Ignore anyone who tells you that debt levels don’t matter.
by ilene - February 13th, 2010 5:02 pm
Guest author David Merkel discusses a topic we touched on the other day, via Tim Iacono’s article questioning L. Randall Wray’s essay on why government debt doesn’t matter. L. Randall’s argument seemed like a smoker’s defense of his habit on the basis of not having died yet. David’s article takes a longer term perspective. - Ilene
Ignore anyone who tells you that debt levels don’t matter.
Courtesy of David Merkel at The Aleph Blog
Debt levels in an economy matter. They matter a lot. An economy that is financed primarily by debt can be like a chain of dominoes. If one fixed claim fails, and it is large enough, many other fixed claims that rely on the first claim could fail as well, triggering a chain of failures. This is a reason why a fiat-money credit-based economy must limit leverage particularly in financial institutions.
Why financial institutions? They borrow and lend. They also lend to other financial institutions. A big move in the value of some assets can make many banks insolvent, and perhaps banks that lent to other banks. The banks should have equity bases more than sufficient to absorb losses at a 99% probability level. That means that leverage should be a lot lower than it is now.
Economies are more stable when they limit fixed claims and encourage financing via equity rather than debt. Imagine what the economy would be like if interest was not deductible from taxable income, but dividends were deductible.
- People would save money to buy homes, and would put more money down when they borrowed.
- Corporations would lower their debt-to-equity ratios, and would pay more dividends.
- Fewer people and corporations would go broke.
Pretty good, but in the short run, the economy would probably grow slower. The debt bonanza from 1984-2006 pushed our economy to grow faster than it should have, where people and firms took more chances by borrowing more, and making the overall economy less resilient. Debt-based economies lose resilience.
What was worse, the Federal Reserve in the Greenspan and Bernanke years facilitated the debt increases because the Fed never took away the stimulus fast enough, and offered stimulus too rapidly. This led to a culture of unbridled debt and risk-taking. If only:
- Greenspan had been silent when the crash hit in October 1987.
- Greenspan had not given
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Philip R. Davis is a founder Phil's Stock World, a stock and options trading site that teaches the art of options trading to newcomers and devises advanced strategies for expert traders...
Ilene is editor and affiliate program
coordinator for PSW.