Debt is bad. We all know it. It brought on the financial crisis. Our governments need austerity. We need to stop living beyond our means. “Neither a borrower nor a lender be.” Sebastian Mallaby suggests in today’s FT that Mitt Romney should come out against debt and bring American capitalism closer to a pay-as-you-go model. Sounds sensible. Does he have a point?
Actually, I don’t think he does. Mallaby’s conventional, sober opinion is worth refuting. He forgets the fundamental role that increased levels of debt have played in stimulating the economy for over a generation. We are seeing high unemployment today not because debt is rising, but because it is decreasing. The private sector, both here and the US is paying down debt incurred during the boom. Without all that borrowing, the collapse of 2008 would have come much earlier.
Ever since the 1980s debt has been the world economy’s essential engine of growth. That is because debt stimulates demand and without demand, the economy collapses, along with employment. Policymakers know this well. Any slowdown from 1987 up to the present day was met by immediately cutting interest rates, to allow more debt-fuelled consumption.
In 2007, this economic model, based on easy money, asset price inflation and ever increasing levels of debt fell apart. Instead of blithely rolling over loans, banks called them in. Households and firms stopped borrowing and started to pay down what they owed. The consequence was the subsequent Great Recession.
This should be enough to tell us that the private and public deleveraging Mallaby recommends would be disastrous, causing more unemployment and destroying any prospects of growth.
It is all a bit confusing. The cause and the cure of the disease seem to be the same. We got into this mess as a consequence of high debt levels but deleveraging will make things worse. What is to be done?
The problem, perhaps, is that the boom was fuelled by borrowing used to fund consumption rather than investment. An investment creates a cash flow with which to repay the debt. Debt-fuelled consumption on the other hand is a bit of a Ponzi scheme; you need to borrow more just to pay off your loan. This worked for thirty years. Low interest rates and increased borrowing raised asset prices, which created paper collateral that convinced banks to keep lending more.
Perhaps the solution is increased borrowing for investment rather than for consumption. Unfortunately, today the private sector has little reason to invest. Why borrow and create more capacity when demand is stagnant, when we already cannot sell all we produce? Thence all the cash sitting idle in corporate coffers.
The previous macroeconomic era is dying; the new one hasn’t yet been born. Austerity isn’t working, debt-fuelled consumption has run its course. We need a rethink. I would suggest, as a first step, we take advantage of extremely low borrowing costs to fund public sector investment in infrastructure and education. These investments will make Britain stronger ten and twenty years down the road and increase employment today.