Debt: Good, Bad, Ugly, and Not-Really

Debt is often considered something bad in our society. At the beginning of any semester in the macroeconomics principles I’ll have many students identify debt – either the “national debt” or student loan debt or even just household debt – as a leading macroeconomic challenge facing the nation. The reason is because debt is an ideological issue as much as an economic issue. The ideology surrounding debt, the ideas that it’s purely an individual decision, that the borrower is the one morally culpable, and that default is a character or moral failure of the borrower, is part of enforcing a particular property rights and political power structure.

To determine if debt is “good” or not economically, we should ask what the function or role of debt is.  Why is money being borrowed? What is accomplished economically by allowing borrowing? Why might loans not be repaid? Who benefits from a loan?

The basic economic role of private debt is to help overcome a temporal mismatch. The role of public debt is often to change the distribution of resources and activities.

Private debt is basically a temporal problem. Many desirable economic activities have a mismatch in timing. For example, consider one of the oldest temporal mismatches: agricultural production. Farming requires spending resources (costs) well in advance of the receiving payment or revenue. A farmer has to eat all year and pay for seed, etc, before and during growing season but only receives revenue at the end at harvest. A farmer who isn’t independently wealthy then borrows and pays it back from the harvest.

Student loan debt is another example of temporal mismatch. An educated student can be highly productive as a worker/employee after they receive their education. But the costs of education come first. Obviously having students borrow money to pay the costs and then pay back later out of their (assumed) higher productivity and earnings is a way to pay for the costs. It’s not the only solution. It would also be possible for the government to pay the costs of education now and then recoup the government’s “investment” through a larger tax base and/or more prosperous populace.

Since food and knowledge are generally good things and debt facilitates producing them both, you might think debt would be considered good. But there are also situations where it’s not desirable.  To explain, I’m going to classify debt into four types: Good, Bad, the Ugly, and Not-Really.

Good Debt

Good debt is a temporal (and temporary) redistribution of resources aimed at increasing total production. This includes the example above of a farmer borrowing capital to enable clearing fields, acquisition of seed and fertilizers, equipment, and working capital before and during the growing season. The debt is then paid back from part of the proceeds of the harvest. Much corporate borrowing when the debt is used to finance expansion or capital equipment falls into this “good debt” category. Among individuals and households, debt can also be “good debt”.  Student loans fall into this category. Even car loans can sometimes be considered this category since access to a car is often necessary for employment.

These are economically “good” debts because they enable greater production, greater goods, and a better life in general – all aims of our economy. But being “good” debt doesn’t mean risk free. Any debt is inherently risky. The future is unknowable. Since debt means a partial transaction now (borrower gives lender $) and a completion of the transaction (repayment in the future), it’s always possible the future doesn’t play out as expected. The harvest prices might be too low and the farmer can’t repay. Employers might not pay enough to graduates to enable repayment of loans or recessions may send unemployment rates too high. Societies often provide a “reset” button to enable individuals who are deeply in debt and the future didn’t work out right to enable repayment. In ancient times, many societies instituted “debt jubilees”. In our society we have bankruptcy courts. Either way, the function is to spread some of the risk of the future to lenders and not just on borrowers.

Bad Debt

Economically, bad debt would be debt that facilitates excessive consumption of resources today without increasing our future ability to produce. It’s just shifting consumption forward without creating new or greater resources. It’s prodigality. It’s the spendthrift.

This is image that I suspect many have when they think of debt as “bad”. In most systems or religion, morality, or ideology there are often admonitions against prodigality or being a spendthrift. In our current society this debt could be the household that borrows excessively for recreational toys such as boats, excessive clothing, etc. But it’s not just households that engage in “bad” borrowing. Firms often do too. The productive, profitable firm who is acquired and taken private by “private equity investors” is often forced to borrow excessive amounts of money simply to pay dividends to those same “investors”. No new economic productive capability or resources are created. It’s just a redistribution of wealth to the wealthy.

Not all borrowing for immediate consumption purposes should be judged “bad” though. It depends, like most economic analyses, on what the alternatives are. Typically, the idea of borrowing to finance current personal consumption needs is considered unwise. For example, borrowing money on a credit card to finance the weekly grocery shopping strikes most as a bad idea. But, if the only alternative to borrowing money is starvation or disease, then borrowing is the right thing to do.

The Ugly Debt

Economically ugly debt is debt that’s tainted by fraud or moral hazard. Socially we condemn the borrower who borrows knowing they don’t intend to pay back (Fraud) or conceals from the lender information about future actions (moral hazard). But fraud and moral hazard are present on the lending side as well. In the run-up to the Great Financial Crisis of 2008 banks and mortgage brokers often encouraged marginal borrowers to take out mortgage loans knowing those borrowers were unlikely to be able to afford it. The lenders then sold the mortgages to others, getting their fees and leaving others with the risks and costs of default. Fraud and moral hazard.  Neither are economically useful.

Not Really Debt

All the situations I’ve described above involve what economists classify as “private debt”. That is, it’s private parties, either firms, banks, or households, that are the lenders and borrowers.

When the borrower is the national government it is “public debt”, not private. In the U.S., this is often called the “national debt”. Public debt isn’t like private debt at all. At least if the government is a national government with its own sovereign currency. This means the US, UK, Canada, Australia, China, Japan, and many, many others.  It does not include members of the European Monetary Union such as Germany, Italy, Spain, or Greece.  As long as the nation borrows in its own currency and that currency is a fiat currency, there is no risk of default. This is because the nation can always issue new currency to pay off any bonds used to “borrow”.

In practice, such public debt isn’t really debt in the way we traditionally think of private debt. It doesn’t really have to be “paid off”. Technically bonds come due but can either be rolled over into new bonds or paid off with newly issued currency or acquired by the central bank (same effect as issuing currency). In fact, it’s misleading to draw analogies between the public debt to private debt. Public debt is more like the currency itself. Consider the differences between a $1000 government bond and a $1000 note. Both represent commitments from the government to provide $1000 worth of value in exchange. The key difference is the bond pays interest and the note doesn’t.

There is a limit on the borrowing/spending capacity of the government though. That limit, though, is not the kind of limits we associate with private borrowing/lending. Rather, the limit is inflation and availability of real resources. As long as the unused, unemployed real resources or productive capacity exists in the economy, then the government can create the spending to utilize those resources. Whether or not the government decides for accounting purposes to create new money or to borrow existing money from banks is a macroeconomic policy choice decision. Unlike private borrowing where the money must be borrowed or otherwise obtained first before being spent, the government spends the money into existence first and then uses either taxation or borrowing to remove the money from circulation in the economy.

A major reason for governments to “borrow” money has to do with risks and private spending habits. Wealth and money are very unevenly distributed across the economy. A few very wealthy people possess most of the money. However, those people often do not desire to risk their fortunes by lending it as “good debt”. Instead, they seek interest-paying safe, risk-free ways to store their wealth. Government bonds provide those risk-free ways of storing money. However, in the process, this means the money (capital) is withdrawn from general circulation and doesn’t get put to economically useful “good debt” productive activity.  The government, by issuing risk-free bonds and simultaneously running a budget deficit, provides the safe “investments” for people’s savings and puts the money back into circulation through government spending. In the absence of such deficits, people’s private desires to save part of their incomes and put it into risk-free bonds would create a shrinking spiral of circular flow money in the economy, leading to recession and depression. Deficit spending restores the vitality of the circular flow.