There was much drama around the last-minute congressional deal to raise the debt limit in June. The heavy focus on this public debt, which had climbed above $31 trillion for the first time, is misplaced, however; it’s private debt that should be the center of attention. That’s according to Richard Vague in his new book, The Paradox of Debt.
The news on that front is less than ideal:
What gives? The US economy has grown at 3.2 percent, 2.6 percent, and 2 percent in recent quarters.
Vague’s Paradox of Debt explains that for the economy to grow, debt must rise. It is, according to Vague, “an inherent feature of the modern economic system.” The problem is this eventually leads to too much private debt, bad lending and a crash before the debt continues to grow ever higher. While economists obsess over public debt, financial crises are overwhelmingly caused by out of control lending in the private sector:
Total debt has always grown as fast or faster than GDP, except in periods of calamity. Debt outgrows income, and this growth is not a cycle, but instead a jagged yet nevertheless unending upwards march.
It isn’t just high private debt alone that causes a crash, rather it is the rapid acceleration of debt growth that signals rough times ahead. Vague’s research with his colleagues shows the following:
When the ratio of private debt to GDP in a major, developed country increases by at least 15 percent to 20 percent in five years or less, then a financial crisis or some other calamity is likely, especially if the overall private debt ratio is at 150 percent or higher.
Here’s what total private debt to GDP looks like in recent years:
Private sector debt (the sum of household and non-financial business debt) percent of GDP is overwhelmingly in the household mortgage and commercial real estate debt.
Is Economic Growth Possible Without Overreliance on Debt?
In his book Vague goes into fascinating detail on all aspects of US private debt and debunks widespread myths on government spending and inflation with thorough research. Vague describes how private debt deleveraging requires public debt growth (and vice versa) in order to maintain GDP growth and household income (which helps explain the decline in private debt in the graph above following pandemic government stimulus).
While public debt ratio to GDP used to decline when the private debt ratio increased and vice versa, since the 1980s in the US both private and public debt ratios have continued to grow.
Increasing net exports is one option, although it’s difficult (the US hasn’t had a surplus since 1975). The other option is to moderate debt growth, although again, that’s easier said than done as debt is outgrowing GDP in the 300 – 600 percent range in the world’s large economies.
Vague also offers compelling examinations of the different debt profiles of the world’s seven largest economies. It’s not great news anywhere despite the different debt growth strategies. China, for example, follows a path that relies heavily on business sector losses and debt and has been struggling to change course without slowing the growth of household income.
Germany, which for decades had followed a trade surplus model, is searching for a new route of growth following Berlin’s decision to sever itself from Russian energy and amid worsening ties with its largest export market in China. The shift is likely to be painful for most Germans.
He also examines the UK, France, India, and Japan. One common theme in all countries is that this debt paradox also drives up inequality.
“One Entity’s Liability Is Another’s Asset.”
While Vague says the debt growth we should be worried about is private debt, there’s also this fact: rising levels of government debt lead to rising inequality.
So without changes to government policy, it seems we should also be worried about government debt. While it may not portend some sort of crash, it causes its own calamity in other ways.
On the private debt front, the bottom two-thirds of Americans are the ones falling further and further behind, which only enriches the wealthy even more.
And the great debt explosions in recent decades has fallen hardest on lower income households:
The reality is that the debt service ratio, which is a household’s monthly debt payments in ratio to their income, is today 30 percent higher than it was in the 1950s and 1960s…the trend in the debt service ratio is worse for households in the lowest income segment.
Increased debt has led to an increase in land and stock purchases, which has sent their values soaring, but those “gains” have not been evenly distributed:
We’ve seen that most of the gain in household wealth comes through the increased value of stocks and real estate, which increase in value as debt increases. Because the top 10 percent of US households own most of the stocks and real estate, these rewards fall on them disproportionately while the burdens of increasing debt fall disproportionately on the bottom 60 percent. And because growth in debt is essentially perpetual, with only episodic, calamitous reversals, the pressure towards growth in inequality, however fast or slow, is likely also essentially perpetual, absent some major countervailing change, such as a change in tax policy.
More debt among the bottom 60-plus percent helps push up the value of real estate and stocks owned overwhelmingly by the wealthy, which Vague says “adds to our growing inequality dilemma.” But is it really a dilemma for the country’s elite or is it working exactly as the American elite want it to?
The promise of trickle down wealth has never materialized. Debt, however, that’s another story:
In the period 1945 to 2020, when household net worth nearly doubled, US household debt grew a monumental sixfold, from 13 percent to 79 percent of GDP. However, in relative terms, this increase has fallen harder on middle- and lower-income Americans, with significant economic and political consequence.
Vague doesn’t get into what those consequences are, but typically inequality unaddressed can lead to some dark places. Because inequality is already so entrenched it’s difficult to reverse or even slow down.
Pandemic relief, basic income, welfare, or any government policy that sends money to help people survive ultimately ends up enriching the wealthiest since the money is inevitably spent on goods and services overwhelmingly controlled by them. In other words, our society is already so unequal, it’s challenging not to make it more so:
Tens of millions of both middle- and lower-income households – those in the sixtieth to ninetieth percentiles as well as the bottom 60 percent – have essentially no net worth and high levels of debt. And much of that debt is for purchases of goods and services from companies owned largely by the top 10 percent.
So millions of Americans are stuck slaving away with no hope of ever climbing onto sturdier ground; they slog on just to survive and further enrich the rich. And the results are predictable:
We see that the total net worth of the top 10 percent of US households has increased from 161 percent to 288 percent of GDP, an extraordinary increase of 78 percent. At the same time, the debt to income ratio of the top 10 percent has increased by less than 20 percent, from 52 percent to 61 percent of GDP – a small amount in the context of their overall balance sheets.
In this same period [1989 – 2019], the total net worth of the bottom 60 percent of households has actually declined, from 63 percent to 59 percent of GDP. … Further the debt to income ratio for the bottom 60 percent has nearly doubled, from 38 percent to 72 percent of GDP.
Reforming to the Current System is a Sisyphean Task
As I read the above-mentioned statistics on how debt intertwines with inequality, I was ready for drastic solutions to meet the scale of despair and destruction wrought by this economic system. Alas, I was underwhelmed by the relatively orthodox prescriptions to avoid crashes and make debt more tolerable.
Vague believes these crises can be averted by watching for such overlending and increasing regulation when the alarm bells begin to sound. His solutions to the debt paradox basically boil down to detect and stop.
While Vague acknowledges this wouldn’t be easy, it’s worth emphasizing just how difficult it would be. As Vague mentions, inequality is already so far out of the barn, it’s nearly impossible to enact a government program that helps the poor without simultaneously increasing inequality. But that’s not the only way inequality has spun out of control.
There’s also the problem of how much power rests in the hands of the rich due to that inequality. How is proposed detection and regulation going to overcome such regulatory capture and bipartisan opposition? Vague mentions the case of Federal Loan Bank Board Chair Edwin J. Gray who tried to put a stop to irresponsible lending in the runup to the savings and loan crisis in the 1980s. How did that go? The industry threw money around and got him removed from the board. That type of control over government has only increased over the 40 years since.
Is there any other incentive for lenders to guard against overheating? Vague mentions the moral hazard point that people who get bailed out could be more imprudent with future borrowing. But what about lenders who are the ones actually receiving bailouts. Why would they relinquish control of government and submit themselves to regulation when they can simply profit, crash, and get bailed out?
Vague has a lot of plans for eliminating the taxes on dividends for the bottom 60 percent and means-tested relief for mortgage, healthcare, and student loan debt. He also proposes debt jubilees:
Debt forgiveness is actually an ancient idea. Kings of Ancient Egypt and Babylon routinely proclaimed an amnesty from debt when debt levels began to crush the population, which provides surprising attestation to the universality of the problems of debt overaccumulation. We need modern-day private debt jubilees to be a component of our economic system if we are to reduce accumulated debt sufficiently to meaningfully improve lives and economic growth, and to do so without damaging the economy.
Maybe I’m too cynical, but it’s hard to see how these proposals would do more than make the situation a little less horrible. Any assistance would certainly be welcome, but would it be enough or does it end up like current solutions to the US’ ever-increasing homeless problem: get one person off the streets and into stable housing, and five more take their place because it’s simply impossible to keep up, and all it takes is one bad break.
Debt jubilees, for example, sound great, but unless you fix the underlying rapaciousness, how often do you need to beg the king(s) for a jubilee? Once a year? Every six months? The jubilee might come in time for some, but not for others.
For such situations, Vague turns to Massachusetts Senator Elizabeth Warren’s proposals for reforming bankruptcy law. These all sound logical, but the simpleton in me wonders if it wouldn’t be better to have an economic system that didn’t cause so many people to go bankrupt from healthcare, education, housing, and other costs.
Vague also advocates for a strengthening of the social safety net to prevent people from falling further behind, but his main goal is to offer plans that would help individuals “advance financially.”
And how are individuals starting from behind supposed to do that in order to take advantage of IRA tax breaks? Vague wants to “boost the marketable skills of the millions of people who are currently underemployed in the economy.” How to do that? Vague writes:
Lifelong education is not a temporary challenge, nor is this solution meant to be a stopgap for a few years while we wait for well-trained young people to fill the ranks. We have to learn how to train, re-train, and properly utilize the full complement of an aging workforce.
Maybe it’s just me, but that sounds like a horrible existence. I have different hopes for my 40s, 50s, and 60s other than frequent re-training so as to stay afloat. And while I’m no economist, I’d argue that if people cannot have shelter, healthcare and an education without going into crushing debt (and without such debt, the economic system as a whole begins to falter), maybe that entire system needs a rethink.
Richard Vague is the author of The Case for a Debt Jubilee, An Illustrated Business History of the United States, A Brief History of Doom, andThe Next Economic Disaster. He is a former banking executive and the former Secretary of Banking and Securities for Pennsylvania. His latest book, The Paradox of Debt, is available July 11.
