Global Financial Watch

The once-vital air of commerce, debt, has turned toxic

Debt and Devil.jpg

More than 180 years after debt was described as the “vital air of modern commerce”, at least one top expert believes it now “needs to be taxed as a form of economic pollution”.

Big and powerful companies and commercial interest groups, which in some instances have had their debt tax-incentivised for more than a century and a half, are likely to fight the suggestion by ex-chairman of the United Kingdom Financial Services Authority, Adair Turner, tooth and nail.

However, in a recent article in The Economist under the title “The great distortion” it is argued that the subsidy that governments give to debt causes a “vast distortion in the world economy”.

“Half the rich world’s governments allow their citizens to deduct the interest payments on mortgages from their taxable income; almost all countries allow firms to write off payments on their borrowing against taxable earnings. It sounds prosaic, but the cost – and the harm – is immense,” the article states.

And the time to make structural adjustments in this regard is probably running out quicker than generally realised before another major financial crisis hits the world economy.

In another article earlier this month The Economist wrote: “Acting in concert or alone, countries should act soon. When interest rates are low, as now, the sweeteners for debt are smaller and thus easier to remove. When rates rise – as, inevitably, they will – the subsidy will become more valuable. This is the moment to tackle the great debt distortion. There may never be a better chance.”

In his book Between Debt and The Devil, to be published by Princeton University Press later this year, Turner, presently a senior fellow of the Institute of New Economic Thinking, challenges the belief that we need credit growth to fuel economic growth, and that rising debt is okay as long as inflation remains low. In fact, most credit is not needed for economic growth – but it drives real estate booms and busts and leads to financial crisis and depression.

In a recent article, co-written by Susan Lund, a partner at the McKinsey Global Institute, some other conventional wisdoms are challenged. Among other things the article states that it is “simply not feasible for the most highly leveraged governments to grow their way out of debt.

“Nor can austerity alone suffice, as it would require countries to make such large fiscal adjustments – 5% of GDP, in Spain’s case – that citizens would likely resist them, as the Greeks have done.”

Extraction will not be easy

The process of getting extracted from the addiction to debt that has beset so many economies across the globe will not be easy, from both an economic and political perspective, despite the fact that it has become counterproductive from most conceivable angles.

The latest McKinsey report, “Debt and (not much) Deleveraging”, states: “Seven years after the bursting of a global credit bubble resulted in the worst financial crisis since the Great Depression, debt continues to grow. In fact, rather than reducing indebtedness, or deleveraging, all major economies today have higher levels of borrowing relative to GDP than they did in 2007.

“Global debt in these years has grown by $57 trillion, raising the ratio of debt to GDP by 17 percentage points. That poses new risks to financial stability and may undermine global economic growth.”

It finds, among other things that:

  • Government debt is unsustainably high in some countries. For six of the most highly indebted countries, starting the process of deleveraging would require implausibly large increases in real GDP growth or extremely deep fiscal adjustments. To reduce government debt, countries may need to consider new approaches, such as more extensive asset sales, one-time taxes on wealth, and more efficient debt-restructuring programs; and
  •  Household debt is reaching new peaks. Only in the core crisis countries – Ireland, Spain, the United Kingdom, and the United States – have households deleveraged. In many others household debt-to-income ratios have continued to rise.

Turner and Lund suggest three broad options available to countries to help limit future debt accumulation:

  • To employ countercyclical macroprudential measures to dampen credit cycles and prevent excessive borrowing. For example, stricter loan-to-value-ratio limits and higher capital requirements for banks could slow credit growth when housing or commercial real estate markets are overheating. Yet precisely the opposite approach is now being taken in the United States, where some first-time homebuyers have been given access to 97% loan-to-value mortgages;
  • To introduce mortgage contracts that enable more risk sharing between borrowers and lenders, essentially acting as debt/equity hybrids; and
  • To reconsider tax rules that favour debt since, in many countries, interest accrued on a mortgage remains tax deductible.

They concede that some of these steps will be difficult to sell politically, and suggest a phased approach, with a broad range of tools, including debt restructuring. In some countries the sale of public assets and a one-off wealth tax could also be considered.

Where it all started

It was an American senator, Daniel Webster, who, in 1834, argued that debt is the “vital air of modern commerce”.

In 1853 Britain became the first country to render interest paid by businesses tax deductable and America followed in 1894 with the aim of assisting the indebted railroad industry. It was broadened in 1918 to help companies struggling to overcome the impact of the First World War.

At the time the present situation could not be foreseen, where global debt stands at 286% of collective GDP. Tax breaks on debt have become embedded in most economies and regarded as “the natural order of things”.

As Turner puts it: “I think the crisis of 2008 was – in addition to being the crisis of particular institutions – a crisis of the intellectual theory that applied complete and free markets to the financial markets as well as, say, to the market for restaurants or the market for bananas or the market for automobiles.

“The fundamental point is that the market for finance is different, so many of the propositions in favour of free and complete markets that are powerful in other sectors of the economy are much less powerful in finance.

“Specifically therefore, I think that some of the things that we accepted before the crisis – for instance, that banks should be free to operate globally as single legal entities if they wish, and to move liquidity around the world according to their own profit-maximizing objectives – were mistaken.”

Conclusion

In their joint article Turner and Lund come to the conclusion that the global economic crisis laid bare the challenge of debt reduction – and the risks that excessive indebtedness raises.

According to them the crisis also intensified government and household dependence on leverage, causing debt levels to continue to rise – a trend that, left unchecked, “will lead to more crises in the future”.

“It is time to redirect financial innovation toward developing new tools and approaches to address these challenges. Only then can the world economy move onto a sustainable growth path,” they write.

by Steve Whiteman

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