I have never heard anyone say that debt is too high and so (some) people should earn less, consume more, or buy more assets. [Update: OK, “never” is too strong; I’ve even said it myself. But why does debt reduction usually get framed in terms of debtors saving more rather than creditors dissaving more?]”
I will. Wealth/income inequality should be limited along with currency denominated debt. IMO, if a lot of currency denominated debt is being produced without price inflation, then some “entity” is suffering negative real earnings growth. I would say that entity is usually less financially sophisticated and shouldn’t be borrowing.
I don’t believe there is enough emphasis about the time differences between spending and earning (mostly wages) that currency denominated debt allows.
“2. What public policy would you recommend to correct that externality?”
a tax bracket of 80% to 100% for certain incomes
stop targeting price inflation without targeting currency denominated debt levels
reverse or fix the 1980’s policies that were IMO used to allow currency denominated debt levels to rise without price inflation (that is oversupplied the labor market) ; those would be cheap labor free trade, cheap labor legal immigration, and cheap labor illegal immigration
get rid of the fed so they can’t try to set the amount and mix of currency vs. currency denominated debt
don’t give politicians, economists, or bankers the power to determine the amount and mix of currency vs. currency denominated debt
All those amount to running a more balanced economy (especially for workers) and a more balanced currency vs. currency denominated debt mix.
Nick said: “That’s interesting. I wonder what the underlying theory is? I wonder if liquidity is at the root of it? (I find it easier to imaging externalities in liquidity.)”
Liquidity is a part of the story. I am also thinking about capital asset pricing model as an implementation of EMH, and it seems that unrealistic assumptions behind CAPM are even more important for debt instruments than they are for equities.