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Banbury Cross

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Post details: Good Debt, Bad Debt

Good Debt, Bad Debt

Suppose you have a large mortgage, you are paying off your car and you have $30,000 hanging on your credit card. In other words, you are up to your ear tips in debt. Would it be economically prudent to take on some more?

If you are about to jump from your chair and exclaim "Noooo!", hold your horses and give it a little thought. There is actually good debt and bad debt, and the answer really depends on what you are going to do with it. In the first scenario, you borrow money in order to put yourself in a position that will create a positive cash flow in the future. You could use your debt to increase your education level and pay for a tuition at a respectable college, or you could buy an equipment that would help you start a new business. If all went well, you would soon be able to make enough money to pay off all your debts. In the second scenario, you would use the new debt to merely help cover your living expenses, or worse to pay for some luxury items, like a plasma TV or a vacation in Bermuda. This kind of borrowing would clearly exacerbate your financial predicament and send you on the way to a bankruptcy spiral.

National finances, albeit operating on a scale several orders of magnitude larger, have to obey the same laws of economics, much like all material objects, whether the Earth or a snowball, have to obey the laws of physics. Going into debt may not be a bad thing if you know what you are doing. Republicans like to reminisce that Reagan proved that budget deficits don't matter and that a nation's borrowing power is virtually unlimited. But the reality is not that simple. Nations have to heed what the debt is used for as well, they just have much larger leeway in dealing with consequences.

Contrary to what the Greenspan/Bernanke school of thought would make you believe, money does not grow on trees. It is supposed to represent value. Just because Central Bank can create money out of thin air, does not mean that it can solve all our problems by dunking them in a vat of dough. Just ask Rudolf of Havenstein, one of the Weimar Republic's central bankers, who learned the hard way that you cannot have something for nothing. He controlled the German financial system in the early 1920s when runaway hyperinflation basically wiped out their currency. His undoubtedly good intentions eventually paved the political way for one Adolf Hitler. And we all know where the road paved with good intentions leads to.

In the past two years our national debt increased dramatically. That means it is about time for us to start paying very serious attention to how that money is being spent.

We could spend our financial resources on education grants to talented kids from poor neighborhoods, on laboratories developing new generations of materials that the world would love to buy, on upgrading our aging infrastructure (whether introducing fast trains or superconducting grids) to facilitate future economic activity or on reducing our energy needs and steering the whole industry towards alternative and green sources. That would be the good debt. But we could also spend the borrowed funds on supporting overgrown bureaucracies at all levels, on rectifying grave investment mistakes of private banks, on recapitalizing institutions hollowed out by their greedy and incompetent management, or on bankrolling unproductive pork barrel projects, such as building water pipelines to money losing golf courses or funding research of Icelandic Arctic Environment in Viking Era.(*)

(*) Both of these examples came from the recent stimulus bill. I understand that pork barrel projects serve as important bargaining chips in political maneuvering, but I think it would be entertaining to hear the legislators publicly explain how these projects will contribute to the nascent recovery.

At the end of the day, it is our choice how we use the money we borrow and that choice will determine our economic future. We can either educate our population, modernize the production lines and repay our debt with something of value, or we can follow in the footsteps of Rudolf von Havenstein and annihilate our economy by gradually monetizing our obligations (i.e. paying them off by printing more and more of an increasingly worthless currency).

The report card is not very impressive so far. I hope Paul Volcker will take a hard look at it.

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