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Should We Really Have More Debt, Not Less?


Not all debt is created (or repaod) equally.

Recently I ran across an article by Kenneth Fisher in Financial Planning, "Learning to Love Debt: The idea that debt is good may be counterintuitive, but the U.S. should have more debt, not less."

First off, as an overall comment, I would say that debt per se isn't a problem at all, it's managing that debt as a function (f(x)) of the rest of an entity's financial profile (balance sheet, income statement, cash flows) that matters.

Rather the problem here is Fisher is using a classic straw man debate tactic: propose that all debt is bad and then debunk that "purportedly" widely held belief. As debate tactics go, it's particularly cowardly from an intellectual standpoint. But I digress. On to the specific points he makes:

"Big federal budget deficits are good because stocks appreciate for 36 months afterward."

First, he's implying a relationship exists between these two series based on the statistics alone and not on any theory of WHY budget deficits are 'good' for asset price returns. There could simply be a giant coincidence and he would have no idea. This is why we need a positivist economic framework to determine if seeming statistical relationships are merely coincidental or are causal in reality.

Second, it is important to remember that within the Keynsian economic framework, money can be created out of thin air (budget deficits are funded with money created out of thin air by the treasury) and there is no theoretical cost to doing so. But in reality, government deficits are future-financed outlays. In modern government finance, they are arrived at by debasing the currency – lowering its value relative to all other goods, services, and monies. And this obviously does have a cost; to suggest it doesn't is simply to ignore (Austrian) theory and the historical reality.

There is a great book entitled: Debt and Delusion that speaks to why the large creation of money by governments has NOT led to price inflation for goods or services (by and large) but rather has been contained to the financial system. In a good article from 2004, Robert Blumen speaks to this:
"Debt & Delusion effectively argues that institutional changes …have confined the price adjustments resulting from monetary expansion to the financial system. The character of the 80s and 90s inflation differed from that of the 70s. In recent decades, price changes following money quantity changes have been in stocks and bond prices, rather than wages and consumption goods prices.

How can inflation sometimes affect financial assets and other times mostly consumer prices? The monetary framework of Ludwig von Mises can explain this. Mises accepted a general relationship between money quantity and money prices, but he argued that introduction of new money into a community will not affect all prices uniformly. Relative as well as general price changes will result.[12] The particulars of magnitude and goods depend on where the new money enters the economic system, and what the initial recipients spend it on.

[Author Peter] Warburton calls the recent period "an excursion into the realm of financial fantasy." The fantasy is that central bankers have found a way to inflate without any negative consequences. While the effects of money supply growth can be confined to stocks and bonds, inflation is hidden in plain sight."

But back to the Fisher article. Fisher attempts to confuse the types of debts: corporate, government, and personal: "Consider this: Do folks fret when GE or Apple incur debt? Hardly. Most rational people understand that corporations use debt responsibly all the time to grow, invest in research and develop cool new iterations of the iPod. We don't worry about corporations."

There is a difference – a large and very important difference – between the two main types of debts: Self Liquidating Debt, and Consumptive Debt.

1) Self Liquidating Debt is borrowing money to create widgets that are sold to pay back the money that is used to produce them in the first place. That is what companies such as GE or Apple do every day.

2) Consumptive Debt, however, are debts that are taken to provide for purchasing a good that is consumed.

It is a truism that production is funded out of savings (future savings or present savings). Thus, one cannot go on forever consuming things without producing them. Thus, taking out consumption debt at a far greater rate than productive debt is a policy that has a limit and an end. And guess what: by FAR, the debts that have been incurred by consumers have been consumptive debts and not of the self liquidating variety.

Second, he proposes the ''worst case'' debt creation:
"So, consider the worst case: a heroin addict. When an addict borrows money, he might stupidly buy drugs with some of it. But with the remainder, he might buy groceries and a new cell phone. The grocery store uses the heroin addict's money to pay for produce, electricity and employee salaries. The recipients take their money and spend it again--normally, not stupidly. The phone store manager does the same thing with the cell-phone money. The addict's dealer may spend part of his money to replenish his drug inventory, but he also pays rent for his fleabag apartment and maybe some salaries for druggy underlings. And everyone who receives the money, whether a slumlord, utility company or organic farmer, benefits from the borrowed and spent money."

There are a few points to be made here. The author fails to understand that ALL economic calculation is based on prices, and that debt-fueled spending changes the relative prices of goods – incenting changes in the productive structure of the economy (building too many houses for instance or cars) - based on the spending of consumers. But to the degree that the heroin addict has received that debt from a free market source (from anyone – person, bank, or corporation) of savings, then voila – there is no problem because that "stupid" loan won't get repaid and that lender will go out of business. But – and this is 100% the case today – when that loan comes from a federally insured/backed/guaranteed institution who farther back up the money stream received their funds from the treasury and the Fed via money-out-of-thin-air operations, then that loan (debt) is endless and can be lent "stupidly" for a long, long time while the entire structure of the economy gets perverted around the tastes and dislikes of the heroin addict.

"It's all about return on assets. If return on assets is low relative to borrowing costs, less debt is in order. But if return on assets is much higher than our borrowing cost, we're under-indebted, not over-indebted--and, in a sense, depriving society of greater wealth. Now, that's immoral! Is the U.S. over- or under-indebted? Since we have total assets of about $120 trillion (according to the Federal Reserve Flow of Funds Account) and a GDP of $13 trillion, our return on assets is 11% after taxes--that's very high. A current fair estimate of borrowing cost is about 6%, or 4% after taxes--much less than our return on assets. We're not over-indebted. Instead, we're falling far short of profit maximization--immorally so!"

But here's where he rests his case: "This is true in theory, but the ultimate proof is the stock market." Voila, a recursive argument: we need to have a higher debt load because going into debt has created higher stock prices.

But as we saw above, the 1980s/90s/00s have shown that monetary debt creation has manifested in inflation in asset markets, NOT the general economy. Thus, creating money out of thin air has created higher nominal stock prices as that's where the money is going because of the incented speculation on the part of corporations and consumers. Thus, he is really arguing that we should create more government debt because higher debt levels lead to higher nominal stock prices. Nominal being the key word (you know the argument already that REAL stock prices are 25-50% less than in 2000).

A few things he never mentions are: the widening gap between rich and poor that is itself a a function of debt creation; nor does he mention the larger and more disruptive shocks the economy has felt as a result of explosive debt creation over the last four decades; nor the growth of the government as a percentage of GDP. All of these things are demonstrably bad (read history) and they are all fueled by debt creation.

As a manager of a $30 billion mutual fund complex, Fisher wants debts to grow as high as they can simply because that new money has shown the remarkable ability to make its way first and foremost into the stock market. Rising stocks means rising fees for Fisher investments, no matter what his actual performance. Case closed.

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No positions in stocks mentioned.

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