Why Is Debt Bad?

by seangljacobs

Debt causes and exacerbates recessions

Sean Jacobs, Hip Hop Republican, 12 November 2014

Rarely are the harmful effects of debt explained or unpacked at length. Greed is often the main explanation for the 2008 Global Financial Crisis alongside Wall Street malpractice and complaints of ‘the top one percent.’

These are certainly much easier targets for blame than household debt, which appears to have a subtle but much more potent effect in causing and exacerbating recessions. This is the message of a new book called House of Debt: How They (And You) Caused the Great Recession by American economists Atif Mian and Amir Sufi.

While technical in parts their argument is simple enough for non-economists. In the lead up to 2008, they explain, U.S. household debt ballooned to unprecedented levels. Between 2000 and 2007, for example, the total amount of household debt doubled to $14 trillion while the household debt-to-income ratio jumped from 1.2 to 2.1.

Why is this so economically lethal? Simply because high debt households crawl into a shell when the economy contracts.

But this is only part of the story. Americans, like many in other countries, have a great deal of their wealth tied up in the value of their homes. Naturally, if house prices dip, households – especially those with high debt – recoil even more.

While this is common sense the figures are staggering. The decline in home values, for example, led to a $275 to $385 billion decline in U.S. retail spending. ‘Yes, the poor were poor to begin with,’ Mian and Sufi explain, ‘but they lost everything because debt concentrated overall house-price declines directly on their net worth. This is a fundamental feature of debt: it imposes enormous losses on exactly the households that have the least.’

Throughout the 1990s and in the lead up to the Great Recession money became easily available to persons with low incomes or simply bad credit scores – behaviour that Mian and Sufi call ‘aggressive credit expansion.’ This also relates to what Thomas Sowell calls ‘the political crusade for affordable housing’ which, despite being bad economics, made impeccably good politics. Who, after all, is not for affordable housing?

As current U.S. economic settings show household debt has not only driven the Great Recession but made the recovery much slower. Unsurprisingly other economies like the United Kingdom and Sweden – who also carry high levels of household debt – have recovered the slowest.

To mitigate the effects of debt there are some solid ideas around debt financing reform, introducing equity-like arrangements (rather than rigid defaults) or through shared responsibility mortgages. This last idea, in particular, would mean giving protection to home owners if the value of a home goes below purchase price.

But trying to correct the general debt addiction is difficult on three fronts. First, not just in the U.S. but other economies, people simply save less than before. In Australia, for example, net national saving has gone from 12% of GDP in the 1960s to around 5% today. A finance sector that thrives on lending is unlikely to abate while demand remains.

Second, in terms of home ownership, making housing more affordable through the free market (and not credit expansion) is near-politically impossible. Freeing up housing supply and relaxing regulatory restraints would, in addition to making housing cheaper, decrease home values – a politically unfeasible move.

Third, in terms of government spending, debt is now an intimate feature of the pre and post-GFC landscape. Despite talk of austerity Western governments still spend more than ever before. Now in many circumstances ‘cutting spending’ actually means cutting the ‘rate’ of spending. This, to paraphrase commentator Jonah Goldberg, is like driving a car off a cliff but only negotiating how fast it goes.

But beneath all of these complexities, and not always acknowledged in economic or financial data, rests the consideration of values. Debt is the reason why not ‘living beyond one’s means’ and pointing to the hazards of generational costs remain important.

‘If you know how to spend less than you get,’ said Benjamin Franklin over two hundred years ago, ‘you have the philosopher’s stone.’ And as Adam Smith suggested at around the same time – no one spends other’s money like they spend their own. Even if not always acknowledged, being alive to the harmful considerations of debt will continue to be critical. Prosperity and recovery clearly depend on it.