

We can only cut debt by borrowing  - chrismealy
http://blogs.ft.com/martin-wolf-exchange/2010/09/26/we-can-only-cut-debt-by-borrowing/

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ctdonath
Absurd. Upshot is a continuation of what got us into this mess: denial of
risk.

He starts with the misguided notion that net debt is zero. The point of
interest-bearing debt is that the debtor might NOT be able to pay the debt
off. He then proposes ways to reduce risk to zero, with lenders suffering no
consequences of risky loans - a furtherance of policies which got us where we
are, determined to take risks then legislate away the consequences.

The system is vibrant because of the willingness to accept risk. To enforce a
risk-averse system is to destroy the benefits of risk. Isn't risk the core of
ycombinator's purpose? to take risks, and to manage them better than others?
The system cannot be cleaned up until the buck stops somewhere, until the
music stops and those without chairs leave the game.

Borrowing, in a fractional-reserve system, means that for every real dollar
there are tens or hundreds of claims on that dollar. You can't pay everyone
off because there isn't enough money - unless the government opts for
hyperinflation, achieving the same basic ends thru redistribution of abject
losses.

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gvb
I'm having a hard time swallowing the whole of the article, based on assertion
_[A]t the global level, debt cancels out: net debt is zero. So, in paying down
debt, one is also reducing credit by an equal amount._

I agree that (credit - debt) = zero. The problem is that credit is not a fixed
amount due to the fact that it is leveraged... see fractional reserve banking.
<http://en.wikipedia.org/wiki/Fractional-reserve_banking>

The leverage formula is (1 / reserve) where reserve is a fraction tending to
zero. This is a non-linear relationship and we all know that the lim x -> 0
(1/x) = infinity.

If lenders (e.g. banks) hold a 20% reserve, they will "expand" the money
supply by 1/0.2 or 5x. If they hold a 10% reserve, they will "expand" the
money supply by 1/0.1 or 10x. If they hold a 1% reserve, they will "expand"
the money supply by 100x. As the reserve fraction goes to zero, the effective
credit part of Martin Wolf's equation goes to infinity.

A lot of exactly that type of lending was being practiced during the "bubble",
especially in the housing market where mortgage underwriters were loaning more
money than the houses were worth. This was happening _before the housing
crash_ \- mortgage originators were advertising "we will loan you 100% the
value of your house" (sometimes more than 100%).

~~~
anigbrowl
I'm unsure why you think the reserve fraction must inevitably tend towards
zero.

You seem oblivious to the fact that current proposals (known as Basel III,
after the city in Switzerland) requires banks to raise their tier 1 capital
ratios, ie reduce their capacity for leverage. Currently central banks are
acting as lenders of last resort, but once healthy growth resumes they will
gradually sterilize that funding. That will be a limiting factor on growth,
but one that seems preferable to a total credit freeze.

[http://www.bloomberg.com/news/2010-09-23/ubs-credit-
suisse-m...](http://www.bloomberg.com/news/2010-09-23/ubs-credit-suisse-may-
face-12-capital-ratio-analysts-say.html)

~~~
lzw
In practice, the reserve ratio has continued to decline, and in fact, via the
fraudulent FDIC underwriting practices massive moral hazard has been created
in the banking sector.

In short, banks can leverage as much as they want, and the FDIC will cover
their butts if they fail, but the FDIC does not charge adequate premiums based
on risk. Further the federal reserve isn't really a "lender of last resort"

In fact, the term "lender of last resort" is inaccurate, as the federal
reserve offers rates on money that are lower than the market. They are doing
this now as a response to a crisis that was caused by them doing it in the
past (as I pointed out elsewhere.)

A lender of "last resort" would be one you could always go to, but who was
expensive and therefore you were incentivized - "first resort" - to go to the
market.

~~~
anigbrowl
Really? Please back up your claims with some data. Also, your theories about
fractional reserve banking should hold equally true in other countries where
the FDIC does not operate. And I'm a little skeptical of your complaints about
moral hazard, given the frequent closures of banks by the FDIC, and the
resulting haircut for those banks' investors.

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mkramlich
Whether the author's plan would work or not, what bothers me about it is that
it seems that the 2 major actors within the US government that would have to
carry out this plan, namely Congress and the Executive branch, appear in
recent times to the lack the ability and/or willpower to carry out any long-
running fiscal-scale mission in a consistent way. I'm in my thirties and from
what I've observed so far in life it is extremely hard/rare for them to carry
out any single plan regarding Federal spending consistently for more than 2
years or so, before making significant changes, adding loopholes, gutting it,
making exceptions, making a total 180 degree turn in direction, etc.

To give just one example, if you follow US Congressional news you'll
periodically hear about something called a "debt ceiling" that supposedly
Congress has to follow, which puts a limit on how much debt/deficit is allowed
to exist at the Federal budget level. The problem is that they also
periodically raise this "ceiling", whenever it is convenient. Whenever there
is some supposedly exceptional or temporary state. And these exceptional cases
and temporary conditions keep happening. Therefore the Federal debt just keeps
going up and up (mostly: except during part of the Clinton presidency.) Memo
to Congress, I don't think the word "ceiling" means what you think it means!

The crack baby treatment of NASA is another example. "Give us a big plan to
return to the Moon and Mars and we'll fund it. Okay, thanks, great plan, we'll
start funding it." Few years go by. "Oops, sorry, we changed our mind, uh,
could you repurpose that into a cute little station escape pod for us? k thx
bye."

~~~
lzw
If you look at history, this has been the case ever since the founding of the
Federal Reserve. This is not a failure of will, this is the way the system is
designed. The system is designed to fail, because this maximizes profits for
the bankers in the long run and for politicians in the short term. When the
system fails, most of the politicians who propagated the bad policies will be
out of power.

The federal reserve put us on a boom-bust business cycle, and those who
understand the cycle profit from it. The fed drives up the boom, as they did
with housing, and everybody who is smart makes money, then they raise rates
and trigger a bust, and when that happens to the point where serious damage is
going on, everybody buys up assets really cheap.

The politicians profit from this as well- during the boom they say "look at
this boom I created!" and get reelected. During the bust they say "look at
this bust the other guy created, give me more power!" and they get more power.

The ultimate boom, of course, is in the value of the dollar which is actually
nothing more than a debt instrument itself. When it crashes there will be huge
political opportunity to remake the country, including constitutional
amendments or even a new constitutional convention. People will suffer, but
there's nothing like a good crisis for the politicians.

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sridharvembu
This article ignores the other possibility, which I believe to be the only
real solution: default on the debt, wiping out shareholders where appropriate,
convert debt to equity, thereby reducing systemic debt. Bondholders will have
to take a haircut, and the sooner the better.

This would result in a sharp GDP contraction for a relatively short period, a
sharp hike in unemployment, but then growth would resume fairly quickly, once
the realization sinks in that we are not dead after all.

Government can do two things to make this process faster: 1) make the justice
system work faster in resolving the various disputes that will inevitably
arise in imposing hair-cuts on bondholders 2) Make sure no one starves, and no
one freezes. These things it can do.

The present course of cutting-debt-by-borrowing has a clear destination:
zombiehood without an exit strategy. Look at Japan for the best illustration
of this. It is becoming increasingly clear that Japan is not going to resolve
its problems without a major crisis. It should have taken that sharp GDP
contraction in 1991 instead.

~~~
mkramlich
Defaulting on the Federal debt to China could have a wee bit of a
repercussion.

~~~
anamax
> Defaulting on the Federal debt to China could have a wee bit of a
> repercussion.

They'd seize every US or American-owned asset that they could get their hands
on and stop sending us stuff on credit. The former is much smaller than the
debt that they hold (so we could compensate private holders and still end up
ahead) and the latter is arguably a good thing.

~~~
po
> They'd seize every US or American-owned asset that they could get their
> hands on

That might include coming over to get it by force.

~~~
anamax
> That might include coming over to get it by force.

How? They don't have a blue water Navy.

~~~
mkramlich
They're building one.

------
cjlars
"While the highly indebted and the newly “asset-poor” have good reason to
spend less than before the crisis, creditor households have no reason to spend
more. Indeed, the collapse in interest rates in a slump lowers their incomes
and so is quite likely to make them want to cut back on their spending, too.
The aggregate effect of these changes in behaviour is, of course, a rise in
the desired household rate and so the desired financial surplus of the
household sector."

Read this carefully, because I'm fairly certain the author is trying to
disguise something. His argument is this: Households cut spending and drive
down rates, therefore creditors have less income and cut spending, therefore,
creditors demand higher rate and more household debt.

You can see the sleight of hand, creditors desiring a higher rate does not
force a higher rate. In fact, as he already admitted, debtor payments have
pushed down the rate. What the author fails to admit is that rates stay low
AND debtors pay down their balances. Debtors do not need to somehow 'outsave'
their creditors in order to pay down their debt. They simply pay down their
debt.

There may be arguments for stimulus packages and other counter-cyclical govt
spending, but the author doesn't make a fair point for them. I certainly don't
see why it would be necessary for govt borrowing to offset an increase in the
private savings rate.

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anigbrowl
I strongly agree with Wolf's remarks. In a nutshell, he is pointing out that
the major cause of the current economic stagnation is a lack of cash flow.
Deficits can not be increased forever, but absent cash flow then GDP will
continue to shrink, increasing the relative size of a nation's debt. Boosting
GDP (ideally through sensibly targeted investments in infrastructure) makes
debt more manageable, not least because infrastructural investments tend to
pay off over the long term.

With a little imagination and selectivity, a situation like this can be a good
opportunity to reduce transfer payments and endorse productivity in both the
social and industrial sectors.

~~~
lzw
This is standard neo Keynesianism (neo because nowadays governments just roll
over the debt while Keynes advocated repayment in full at the end of the
recession.)

The counter argument to it is very simple: this spending is spending money
that comes out of the economy, and taking money out of the economy hurts
economic growth. Further, many argue that the spending produces less froth
than the money destroys when taken out- lower profits at the personal or
corporate level mean less investment in growth via consumer spending or
business expansion.

Further we have just witnessed a perfect implementation of this theory- after
the dot com crash, government lowered interest rates below inflation, making
free money and spent massively running up record deficits. It managed to spark
a housing boom and a lot of consumer spending... But the situation we find
ourselves in now is simply the hangover from that party.

If we get drunk again, it isn't going to banish hangovers and each time we do
it, it gets worse while the body gets closer to death.

~~~
dasil003
Medical analogies for financial markets are pretty tenuous, but I find myself
in agreement. A big issue from my perspective is that everyone is ringing
their hands about home values and trying to prop up the deflating bubble. As
someone with aspirations to own a home, this is infuriating. I can't afford a
home, and neither could all the people who bought them. They need to let the
prices fall to where people can actually afford them instead of trying to save
the speculative value which we already know was based on hot air.

~~~
walkon
That was (and is) the ironic thing about all the government sponsored home
ownership programs and legislation. They pumped up demand at an unreasonable
rate, causing ever increasing prices, which made it harder to afford a house,
which prompted further government stimulation...an endless loop, at least
until the fiat charade ends.

~~~
anigbrowl
So why didn't the banks try to throttle the supply? It's funny, I don't recall
any CEOs complaining about the economy being driven off a cliff in the runup
to the bust.

On the contrary, I was astonished at their readiness to give money away. Don't
you recall the endless stream of refinancing commercials on TV? shows like
'flip that house'? The way everyone and their dog suddenly seemed eager to
have a realtor's license? The guy at my local _pizza shop_ had his realtor
business cards on the counter next to the delivery menus.

Edit: I see the truth is uncomfortable for some people. But the fact is that
government promotion of home ownership is one thing, and instant approval of
jumbo loans with 0% down are quite another. I got burned in a property boom
when I was about 20 and this time I decided to stay out of the market.

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danbmil99
what about good old fashioned inflation? That seems the obvious, if odious,
way out of this bubble.

