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Debt Delusion
November 2010

 

Can I borrow from myself? Of course not. Further, I cannot have too much debt to myself. My future spending plans cannot be constrained by any obligations to make payments at later dates, since those payments will be to me myself. 

Similarly, the world cannot borrow from itself and the world economy cannot be over-indebted to itself. In the absence of financial transactions with Mars and Venus, the claim that "the world economy has too much debt" is a misunderstanding. The growth of demand in 2011, 2012 and later cannot be held back by allegedly excessive "global debt". 

These remarks are surely obvious. Nevertheless, a common argument since the meltdown is that an overhang of excessive debt will hold back spending and lead to a prolonged period of weak demand. One of the most articulate exponents of this view has been Mohamed el-Erian of the Pacific Investment Management Company. He predicts a long "new normal" period of slow growth, as consumers pay off loans, companies reduce their leverage and governments trim deficits. 

Two fallacies are at work here. First, the new normal thesis overlooks the fact that every debtor must be matched by a creditor. Any reduction in spending by net borrowers can be offset by an increase in spending by net lenders. 

Second, contrary to media stereotyping, most borrowing is not for the purposes of consumption or even investment in newly-built or soon-to-be-built structures. The greater part of borrowing by individuals is to buy existing houses, while most by companies is to acquire capital assets that are already complete and may have been traded several times. The el-Erian thesis rests on the assumption that lending and spending are related. This is just not so.

More concisely, debts are always matched by identical financial assets, and the cancellation of loans and borrowings arises largely in the course of asset transactions. No inevitable relationship holds between large debt repayments and weak aggregate demand. The private sector may repay debts rapidly and yet the economy can still be booming. 

The el-Erian propositions raise the question: "What is the correct theory of national income determination?" The doctrine of the new normal depends on a theory prominent in late 2008 and early 2009, which is now — mercifully — being heard less often. The theory is that lending determines spending and could be called "creditism". It has its roots in papers written by Ben Bernanke, the Federal Reserve Chairman, and other US economists in the 1980s and 1990s. 

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Ralph Mugrave
November 3rd, 2010
5:11 PM
Tim Congdon disputes the claim that excess debt leads to a reduction in GDP by saying that: “Any reduction in spending by net borrowers can be offset by an increase in spending by net lenders.” Well obviously reduced spending by borrowers CAN be offset by increased spending by lenders. But the $64k question is whether the offset actually works. In particular, where lots of debtors suddenly see the value of their houses fall dramatically relative to what they owe (more or less what has happened in the last two years), they are likely to cut their spending, i.e. deleverage (exactly what they’ve done). Meanwhile, there is no particular reason for creditors to INCREASE their spending to compensate, far as I can see. Net result: reduced AD. TC then claims he has spotted a second flaw in the PIMCO/El Erian argument. TC says, “second, …most borrowing is not for the purposes of consumption or even investment in newly-built or soon-to-be-built structures. The greater part of borrowing by individuals is to buy existing houses, while most by companies is to acquire capital assets that are already complete and may have been traded several times. The el-Erian thesis rests on the assumption that lending and spending are related. This is just not so.” It is difficult to check up on this because TC does not give the URL of the PIMCO article. However, I think I’ve found it here: http://www.pimco.com/Pages/MAE10-8-10.aspx And I just don’t see where the above mentioned “assumption” is. The PIMCO article DOES refer to the idea I set out above, namely that excess debt leads debtors to spend less. And obviously I agree with the latter idea.

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