I was fortunate to be part of a panel yesterday at the Economic Policy Institute commenting on Robert Kuttner’s important new book, “Debtors’ Prison.” Here’s the video of the event though for some reason the sound doesn’t start until about six minutes in—here’s a written summary. Bob also gives a fine summary and I very much admired the comments of Teresa Ghilarducci (note her provocative points on financial literacy) and Damon Silvers, who brought in a fascinating cultural dimension to the analysis.
Here’s my comments:
A tale of two debts: Bob’s book is a very rich one, and I’m just pulling out one theme here, though it’s one that’s central to the book: there’s good debt and bad debt. Economists and policy makers pretty fundamentally misunderstand the difference, which is one reason we’ve fallen prey to a) a massive housing bubble inflated by reckless leverage from which we’re still recovering, and b) austerity regarding public debt which is prolonging the recessionary damage here and in Europe.
Note the policy perversity driven by our inadequte understanding of these different aspects of debt: we allow bad debt to tank the economy, and we refuse to apply good debt to fix it.
“Good debt” serves at least two functions. Through private debt markets, it provides investment capital to borrowers who will put excess savings to productive use, and through public borrowing, it offsets private slumps through Keynesian measures.
“Bad debt” is harder to identify. Debt-financed “speculation” can’t be the answer. That goes on all the time. Bob’s got a great quote in the book from Edward Chancellor: “”The line separating speculation from investment is so thin that it has been said both that speculation is the name given to a failed investment and that investment is the name given to a successful speculation.”
As I see it, a key to bad debt is what I think of as underpriced debt, or more fundamentally, underpriced risk. When an economy gets that price wrong, bad things happen.
So a good way to avoid some of the pitfalls Bob documents is to think about what leads to risk being underpriced and how we can prevent it. Bob spends considerable time thinking about and reflecting on periods in history when financial market regulation worked a lot better than it does today, leading him to an insight that I consider fundamental: the best way to avoid moral hazard is to not get to a point where you have to invoke it to avoid a prolonged recession or worse.
Clearly, the problem with putting debtors in prison is that they can’t pay back even part of their loan once they’re in jail. But the problem with debt forgiveness is moral hazard: if debtors can costlessly default, then many will do so and debt markets will collapse. Bob’s book is in no small part an illuminating tour through ways in which economies throughout history have struggled with this dilemma. And one of his noteworthy, if unsurprising, conclusions is through stringent oversight.
What does that mean in practice? Here’s a handy list of practices that underprice risk and are thus targets in preventing bad debt build-ups:
—non-transparency: when financial instruments and sub-markets (shadow sectors) are poorly understood, the risks they engender are also misunderstood. So, when finance CEOs themselves readily admitted that they didn’t really understand the stuff their traders were fooling around with, that was a bad sign.
Now, you might well argue that since humans are generally thought to be risk averse, when they don’t understand something like a synthetic CDO, they won’t screw around with it, right? Actually, wrong. Go read your Minsky: as expansions mature, risk aversion flips. As John Cassidy put it, when it comes to financial markets stability is destabilizing…go figure.
—Securitization: It’s a fine thing in terms of generating liquidity to package and recirculate debt, but only if at least two criteria are met. First, the credit rating agencies must reliably rate the quality of securitized debt, and two, lenders need to always have some skin in the game. Absent those criteria—Bob reminds us of IBGYBG loans (broker one to broker two: “by the time this note comes due, I’ll Be Gone, You’ll Be Gone, so why worry?”)—securitization can lead to underpriced risk.
—Too much easy money printed by the Federal Reserve: I tend to support Fed monetary stimulus and have worried much more about the central bank choking off growth based on the phantom menace of inflationary spirals. But I put this in here because it’s probably the most common view as to why risk has been underpriced. Many observers incorrectly believe that the Fed is stoking the shampoo cycle (“bubble, bust, repeat”). How can I brazenly say “incorrect?” Read the book.
–Income inequality and wage stagnation: When inequality creates a wedge between the economy’s growth and the paychecks of lower- and middle-income people, the only way for them to get ahead is by borrowing. When that demand collides with the supply of credit flows suffering from the flaws just noted, risk is underpriced and bubbles inflate.
So, fix all of those, and the likelihood a bad debt accumulation is much diminished.
Finally, reading Bob’s anti-austerity message at a time when budget deficits are contracting sharply led me to wonder: do those of us who inveigh daily about the damage of austerity measures right now believe that deficits matter at all? Is there no time when we should worry about fiscal imbalances?
I’d be very interested in Bob’s thoughts on this [listen to them at the end of the video] but I’ll offer two right here:
–First, a higher debt level means we’re more exposed to interest rate spikes. That’s not a reason to avoid higher debt in downturns, especially given the lower interest rates that accompany periods like this one. But it is a motivating factor for lowering your stock of publicly held debt in recovery.
–Second, you don’t want your debt/GDP ratio to be perceived by policy makers as “too high” at the end of an economic expansion, because when the next recession hits, it will need to go higher. So you want to get to a lower perch, as it were, in the recovery so you’re well positioned for the debt ratio to go up, as it must in a downturn.