The Debt Debate

"Am I in debt?  I'm a true American." - Balki Bartokomus

"Slight was the thing I bought,
Small was the debt I thought,
Poor was the loan at best -
God! But the interest." - A poem by Paul Laurence Dunbar

As the levels of global debt increase a debate that has raged for many years is growing in volume.  Currently total global debt stands at almost three times total global GDP.  This is a staggering number and one that is not getting any smaller.  With many governments around the world awash with debt and businesses and consumers seemingly hooked on it, the prospects for debt levels decreasing any time soon seems dim.  This is worrying most economists due to the expectation that interest rates will start to rise at some point in the future and when they do, servicing this massive debt burden will have a large negative drag on economic growth.  Furthermore with seemingly ever person, company and government agency up to their eyeballs in debt not only will the impact be felt by consumers and businesses but governments will find a massive hole blown in their budget plans.

Interestingly though most first world economies treat debt with reverence in that debt payments receive a subsidy in the form of tax relief.  While a lot of advocates harp on the loopholes in tax law or farming and oil subsidies few discuss the subsidy that is the ability to deduct interest payments as a pre-tax expense.  This benefit is not only provided to companies who can deduct interest as an expense before tax but consumers can deduct the interest paid on their mortgages from their income earned.  It is estimated that this subsidy drains roughly  $800 billion a year in lost tax revenues from the United States Treasury alone.  This is more than the amount spent on defense each year.  As the current budget deficit is roughly that number, removing this subsidy would almost instantly balance the budget.  Furthermore studies have shown that the main beneficiaries from this subsidy are the wealthy as they are more than likely to have a loan (or the ability to obtain one), so in effect this $800 billion is a large cause of the inequality gap being seen across the globe.

One of the main proponents of the subsidy is to encourage home ownership.  It is argued that without this subsidy home ownership in the United States would fall precipitously.  This would drag down home prices and impact the entire home industry from DIY stores to Realtors to builders.  The impact is expected to be so large that it is almost unthinkable to remove the subsidy.  Taking a look at economies that do not provide this subsidy have shown that while there would be an initial sell off, home prices would only fall roughly 10% and subsequently recover.  The study found that not only do people naturally wish to own their home but that once prices fall to a certain level investors snap up the inventory and create a rental portfolio of properties. Therefore it is thought that the impact of removing this subsidy would be less dire than once thought and would be temporary.

Removing the luxury of deducting interest from company income statements would result in a restructuring of many companies balance sheets particularly the balance sheets of banks.  As interest is currently a pre-tax deduction, moving it below the tax line would remove the luster.  Companies might view debt very different as suddenly the thought of adding debt or issuing equity becomes a more evenly debated topic.  As a company can stop paying dividends without being forced into bankruptcy it is thought that many would curtail borrowing in favor of issuing equity.  The risk of adding more debt, which is less forgiving than equity, would push companies to add more equity rather than debt reducing the probability of another financial crisis.

As an example during the popping of the NASDAQ bubble more than $4 trillion of wealth evaporated.  In comparison the banks lost $2 trillion during the 2008 crisis and we are still trying to recover from that problem whereas the lost equity, while devastating to a lot of people, did not create the same economic after shocks as the financial crisis has.  Transferring the risk of investments from the banks and governments onto the equity investor seems like a lost art as every year since the Great Recession less and less money has been raised through the stock markets while the preferred funding source of debt spirals higher.  Changing this course seems to make sense but it will only happen once the subsidy is removed.

Against this positive effect is the cry that a number of companies would be driven out of business due to this lost benefit.  Furthermore many mergers and acquisitions not to mention leveraged buy outs would suffer.  While some of these deals do create value the majority result in a large payout to the funds putting the deal together with little benefit to the company and their employees so to me this is an argument with limited merit.

So while all may be well it is a sure thing that problems will arise from the debt gluttony once interest rates start to rise.  As it appears that interest rates will remain low for a while it could be a good time for governments around the world to quietly remove some or all of these subsidies.  Not only will this have the lowest level of impact right now but it will provide the safety net against another debt lead crisis.  Leaving the subsidy in place will have the double effect once interest rates rise of not only reducing government tax revenues due to the increased subsidy given to companies and consumers bu their deficits will spiral out of control as they will be required to service their gargantuan debt levels with ever larger amounts of borrowed money!  Lower tax revenues and higher deficits at a time when no government has the ability to handle any more financial stress, sounds like a great plan and one we are surely stuck with.  So while it may seem like a small bridge to cross for a large payoff there is no politician on earth that would try to push that policy through parliament until it is too late.  Pity as we could use a safety net rather than more interest.