Dangerously Out Of Scale

The debt economy – where the top of the pyramid has national debt now topping $12 trillion. The cost of servicing that debt is expected to exceed $700 billion a year in 2019, up from $202 billion this year. The surge in borrowing over the last year or two is widely judged to have been a necessary response to the last financial crisis and deep recession, and there is still a raging debate over how aggressively to bring down deficits over the next few years. But there is little doubt that the United States’ long-term budget crisis is becoming too high to postpone.

According to The Economist – thinking about the crisis and potential solutions extends to the military. Students at National Defense University in Washington DC, were recently given a model of the economy and told to fix the budget. To get the federal debt down, they jacked up taxes and slashed spending. The economy promptly tanked, sending the debt to higher levels than before. The lesson: “You’ll never get re-elected and you do more harm than good,” concluded Eric Bee, an air force colonel who took part in the exercise.

The debt economy has no exceptions – everyone, from homeowners, private equity investors, our largest bankers – have taken on enormous amounts of debt. The sub-prime debt crisis highlights what Charles Dickens said about credit, “Credit is a system whereby a person who cannot pay gets another person who cannot pay to guarantee that he can pay.” Debt did not get dangerously out of scale because the system was broken. It got out of scale, in part, because the system worked.

As The New Yorker pointed out in the November 23, 2009 issue:

The government doesn’t make people go into debt, of course. It just nudges them in that direction. Individuals are able to write off all their mortgage interest, up to a million dollars, and companies can write off all the interest on their debt, but not things like dividend payments. This gives the system what economist calls a “debt bias.” It encourages people to make smaller down payments and to borrow more money than they otherwise would, and to tie up more of their wealth in housing than in other investments. Likewise, the system skews the decisions that companies make about how to fund themselves. Companies can raise money by reinvesting profits, raising equity (selling shares), or borrowing. But only when they borrow do they get the benefit of a “tax shield.” Jason Furman, of the National Economic Council, has estimated that tax breaks make corporate debt cheaper than corporate equity. So it’s not surprising that many companies prefer to pile on leverage.

“The lack of money is the root of all evil” – and using the tax code to formulate public policy (i.e., support development and home ownership) and modify economic behavior probably goes a long way in supporting Mr. Twain’s observation. The hurdles are both political and psychological – tax breaks have been around for a long time.