Private Debt and How to Manage Risk in the Financial System

The issue of debt is not well-understood in this country, or in many others for that matter.  The total burden of financial debts in the world outweighs the amount of savings that citizens have, and this is an extremely concerning issue.  Many economists will tell you that debt fuels economic growth.  In the words of Paul Krugman: “your debt is my income and my debt is your income.”  The problem with this very simplistic analysis is that debts lead to production that aren’t matched by an equivalent reserve held anywhere in the bank and those debts accumulate interest liabilities.  A consumer with a mortgage, car loan, and likely some student loans and credit card debt, becomes a slave to interest.  Whatever savings are accumulated are immediately diverted towards simply paying back interest on the loan.  Anyone with a friend that has significant debts is well-aware of their difficulties in simply making a dent in the principal payment.

Private Debt

Private debt is a liability owed by consumers and businesses while public debt is a liability owed by the government.  While many citizens are well-aware of the infamous $20 trillion public debt figure, it is often completely unknown how large the swelling private debt has become.  By 2016 private household debt had risen to $12.6 trillion, just barely below 2008 recessionary levels.  The exact composition of that debt has changed slightly since the peak of the housing bubble, with growing consumer burdens on student loans and car loans taking up the slight drop in mortgage debt; however the total figure is nearly the same.  Among the countries with the largest private debt burdens are Australia, Switzerland, Canada, and the United States.

Debt to GDP

US debt composition.png
US households deleveraged slightly following 2008 but levered up again to pre-recession levels as the economy showed superficial signs of “improvement” i.e. – rising stock market and declining unemployment

How is private debt different from public debt?

Public liabilities owed by the government have swelled to almost twice the level of 2008.  This massive liability is surely a problem, but the reason it hasn’t created an instant recession is due to the fact that the government has it’s own metaphorical printing press, thus allowing any accumulating debts to be printed up.  While social security and Federal Reserve liabilities have contributed massively to the $20 trillion in public debt, the Federal government almost always prints up payment for its liabilities and has only chosen default on very few occasions in recent history.  Public debt contributes to declining purchasing power by inflating away savings accounts; however, recent maneuvers such as the Fed’s Q.E. program are leveraging government printing power to keep the financial system afloat by injecting much-needed liquidity into the banking system and allowing it to continue lending practices.  While public debt isn’t the same as private debt, it is being used as a catalyst to prop up the financial lending system and contributes to inflation in the meantime.

How do we solve the private debt crisis?

The private debt crisis arises from a complicated mechanism tied into our banking system.  Historically, private debt begins to swell when the economy is deemed to be in a state of irrational exuberance.  Some consumers, such as the Japanese, have actually continued the deleveraging process despite low unemployment rates.  This is quite indicative of the fact that cultural views on fiscal responsibility contribute heavily to the nature of household debt.  The Japanese are historically a very fiscally-responsible society.  At the end of the day no one is forcing consumers to take on loans, thus the values embedded in our collective psyche determine how we respond to superficial signs of economic recovery.  Ideally the deleveraging process would continue unabated following a recession.  Consumers would deleverage and bubbles would deflate, thus allowing prices to return to healthy levels.  In the case of Japan, the government has stepped in as a massive institutional buyer and virtually negated any attempts on behalf of the populace to deflate prices.

Setting aside the fiscal morals of consumers, there are several schools of thought on how to dismantle the mechanisms that lead to private debt accumulation; however, if we examine the issue from it’s core, I think we can arrive at the conclusion that central banking and misalignment of government-dictated incentives are the direct culprit of this issue.  This is not simply my conclusion, but the conclusion of the entire Austrian School of Economics, first developed by Friedrich Hayek and expanded upon by Ludwig von Mises, Murray Rothbard, and academics at current institutions such as CATO and Mises.  The issue of loose bank credit can be, for the sake of simplicity, boiled down to two culprits: central bank interest rates and the FDIC mandate.

Central banks have formally orchestrated the funnel of credit to the economy for nearly 400 years, beginning with the Bank of Amsterdam, established in 1609.  For centuries central banks have acted as the metaphorical “maestros” of the economy, setting one interest rate that dictates the flow of credit.  However, Austrian economists understood that one, centrally-planned interest rate cannot efficiently price the risk of lending to all borrowers.  Undeniably the interest rate is an incredibly complex mechanism that needs to be personalized for each borrower, based on his or her financial standing.  Doing away with centrally-led interest rates would certainly make the financial system more accountable for setting interest rates properly in a way that properly prices risk for each borrower.

Taking into account the existence of centrally-planned interest rates, we can see other culprits that have loosened the grip on financial accountability.  Many economists are well-aware of the moral hazard posed by the FDIC mandate, in particular John Allison, former CEO of CATO Institute who did extensive research on the moral hazard posed by FDIC insurance.  The FDIC mandate says that each bank account shall be insured by the government for up to $250,000.  The moral hazard this creates should be clear and visible to any rational person.  It wipes away almost all accountability by financial institutions to engage in safe lending practices that insure each customer’s savings will be protected in the face of financial lending practices.  Without this mandate, financial institutions would actually be scrutinized by prospective depositors and this would be an extremely positive risk management mechanism for the financial system.

The act of separating commercial and investment banking in accordance with Glass-Steagall does not, by nature, decrease this risk in the financial system.  Many politicians are in favor of implementing Glass-Steagall while breaking up the banks.  Only when financial institutions are fully accountable for their own risks will private debt bubbles be solved and return to normal levels in accordance with true capitalism.