A lot of our conversations these days center around debt, and for good reason, government and consumer debt are at unbearable levels. This is a bit absurd in an age of virtual money. What the debt argument has turned into is an argument about power, concerning the power of banks to keep control of the currency, and morality, in that those who are in debt have a moral obligation to pay their debts. What these arguments are not about is economics. We should be able to engineer broad debt forgiveness, at least on a domestic scale.

In order to engineer debt forgiveness without destroying the banking system we currently have we essentially need to protect the balance sheets of the banks by giving them funds to cover the bad debts they would incur from absorbing these losses. This amounts to “printing” money to pay for debts, and there is an economic argument against this, which is that it debases the currency and has the potential to cause inflation, perhaps even hyper inflation. But this is predicated on the idea that the funds used to repair balances sheets would be used for consumption, it could be retained, however, its release could be controlled through policy, for instance by raising the reserve requirements of banks. It could also be controlled by making default elective, lets say by loosening the bankruptcy laws, then lending could be made much more restrictive. In theory this should happen anyway, but the real world effect of giving banks free money and then removing debt burdens from people would be a rush to lend to these people again. While many bad debts might again be incurred the banking industry could factor in that cost and still make a killing. The act of people walking away from their debts and repairing the balance sheets of banks is largely what occurred during the financial crisis, except the balance sheet repair was done simply for forced defaults occurring from the housing crisis, rather than from broad elective default to free people from unsustainable debt burdens. So people could still be “punished” by restricting their access to further debt and at the same time the risk of inflation could be curtailed by reducing demand.

Now there is a danger of inflation which could occur independently of the debasement of the currency. This is if people, released of the cost of debt service start to consume more. This would be consumption based inflation, demand driven inflation, rather than the inflation caused by the perceived debasement of the currency. This demand driven inflation could also occur if the perception of potential debasement exists. If people anticipate that the currency will lose value they are more likely to spend it. This means that along with debt forgiveness it would be beneficial to create a set policy decisions to make currency appear more dear. Things like increasing the rate paid for passbook savings.

So what we could see is a whole cascade of events related to debt forgiveness. If loans are curtailed after debt forgiveness then the prices of high ticket items, or large life expenses like higher education could be impacted. The initial assumption might be that this consumption would just no longer occur, but what s more likely is that this consumption would still occur but that cheaper forms would be found, for instance community colleges as opposed to prestigious private schools, or used cars as opposed to new cars. In any rate one could anticipate a deflation of the prices for these items as demand drops. This curtailment, or restructuring of spending choices would probably have a negative economic impact, hurting employment to some degree, but it is ultimately a necessary adjustment.

After all one thing that debt does is create a system of false prices. In standard economic theory the supply/demand curve determines price. But debt creates false demand, demand beyond the actual buying power of individuals, which in turn creates higher prices than would normally be witnessed. Since our economy is so debt dependent it only follows that we would be existing in a system where there is broad price distortion due to debt. We can see this starkly reflected in two areas which have seen extreme price increases, higher education, funded largely through student debt, and health care, funded largely through government debt.

It must be admitted though that economic function has a basic reliance on debt. People make the argument against fractional banking, (the system by which banks are able to loan out X amount of dollars for the amount of deposits they hold), that it is essentially inflationary in that the money supply must always increase to cover the repaid amount of the loans, and that this builds a bias for indebtedness into the economy. They are right to a degree, but it ignores why debt is necessary to start with. If in a start-up economy you have someone with a vein of iron ore they wish to exploit then they will need to fund that enterprise before they can even sell the ore, in a modern economy these costs are multiple. This need for debt travels all through the economy, everything involves cost before money can be made. In a way economies wind up fighting the same battle as a perpetual motion machine, why can’t an electric motor run a generator which runs the electric motor, because the input must always come before the yield. The only thing that allows economies to avoid this is the existence of profit, by creating a margin above the cost of financing an operation. That  profit margin should be able to be moved forward, lessening the need for further debt.  For competition to exist and In order for this to happen actors must exist which move profit from some firms and then give it to others. In this regard banks perform an important economic function, they are the guardians of profit. For instance you may have a start up which, although it required debt to get started, becomes profitable and then erases this shortfall for the next potential start up. Now if this profit is used for something which has no chance of making a profit then the benefit is lost. Banks perform the role of making sure that where the profit goes will pan out. They do this by reviewing the worthiness of firms that borrow.

One type of debt doesn’t quite fit the bill of start up debt, and that is government debt. In theory government spending should have immediate access to funds, since it is a byproduct of everything else that occurs, it exists off the profit talked about earlier. There was a piece in the Times recently about how Japan has been unfairly cast as a troubled economy, that since its economy collapsed in the 90′s many things about it have improved, life expectancy has increased, it’s trade balance has improved, etc., It makes for interesting reading but it does ignore the fundamental problem of how ones pays for such staggering debt without economic growth and with an aging population. So clearly Japan is doing things from a policy standpoint that benefits its society, it just isn’t paying for them, when you do this you eventually wind up having to pay what amounts to a penalty tax. This is a cost associated with what governments do when they have taken on more debt than they can pay. The penalty tax can take the form of forced write downs, or roll-overs, or it can take the form of inflating the debt away. When people buy the government debt of a country which is clearly living beyond its means they must face the fact that the debt they are buying has a good chance of not being worth its face value.

Paul Krugman, economist and columnist for the New York Times also made a worthwhile point in a recent piece, In it he talks about a misconception people have about public debt which is that it gets paid, it never really does, it just gets rolled over into new debt, and this is true. In this regard debt serves a very useful purpose traditionally in that the bridge you pay for today doesn’t really get paid for years, and so its real cost is much lower than it seems. The problem with this scenario is that it counts on inflation to reduce the real cost of investment and growth to offset the debt burden. I read recently that income taxes collected until June are required for simple debt service, (this data could be suspect, I don’t remember where I read this and so it comes from the dusty memory bin, but I don’t find the idea to be too hard too believe). In any rate I think it is becoming clear that this scenario for making public debt work is becoming suspect. We are close to levying the penalty tax.

For the United   States sovereign debt is both easier to come by but also comes with extra strings attached since the dollar is the reserve currency for the global economy. This forces the United   States to do things with the currency for the sake of maintaining its integrity as the reserve which don’t do much good for the domestic economy. For instance the world wants a strong dollar, a dollar with a lot of value, but the domestic economy would be better off with a slightly weaker dollar, making domestically produced goods and services more competitive in global trade. so ultimately if one wants to maintain the current economic model what would work best is if the United   States were to decouple the dollar used for the domestic economy and the dollar used for international trade. Since this is a power issue, it is always a sign of empire when ones currency is used as the global reserve, there are nations holding U.S. debt that would probably be willing to exchange punishing the U.S. for the debt levels it has incurred if the Fed were to be relieved of the duty of being the central bank for the world and that power were to be transferred to an independent entity.

Then there is consumer debt. It is unfortunate that government debt receives so much attention but consumer debt does not. This is especially odd given that so many people pay no taxes at all. On the one hand some conservative minded people are glad this is the case, on the other hand some are probably rankled by how unfair this is, that only better off people pay any taxes at all. This is an illusion, of course, if one factors in state and local taxes, (and one must realize this is where the tax burden has increased), which hit the lower income brackets harder, then the real tax burden comes very close to being equal. In any rate if consumer debt were reduced it would be far easier to make the argument that lower income people would be able to pay some share of the federal tax burden. So the two are ultimately tied, and since government tax revenues come secondary to consumer debt if you want to get closer to the root of the problem you need to look at consumer debt.

Consumer debt was one of those byproducts of the functioning of our dear markets. It was obvious that people would take on debt to buy ever increasing amounts of things, and with the stagnation of wages this became the only way that these purchases could be made. So for a long time the economic “growth” of the U.S. was fueled by debt. This growth was clearly not real growth, in that it was accelerated consumption which by its very nature must decrease future consumption. There is, after all, only so much consumption and debt that can be fueled by a given level of income, we chased that down and then some, leaving many U.S. consumers tapped out.

Today, however, consumers don’t even have a chance to use debt for consumption. First off  many are saddled with staggering amounts of college debt, debts which often amount to the equivalent of having a mortgage, then those who aren’t able to earn the wage a college education buys often must resort to using debt to pay for basic expenses, fuel, food.

So if we could both write off large portions of consumer debt, while restricting access to future debt, and enhance incentives to save, (preferably with small banks that won’t use the savings to invest in things which remove funds from the general economy), we would could remove some price distortions which have been built into the economy by high levels of debt and move to a cash based, as opposed to a debt based economy by taking funds currently used for debt service and moving them to consumption. While this may cause some moral trepidation on the part of those who handle their debt well is should be remembered that they will continue to have access to debt. Their future spending choices will still be greater due to their past thriftiness.

There is another small point I would like to make in regards to debt and that is what is referred to as “moral hazard”. This is when you encourage people to do bad things, in this case take on debts by using credit which is too easy to get. It is believed that if you shove this debt at people you encourage them to do what you wouldn’t want them doing, driving themselves into unmanageable levels of debt. First off this is only true as long as you continue to lend freely to these people, if you don’t then the argument doesn’t hold. Secondly where the moral hazard really occurs is in lending, not in borrowing. Since banks know that they don’t have to bear a price for lending to people who can’t pay their loans back then they have little reason to perform the due diligence to make sure that they are lending to worthy credit risks. The moral hazard argument is largely an argument in favor of punishment, and not an argument in favor of sound economic policy.