Wednesday, March 15, 2017

Why Personal Debt is Different from Government Debt

This morning I got an email from a reader who asks about the prudent limit of personal debt vs. government debt. He writes:
it would be reasonable for a couple with annual income of $115,000 to carry debt of $400,000 on a home mortgage, $30,000 in car loans and $15,000 in credit card and $10,000 still owed on college loans for a total debt of $455,000. It could therefore be said that their debt is 4 times their annual income. If we look at our national debt of 16 trillion and our federal annual income from taxes and other sources at an estimated 4 trillion then the ratio of total debt to annual income is 4 times; the same as my household example.
Now I disagree with this, on the grounds that personal debt is very different from government debt. But first of all I must set forth my fundamental belief about debt, that I got from Walter Bagehot's 19th century classic about the credit markets, Lombard Street.

Bagehot proposes two things needed to avoid a credit crash.

First, people with debt must be able to service their debt. Obviously, if people do not pay their interest then the whole credit system goes upside down.

Second, debt must be properly collateralized, so that it can be liquidated when a borrower fails to service the loan. This is a confidence issue.

You can see that both notions applied to the real estate crash of 2008. In reports of the developing crash you heard a lot about "counterparty risk," the worry that the other party in a financial transaction was solvent. This applied both to the risk that the other party might stop servicing the loan, and also that the loan could not be liquidated by selling the collateral. Just as Bagehot wrote.

Now I believe that personal debt is not the harmless act we are taught to think it is. Personal debt is, in fact, a high-risk bet on the future. The family that takes out a big mortgage is betting that it will still have a job in 5-10 years, or that the price of its home will still be high enough in 5-10 years to liquidate the debt if the family had to sell. Obviously this is not true during a crash when home prices decline and jobs are scarce.

In fact, I believe that a family home is an equity play. If you need to get money to buy the home then the investor in your home ought to have an equity share, rather than be a simple creditor. Same thing with student debt. A student has no clue what kind of income he/she is going to earn in the future; nor does the student have any way of liquidating the debt, because there is no collateral. Student debt is an equity play; people financing students should be equity partners in the student's future earnings.

National debt is a horse of a different color. The national debt is in fact the ruling class betting the whole country on its policy. Normally, of course, the national debt is accumulated in a war, where the bet is pretty obvious. Win the war, and the government pays off the debt. Lose the war, and the government repudiates the debt and impoverishes the people.  The other big use of government debt is in the wake of a financial crash. The same principle applies: the government bets the whole country with an increase in debt to avoid a total credit collapse. You can see that on this view government should be running surpluses except during war or financial panic.

(By the way, the $700 billion TARP bailout was the least of the government's actions to rescue the economy. The total bill of bailouts and guarantees was more like $20 trillion. See my

When the government diverts a flood of credit to keep insolvent borrowers afloat after a crash it may rescue the borrowers and the credit system, but there is a cost. The cost is what we have seen in the Obama economy, with growth struggling along at 1-2 percent per year. The same thing happened after the Crash of 1873, the Crash of 1929. Moreover a ton of distressed borrowers after 2008 struggled along in their underwater houses, did not move to a better job opportunity, could not use their home equity to start a business. But this cost is better than the alternatives of wholesale debt default or hyperinflation.

So my opinion is that both high personal debt and high government debt are bad. There is far too much personal debt out that that is not properly collateralized and this debt puts the whole credit system in peril, and government debt is not debt at all, but a kind of national equity play. In my view we should convert a lot of debt, personal and governmental, into equity, where the investor is knowingly betting on a high risk proposition.

Is the current government debt dangerously high? No, but it makes it harder to pay for entitlements and more likely that government will default on its debt to pay Social Security and Medicare, and default on Social Security and Medicare with monetary inflation.

Could government have got out of the Great Recession with a bigger and better stimulus program? I doubt it. Government spending goes to powerful and politically connected interests. If their plans and projects were so brilliant they would not need government credit and subsidies. So it is likely that most stimulus spending is crowding out more beneficial uses of the nation's treasure to pay for the wasteful plans of the rich and powerful.

The go-to book on crashes is Reinhart and Rogoff's This Time is Different. They argue that government typically increases national debt by up to 100 percent after a financial crash. And they also point out that governments default on their debt all the time. In the Great Depression the US government went off gold, giving holders of US dollars a haircut, and it reset the interest rate on war bonds from World War I, giving widows and orphans a haircut. They argue that whenever a government gets to a debt of about 100 percent of GDP it is getting into dangerous territory. Note that The New Yorker thinks that Reinhart and Rogoff are all wet.

Anyway, my view is that personal debt is too high, and insufficiently collateralized when you can get 10% mortgage loans. Government should not borrow except for wars and crashes, and the high rate of government spending makes it harder to fight wars and recover from financial crashes.

We ought to convert a lot of the present personal debt and government debt into equity and recognize the real risk in many financial transactions.

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