Paying off debt - the Problem

Total public and private debt, in most of the developed world, has reached heights never before seen in an financialized economy. There seems to be a general consensus that these high debt levels are "unsustainable" and a wide view that they should be paid off, as opposed to jubilee'd or inflated away. But I've never seen anybody discuss what it would require for these debts to be paid off. Some consideration of the consequences of paying off debt on a societal scale show that it can't be done by belt-tightening by the debtors, and that the only solutions will be inflation, drastic increases in taxation, or massive default (including almost all sovereign developed governments). This also raises a long-term political issue in that none of these options are currently acceptable to the governing classes of any developed nation, meaning eventually the governing classes will either have to change their minds - or be overthrown.

The problem is that debt has different meanings to a society than to an individual. For an individual, debt is an external item can be paid off, by earning more or spending less, up to some limit. We are all individuals, and we naturally think of debt in this way. But on a societal scale, debt is not external. Debt is a relationship between debtor and lender; the debtor's debt is the lender's asset. So an excess debt problem is, on a societal scale, also an excess asset problem, and the two problem are not just interlinked; they are the same thing. For debt to be paid off on a societal scale, lender assets have to be reduced at the same rate the debtor debts are reduced. Given the enormous sums involved (typically several times GDP) and the highly skewed wealth distribution, this creates a problem.

There are two basic ways for the lenders to have less assets. They can spend at the rate the debtors pay, or they can have assets taken away. Spending would require an almost unimaginable splurge by the rich. Spending by buying assets won't fix the problem, because then they'd still have assets. It has to be consumed.

In the US, almost all the debt is owned by the 1%, and most by the top 0.1%. If the combined debt is reduced from 370% to 270% over ten years, that's about 13 trillion dollars of assets of the wealthy that have to disappear. The top 0.1% own about half the wealth, so if the losses were proportionate, the 300,000 members of this group would have to spend about 20 million each. That's a lot of trips and hotel rooms, fancy cars and big parties, or for that matter, anything.

The simple fact is: the rich aren't spending like that and they're not going to. Luxury spending dropped precipitously in the 2008 crash. It has since recovered, but it's not going up by the severalfold increase needed to allow the debtors to pay things off. The economy probably couldn't support luxury spending at that level anyway. Our society relies on infrastructure, both concrete and conceptual, to produce stuff, and that infrastructure is tied to what it makes. We're not set up to produce luxury goods and services on that scale and it would be a huge project to become capable.

So since the rich can't consume all the rest of society owes them, some of their assets will have to be taken away, directly or indirectly. There are a number of ways to do this. One is for some of the debts to be cancelled. Another is high taxes on the rich. And the last is for high (but not necessarily hyper-) inflation. All approaches have been taken in the past, successfully.

Sometimes debts get cancelled. According to the bible, that's the way God requires. Every 7 years, all debt disappears. We don't have records to demonstrate this actually happened, but in pre-industrial societies land reform was often used to essentially the same effect. Poor farmers borrow for problems, landowners take the land when they can't pay, land reform returns the land to the farmers.

Higher taxes have also been used. Two examples are the US paying off its Great Depression/WWII debt, which was accomplished partly by tax rates of 91% on earned income; and Great Britain paying off its Napoleonic War debt, which was similarly accompanied by high taxes for most of the 19th century. In these case the outcome was quite good for the countries in question. Higher taxes on the middle and working classes have also been tried, but these haven't worked so well, most likely because those people don't have the assets to be taken in the first place. Higher taxes on them causes either general economic collapse or mass cheating on taxes.

Inflation has also been used many times in the past. Generally the results have been inferior to the other two methods, although I think this is effect, not cause. A government has to be strong and far-sighted to jubilee or redistribute, because those are always opposed by the wealthy classes. Weaker governments inflate, and the same weakness that forces them to use the more indirect taking of inflation makes them less able to deal with the kinds of problems that any society must deal with from time to time.

Given that one of these approaches will have to be taken, the next question is how can one of them be picked? Debt cancellation, by bankruptcy, on the requisite scale would bankrupt every bank in the world; as 2008 demonstrated governments won't tolerate that. If that happens, the government will guarantee the banks' assets an in the end will have to assume debt roughly equal to that cancelled by bankruptcy and we're back where we started, except that the debt is now owed by the government rather than by individuals. I know some people advocate letting the banks fail; but I don't want to argue that here; my point is that the current governments won't allow it.

High taxes on the rich is a possibility in some countries. Hollande of France is running on a platform of increasing taxes on the rich to 65% and he may win. I'm not sure that taxes will be raised high enough, though. Roosevelt had to raise them to 91% and the debt problem of the Great Depression was much smaller than that today. The problem with taxes is that the government normally taxes primarily flows (income and expeditures) but needs to use them to pay off an accumulation (debt). Hollande's 65% proposal would help, but I doubt it would come anywhere near fixing the problem.

So that leaves us with inflation. Normally that would be the approach expected of weaker governments, like today's, unable to implement the other solutions. But in the developed world money is controlled by independent central banks. They are without exception controlled by bankers, and their directors all seem to have a horror of inflation. We have seem them step in with large increases in the money supply to stop collapse, starting with Japan in the 90's and expanding to virtually all countries today. But, as soon as inflation even threatens to pick up a little, never mind to the relatively high levels (5-10%) needed to work off excess debt, the excess money gets pulled back. There is only one country currently willing to accept any meaningful inflation, Great Britain. I expect the usual course will be that of Japan since their bubble popped in 1991, with similar results - no growth, and ever-increasing but monetized government debt. In the end they must accept inflation, assuming none of the other approaches to excess assets among the rich get taken. But the end may be very far off, judging by how long Japan has stuck to the strategy. I'm also not sure what would be able to force the central banks to give up on their low-inflation fixation.

A combined approach might be the best we could hope for under the current regimes. Increased taxes on the rich can be used to support the rest of society as it pays of its debts. Increased taxes on capital gains in particular could induce more spending by the rich and induce them to partially consume their excess debt. A "lost-decade" money approach by the central banks could give the time for these policies to work. If the extra time is used to resolve the problem (Japan has not) then perhaps at the end a moderate inflation hiccup could finish the job. In the US, though, even this approach would be totally beyond the pale of proposed policy solutions. I don't see anything adequate except a crisis of a scale to force a change in government against the wishes of the wealthy who control most money spent on politics and the mass media, and I really don't want to live through that kind of crisis.

Solving the budget deficit

The NY Times has a site up for addressing the budget deficit. In opposition to the usual Versailles claims about how hard it is to solve the deficit, I found it pretty easy. My proposal fixes it, essentially by returning to Clinton tax policy, taking the peace dividend, and taxing two activities with substantial negative externalities: CO2 emission and risky bank activities. I don't have to do a thing to Medicare or Medicaid. Other people with radically different political preferences don't seem to find it too hard either. Try it yourself!

Greece and stability

Stability has been much discussed lately but with little useful results. The real problem is not Greece, but that irresponsible finances in *one* medium-to-small country of no major international significance (not a banking center, source of a critical natural resource, etc.) threatens the world economic system. That is seriously unacceptable instability. If the survival of the world economic system requires that *every* country with a GDP larger than um, Massachusetts behaves responsibly at all times, we're doomed.

(Posted as a comment to Naked Capitalism)

The Public-Public-Public-Public-Public-Public-Public-Public-Public-Public-Public-Public-Private Investment Partnership

Timothy Geithner's plan to get money to the banks was released today. One of the guiding principles is:

Maximizing the Impact of Each Taxpayer Dollar: First, by using government financing in partnership with the FDIC and Federal Reserve and co-investment with private sector investors, substantial purchasing power will be created, making the most of taxpayer resources.

But when you get into the details, you find the plan is for 50/50 public/private equity supported by 6:1 leveraged borrowing from the public sector. That means 12 dollars of public money goes in for every 1 dollar of private money, making this the PPPPPPPPPPPPPIP of the title. So, does Geithner actually believe that this is making the most of taxpayer resources? I have to grant that he seems to believe CDO's of mezzanine subprime MBS tranches are "undervalued", which is even less plausible. Foolish or dishonest? You decide.

In the "Legacy Securities Program" Geithner continues to promise he'll develop a plan - someday.

Borrowers will need to meet eligibility criteria. Haircuts will be determined at a later date and will reflect the riskiness of the assets provided as collateral. Lending rates, minimum loan sizes, and loan durations have not been determined. These and other terms of the programs will be informed by discussions with market participants. However, the Federal Reserve is working to ensure that the duration of these loans takes into account the duration of the underlying assetsBorrowers will need to meet eligibility criteria.

Yes, Geithner has known that we have a lot of bad loans since at least the fall of Bear Stearns a year ago. Yes, he has been involved in multiple negotiations trying to save companies loaded with bad debt over the past year. Yes, he has supposedly been working hard on this for at least 4 months.

No, that quote is not from the Onion.

The right amount of quantititative easing.

Krugman has a post up expressing approval of the Fed's announced intent to buy 1 trillion in long-term bonds. I'm all for quantitative easing (I wonder what Orwellian instinct causes them to avoid the proper phrase "printing money") but not on this scale. M1 is only about 1.6 billion (and was less that 1.4 last summer) so this is about a 60% increase in the money supply, coming on the heels of some significant printing in Q3-Q4 2008. Crudely, you'd expect about 60% inflation from this and that's far too much. As Krugman points out, the prices of these bonds will drop as the economy recovers and interest rates decrease. So even if the Fed pulls back as hard as it can in a year or so we're still left with about a 15% increase and I very much doubt the Fed will pull back even that hard as IMO that would throw us into a depression.

I think a better guide would be to print enough money, excuse me, "quantitatively ease" enough, to keep the leading indicators moderately positive. That should be enough to get us out of recession without risking the worst inflationary shock since the Constitution was written.

Tranche warfare, in earnest.

I have seen some discussions about how differing interests of differing tranches could potentially lead to some pathological results, but here's a real example : Carrington Investment Partners LP vs. American Home Mortgage Servicing.

Carrington bought some junior tranches that apparently have the right to control disposal of REOs in the pool (there are legal fights now over whether they do). As long as the REOs aren't sold, the junior tranche gets its scheduled payment. Once the REO is sold, the proceeds are dived starting from the seniormost tranche, which in this case will leave Carrington's tranches in the cold.

So Carrington is trying to force the servicer to keep the REOs, unsold, presumably until they rot into uselessness. Sure that screws over the senior tranches, nearby homeowners, and the economy as a whole, but hey! a hedge fund has to make a buck! Go free market!

Are you ready to be Geithnerized?

Geithnerize, vb: To make somebody grossly overpay for something, and still end up not owning it.

The core problem for the banking sector is that the banks have lost far, far more money than they could have and remained solvent. As Yves Smith pithily puts it:

Let's start with the basics. The US banking system is insolvent. Got that? Insolvent. That does not mean every bank in the US is toast, in fact quite a few are probably just fine, and another large group is no doubt hurting and undercapitalized, but ... a significant portion of the very biggest banks are insolvent.

The fair solution is that the insolvent current banks have to be shut down, their owners wiped out, their managers fired, and new banks started with new owners, new managers, and new capital. Fair, efficient, and straightfoward - but it will ruin many of those responsible for the disaster, especially current bank management. Their solution? Make the taxpayer pay to keep them rich - via Geithnerization!

We've already had a lot of Geithnerization already - the TARP, which overpaid by at least 87 billion for equity that doesn't carry voting rights; the Citibank bailout, where the US government gave Citibank guarantees so grotesquely underpriced they won't even let us find out what they guaranteed; and the similar BOA bailout. And the public is getting wise to the Geithnerization process.

So the new Geithner plan cleverly dresses up another (and huge!) round of Geithnerization with some platitudinous frills (but little substance) to disguise the ravenous monstrosity at the core of the plan. Lurking at the core:

a) TARP style useless equity in the "Capital Assistance Program". Undercapitalized banks get money from the treasury in return for preferred shares - inevitably underpriced, since the bank are undercapitalized. The preferred shares aren't voting, so no control over the bank for the taxpayer who's going to pay so much for it. Just like with Citi, we get to pay more than the banks are worth, and somebody else still owns it.

b) A "public-private investment fund" which will take equity mostly (read all) from the private sector to take loans from the public sector to buy assets that can't be valued accurately. Result: if the assets go up, the private investors take all the gains; if they go down private investors lose a little and the public loses a lot on the bad loan. Geithnerization for uncertain assets!

The plan has some nice-sounding frills calling for bank audits (but with no specifics), posting some information to the Web (but again, no details), and some expanded programs for mortgage modification. Of real merit is a plan to expand the Term Asset-Backed Securities Loan Facility (TALF) to 1 trillion. This really helps, because as I've said, the fundamental solution is to have new bank with new money take over lending. With the TALF the Federal Reserve will be doing it. Of course the point is that since Geithnerizing the public won't actually help the credit market, they needed to put in a program that would. We don't have to rip off the public to expand the TALF.

But no detail can disguise the 1 trillion plus plan to make the taxpayer pay for investors to own and get rich on assorted shady assets. But what do you expect when you appoint a Treasury secretary whose primary goal is saving the banks from nationalization?

Are you ready to be Geithnerized now?