Magical Thinking Drags on Economics

Government Debt and Capital Destruction 

Many economists often attempt to set arbitrary thresholds. For example, if debt hits X% of GDP (or whatever measure) then it is “too” large and “impedes economic growth”. This article cites Carmen Reinhart attempting to do just this. It is the wrong approach entirely.

To understand why, let’s look at productive debt and contrast with government debt. If Joe borrows money to build a factory to produce Supersmart phones, then paying the interest and principle on this bond does not impede anything. His revenues would not exist without borrowing the money, and so we can say with certainty that this debt is good for Joe, it is good for Joe’s customers, and it is good for everyone else including Joe’s employees, Joe’s vendors, etc.

By contrast, what if John borrows to live a lavish lifestyle that his income would not otherwise support? EVERY PENNY spent to service this debt is a drag on John. At first, he was seemingly able to buy things without real cost. But when the first credit card bill comes due, then he incurs cost without being able to buy things. There is no magic number, no arbitrary threshold, no line in the sand. This debt is bad for John, and for everyone else that John touches. (I don’t think that there would be much, if any, consumer lending in a world where savers had to lend their hard-earned gold, a world in which the Fed was not the ultimate source of credit, but that is a different discussion).

Government debt is not like Joe’s debt; it is like John’s. The government borrows so that it can buy more than its tax revenues. Initially, this creates an illusion of prosperity. But soon, the government must begin paying to service the debt (it can never actually pay the principal because there is no extinguisher of debt). EVERY PENNY of this debt service is a drag on the economy. The government is buying fewer goods than what could be paid for by its tax revenues. Contrary to the threshold idea, the drag really begins with the first dollar of debt and it is proportional to the debt.

Two factors obscure this and make it harder to see. One is that the government can borrow more. So long as the government has access to unlimited credit, it can borrow to pay the interest and borrow to consume. A major theme of my writing is that this can only go on while people are willing to feed perfectly good capital to the government so that the government may consume it. When they are no longer willing, or when their capital is depleted, then the game ends. It ended in Greece and it will end in the US at some point.

The other is that it can force down the rate of interest. This makes it cheaper to “roll” its debt, to pay off old bonds as they mature by selling new bonds. If the new bonds have a lower rate, then the government can service more debt for the same payment. Another major theme of my writing is that a falling interest rate destroys capital.

It is no accident that both factors masking the drag of debt have to do with capital destruction. Nevertheless, the drag of the nearly-$17T of debt that the government acknowledges plus the far larger liability that they carry off the balance sheet is very real. One can see it almost everywhere one looks, from the weak labor market to the increasing reliance on the Fed as the only source of credit.