Friday 13 December 2013

How Much Debt is Good Debt?

Debt is now one of the most talked about issues in current affairs. Debt seems to be everywhere. Governments are borrowing to finance their spending. House buyers are taking on mortgages to 'get on the housing ladder,' and millions of young people are borrowing to put themselves through college. The slightest sign that interest rates might change can send shockwaves through financial markets.

But debt has got a bad name. Excessive mortgage lending lay behind the 2008 financial crisis, inflating a house price bubble while parceling out financial risk to investors distant from the original loans. National governments around the world, from the US to the UK, Greece to Japan, are struggling under piles of debt; many countries have received bail-outs and others are on the brink of default. And student loans have created a higher education bubble, with so many students graduating from Universities that many now struggle to find ‘graduate-level’ employment [the Financial Times has run some fascinating analysis of the situation in the UK - helping confirm my earlier conclusion that the new tuition fees regime is hopelessly unsustainable].

As a result we see much talk of 'deleveraging,' meaning a reduction in the overall level of debt in the economy. This process is inevitably a source of economic stress, at least in the short run. If people slow down their spending, in order to pay off their debts, the economy stops growing and may go into recession. This phenomenon lay behind Japan's economic stagnation since the early 1990s, and seems highly likely to take hold in Europe.

All this begs the question, how much debt is good debt? We could moralize about the issue, and say no debt is good, a position taken by some religions and political ideologies*. At the opposite end of the spectrum, the laissez faire view would suggest any debt is acceptable so long as both parties are happy to enter in to it. However, it was this attitude that led to the financial crisis. The structure of the financial system was set up in such a way that there were huge problems of incentive misalignment, information asymmetry and misjudged risks.

To answer the question 'how much debt is good debt' we need to go back to some straightforward economic fundamentals. Taking out a loan is good so long as we invest the money we receive in something that yields a return greater than the interest payments required. The archetypal example is someone purchasing a car on credit. Owning a car means greater mobility, thus a greater range of employment opportunities and higher future wages. The extra wages can then pay off the debt. This cost-benefit calculus is the best way to assess whether a loan is wise, whether you are a government minister looking to borrow $50bn for rail investment, or a young person borrowing $200k to go to college.

Seems simple, so what's the problem? The problem is that we rarely know with any precision whether what the future return is on our invested cash. For government infrastructure projects, teams of consultants are hired to make projections 30 years into the future - but in truth their estimates are little better than guesswork. No one can possibly foresee how the transportation market will progress in the next 30 years. Likewise, it is fruitless for a young person to try and guess how much a University degree will be worth over the course of their career. The UK government is keen to highlight statistics such as 'Graduates earn an average of £100k more than non-graduates over their career,' but this is disingenuous, in fact it is dangerously misleading. While the statistical methods used to calculate this are quite sophisticated, and take into account that it is more able students who choose university, the analysis faces the fundamental difficulty that it uses historical data. It is therefore inappropriate to draw the inference that this 'graduate premium' will continue to apply, since far more young people are now going to University.

One economist who understood the risks of debt and its role in financial crises was Hyman Minsky. Minsky identified three types of borrowers. The first are genuinely creditworthy, the ‘hedge borrowers,’ able to pay back both principle and interest from incoming cash flows. The second are ‘speculative borrowers,’ able to keep up their interest payments, but not to pay back capital. The third are 'Ponzi' borrowers, who can pay back neither capital nor interest from their cash flows, and rely on asset values appreciating indefinitely – which they clearly cannot.

Minsky saw that in a booming economy, more and more credit is extended until it is eventually offered to the Ponzi borrowers. When it becomes clear that much of the capital will never be repaid, the boom turns into bust, and falling asset values can drive all three types of borrowers to default, even creditworthy hedge borrowers. As the economist Nouriel Roubini foresaw, this cycle describes well what played out in the 2008 financial crisis.

Unfortunately Minsky’s work still lies outside of the mainstream of economic education. Until more economists take the vicissitudes of human behavior into account, and take Minsky’s work more seriously, I fear we won’t learn from history, and so we are condemned to repeat it.


*Sharia law, for example, forbids interest payments and requires any loan to be backed by a physical asset with an associated income stream; it is telling that Sharia-compliant investment products fared better than Western funds during the recent crisis.