Download here - Transforming Finance

Good debt and Bad debt
Mainstream discussion pits austerity against increasing debt: if someone says that government
should spend on capital projects to help get us out of recession, John Humphreys or one of his
clones will adopt a tone of astonishment and trounce the proposer of this scandalous doctrine with
‘What! Take on more debt? How can you solve the problem of too much debt by adding to it? The
proposer can do little but retreat into silence and lick his wounds, because to explain the fallacy
behind this response needs more time to explain than is available on a mews programme. I want to
argue that the austerity/profligacy dichotomy, which we have been fed ad nauseam, is the wrong
way to look at debt and to pose another dichotomy: good and bad debt. I shall argue that there is
nothing wrong with debt as such – whether it is good or bad depends on what it finances. I shall deal
with government debt only, but holds for private debt too.
But first let us tackle the Osborne proposition that we must bring the debt down or face, if not
bankruptcy, certainly cripplingly higher borrowing costs, which will, of course, increase debt further.
A country that controls its own currency and issues debt in that currency cannot go bankrupt, so that
allegation is pure hot air. But Osborne still maintains that it is his austerity policy that has kept
interest rates on government debt down, by demonstrating his determination to the market. The
truth is, no-one knows the point at which the market would baulk at further UK borrowing without a
substantial rise in interest rates. But there is an alternative explanation of current low rates: the fact
that the BoE has been buying up vast amounts of gilts. This is certainly a factor in keeping interest
rates down and may be decisive. Furthermore, there is some evidence that before QE became so
extensive, markets were more attentive to the deflationary effect of austerity on the UK economy
than any fiscal probity. Finally, even if it were true that the markets want to see the debt reduced, it
cannot be reduced by austerity in the middle of a recession. This is because the government is not
like us: we can reduce our debt by spending less, but when they spend less and/or tax more,
incomes fall, the private sector cuts back output and employment, benefit costs rise and the tax take
falls. A rise in output and employment is necessary if the debt ratio is to come down.
Let’s also look at the scale of debt. Yes in recent years it has grown substantially, but in the larger
scale of things, the present level of debt is not huge. [slide] Of course the high levels of debt that you
see in the early part of the last century is war debt, and the debt ratio fell through the ‘golden years’
of growth, largely because of the growth of GDP. In 2007-8 we faced the largest financial crisis since
the 1930s, if not larger, and it is still going on. A rise in public debt to forestall financial collapse was,
in the view of all but the most extreme free marketeers, necessary, and again most agree that deficit
spending was absolutely justified to prevent the collapse of the real economy repeating the
experience of the 1930s. This crisis was huge: it has the dimensions of a war. So Keynes’s remark1 is
pertinent; ‘If only I we could tackle the problems of peace with the same energy and wholeheartedness as we tackle those of war! Defence is old-established as a proper object for the State,
whereas economic well-being is still a parvenu.’
1
The Policy of Government Storage of Food-Stuffs and Raw Materials, EJ Sept 1938, p 454.
To get economic activity to rise in a recession, where liquidity is being hoarded by the banks and the
private sector is trying to pay down its debt, it is important for government to stimulate the
economy.
Good debt is debt that pays for itself. Perhaps the best debt – or at least good debt that is easiest to
understand, is created by loans for productive purposes, preferably capital, which, once it is installed
and working, will produce goods that earn a profit sufficient to pay off the debt. The economy ends
up with an improved capacity and the debt is repaid. If banks lend for this kind of activity, there is no
need for the money supply to rise continuously. Growth can be supported by a ‘revolving fund’ of
debt that is constantly being issued and repaid.
Bad debt is generated by loans for unproductive purposes: purchases of existing assets, which
inflates their prices, or consumption, which only brings consumption forward in time. Some of this is
necessary (house purchase and occasional large consumption items), but this kind of debt does
nothing to generate income and should be kept within moderate bounds. Really bad debt finances
purely financial transactions, which generate no wealth or income except to those who act fastest. If
these loans generate leverage, the gains can go on for longer, but the system will become
unsustainable, as we have seen.
I have started with examples of individual debt contracts. But when government (or any other entity
that bulks large in the economy) borrows to invest productively, not only does the investment itself
generate income to pay off the debt but the expenditure will stimulate the rest of the economy to
expand. This secondary effect is known as the multiplier, and because of it, we don’t have to wait for
the debt to be repaid from the proceeds of the specific project it financed: because the expenditure
stimulates the rest of the economy, tax revenue will rise and unemployment benefits decrease with
the economic expansion. Osborne denies this mechanism. At the beginning of the austerity
programme he maintained the opposite: that the private sector, once relieved of government
oppression, would rush in and fill the vacuum left by falling government expenditure. In effect, he
maintained that the multiplier was negative: that the private sector would grow to replace the cuts
in public expenditure. Many academics long thought the multiplier to be low, not much more than
one, but the IMF has recently revised its estimates upward. At the moment, of course, a high
multiplier is working against the economy, as it works in the downward direction too, amplifying
cuts in public expenditure.
Be clear, however, that this multiplier only works for direct public expenditure on the economy, not
for benefits or interest payments. These are transfer payments, payments amongst ourselves. If they
have an effect on the level of economic activity, it is because the effect on spending of the group
that pays and the group that receives is different. So, once again, if government expands debt in
order to stimulate the economy, it ought to use the proceeds for those expenditures that have
multiplier effects, not to make further transfer payments except where these are dictated in the
short to medium term by contractual or statutory obligations (interest payments, benefits, pensions).
This is a point even most economists don’t understand: they tend to lump all government
expenditure together or, at best, take interest payments out (what is left is called the primary
deficit).
The multiplier effect does rely on the private sector responding to a government stimulus. The
trouble is that, after nearly 70 years of peace, it is difficult for the private sector to find good
investment opportunities, except in areas of rapid technical change. The long period of capital
accumulation means that the expected rate of return on many investment projects will have
declined. Corporations have turned to generating ‘bubbles’; from which they can extract rent rather
than contributing to economic welfare by producing things that people want and need. Yet there are
many things that need doing, not least re-tooling our infrastructure and processes toward a greener
future. We know, while apparently government does not, that we cannot return to Business as Usual.
If there is a shortage of profitable opportunities which are also genuinely socially useful, it follows
that there are only two routes to a viable future: either people reject the corporate solution in
favour of local initiatives or government, which can in principle take a long view and distinguish mere
profitability from social usefulness,2 must take the lead. But this they show no taste for doing: they
are as saturated as the rest of us in the neoliberal rhetoric that would leave all economic decisions,
including banking, to the private sector, and despite the private sector’s recent evident and
miserable failures they appear actually to believe it.
Or are they just walking away from problems they ought to address? – playing the role of the
Cowardly State?3
Should they decide to take on the mantle of the Courageous State, the issue they must face is that
debt is good or bad depending on what it is used for. It is always a good idea to spend money wisely,
but with the present constraint of enhanced market sensitivity it is imperative. Spending money
wisely means that there is a need to think through what sort of economy – and indeed ecology and
society – we want and obtain support for this vision. Keynes is understood by those who haven’t
read him as recommending wasteful expenditure, ‘digging holes in the ground’, to boost
employment in a slump. This was a piece of bitter irony, used to lambast Treasury officials for
judging proposed expenditures strictly on whether they would turn a profit and disregarding the
social utility of the improvements that could be brought about by a partial subsidy. What he actually
said was that instead of some wholly wasteful expenditure, like digging holes in the ground, it
‘would … be more sensible to build houses and the like; but if there are political and practical
difficulties in the way of this, [digging holes] would be better than nothing.’4
The Courageous State will need to resurrect active industrial and regional policy. ‘Picking winners’
has to come back on the table, at least in very broad-brush terms. Amongst the weapons they might
use to re-shape the economy is credit guidance to the banks. This policy was followed during the
Second World War and continued into the 1960s. Very general instructions were issued to the banks
– credit for speculation was forbidden and personal lending was severely restricted; exports and
productive investment in some industries were given priority. Present policies of subsidising loft
insulation and the like are very much to the point but need to go further. There should be no
squeamishness about increasing debt for such purposes – it should pay for itself in fairly short order
though its boost to the construction industry and through the multiplier to the rest of the economy.
2
They routinely fail to make this distinction. See Keynes’s complaint that profit is their only criterion (GT p.
129). Today (24 April 2013) it was announced that even the arts should show a profit or lose government
funding!
3
Richard Murphy, The Courageous State
4
General Theory, p 129.
The gains from some types of public expenditure are less easily measurable because those gains are
indirect, eg health, education and the arts. At the moment, government is so besotted with the idea
of profit that we are told that even the arts must show a profit! The government needs to think
more broadly about the economy in terms of ecology and society if it is to spend wisely, but if it does
that, debt is nothing to fear.
This optimistic view of debt cannot be shared by those in the Eurozone, for they have no control
over the currency in which their debt is promised. We are dependent on market sentiment, but they
are far more trapped.