Debt, Redux

"Your servant here, he has been told
to say it clear, to say it cold:
It's over, it ain't going
any further"

I keep writing this same post about the role of debt in the economy and the economic cycle, but I think the reason why I keep coming back to it from slightly different angles is that I am wary of being in disagreement with the majority of experts on a complicated topic about which I am not an expert. It seems as though adherents of the notion that our troubles stem from too much debt and will be cured by eliminating the debt come from the fringes on either the left or right, with few mainstream or 'establishment' figures supporting this notion.

At any rate, here goes.


Consider the game of Reversi, aka Othello. The fun in the game derives from the placement of pieces on the board – deciding which spot to occupy and when to occupy it is what the game is about. At the start of the game, the board is wide open and filled with possibilities. The game ends when the board is full, when there is nowhere left to place stones. At that point the only way to continue to enjoy playing Reversi is to clear the stones off the board and start over.

Now, consider the economy. Economic growth occurs as people invest money into producing goods and services. Generally, investment to support production involves taking on debt. Either people simply don't have enough money available to use as equity to start/expand production, or they figure that if the venture works out, higher leverage (more debt) will increase the return on their equity and if the venture doesn't work out (goes bust) then at least some of the money lost will be someone else's as opposed to their own.

Not everyone has the inclination or ability to go into debt to produce goods and services. In any society there is a mix of people who will and people who wont. For this post, let's call the people who will, entrepreneurs, and the people who won't, bankers (since the people who have savings place them in the bank, and the bank then lends those savings out – effectively anyone with savings is a banker).

To start with, imagine an economy with no debt* – it is like the Reversi board at the start of the game, filled with possibilities. All of the society's entrepreneurial types have no leverage (no debt) and the greatest ability to borrow (for a given level of equity) that they will ever have.

Then you set the economy in motion. As the entrepreneurs borrow and invest, the economy expands. This is equivalent to the placing of the stones on the Reversi board.

The problem is that, although individual entrepreneurs can and will succeed, as a whole they seem doomed to eventually fail. Over time, as the economy expands, both the entrepreneurs and the bankers grow more confident and the level of the entrepreneur's debt relative to their equity increases. i.e. Debt expands faster than the rate of economic growth. True, some entrepreneurs will go bankrupt, eliminating their debts, but there is a strong correlation between the individual entrepreneurs success or failure, so during the up part of the cycle when times are good, bankruptcies will be relatively rare.

Every now and then there is a breakthrough of some sort that allows higher than normal growth rates in a particular area. The invention of the steam engine and the railroad for example, or the development of the internet. These cases lead to an understandable gold rush where a mass of entrepreneurs piles in with their investments until they eventually blow a big bubble which collapses at some point once people realize that the investments have swamped the productive capacity of the new phenomenon (e.g. Once AOL's stock is so high that it can 'buy' Time Warner in a stock swap).

Sooner or later, whether due to a speculative mania or just a steady accumulation of good times and increasing risk tolerance, society reaches a point where the class of entrepreneurs has so much debt that they simply can't or won't take on any more. i.e. The Reversi board becomes full.

When the board is full, you have to clear the stones and start over, much like Solon did in Greece, back in the day. In economic terms, the debts must be eliminated or at least reduced.

Note that although it's certainly not very stable, and people do get hurt, especially in the cleaning stones off the board phase, there's nothing unsustainable about this cycle and the net result is positive (wiping out the debts doesn't wipe out the productive investments that the entrepreneurs have made). In every game the entrepreneurs take the risks and do the investing that builds up our wealth but eventually they lose and they can't play any more stones (take on any more debt) and they have to declare bankruptcy. For example, the Reichmans went bankrupt building Canary Wharf, but Canary Wharf is still there and the Reichmans were able to rebuild their fortune in the next cycle.

The role of the bankers is twofold:

While the stones are being played, they must try to direct the money they lend to the entrepreneurs with the best chance of making good investments with the money. This allows the entrepreneurs to do as much productive work as possible before they eventually lose out. In a sense, the role of the bankers is to try and expand the debt as much as possible while at the same time promoting as much growth as possible in order to sustain more and more debt.

The second role of the bankers in the cycle is to win gracefully. That is, when the game is over they must allow the stones to be cleared off the board so that the game can be replayed. Of course, clearing the stones off the board means wiping out all the accumulated money that the bankers are owed so this can be difficult. Deposit insurance was a progressive innovation designed to prevent small scale bankers (savers) from being wiped out in the process of stone removal so that the costs would fall heaviest upon the large scale bankers who would no doubt feel aggrieved but would still be handily able to clothe, feed and shelter themselves after having their stones removed.

In a sense, both sides are propelled forward by a certain perverse competitive behaviour. The entrepreneurs know that as a class they will eventually get in over their heads and fail, but each one believes that they will be one of the ones that succeeds. The bankers know that they can't accumulate claims against the entrepreneurs forever and that eventually most of the claims will have to be eliminated, but each one believes that they will lend to the entrepreneurs that succeed and that their claims will be preserved.

Besides, in the long run we are all dead, and both entrepreneurs and banks might as well enjoy the upside of the cycle while it lasts.


The question of the moment is what happens when the bankers refuse to win gracefully. What happens when, instead of allowing the stones to be removed from the board, they try to get blood from them instead?

Bankers can use the power of the government** to try and extend the game (or at least prevent it from being restarted) in a number of ways.

1) By lowering interest rates, they can reduce the burden of a given level of debt (sort of like shrinking the stones on the Reversi board so you can have more squares on the same board). The limiting case here is when government set interest rates reach 0.

2) You can substitute household borrowing for business borrowing. So when entrepreneurs can't or won't borrow any more, you encourage their customers to borrow instead (do not pay until 2017!). The resulting increased demand for their products will allow the entrepreneur to expand some more.

Eventually, however, the customers will in turn reach their limit with respect to capacity / willingness to borrow, and again, this can be extended by reducing rates, with a limiting case of 0 rates. (Note that this approach will direct investment towards the priorities of impatient consumers instead of towards whatever entrepreneurs see at the greatest unmet needs of people in general (in proportion to how much money they have, of course) – this may not be for the best).

3) By inflating asset prices, the perception (on both sides) of people's capacity to borrow can be increased, because the collateral is perceived to be worth more. Of course once asset prices get too high, they are vulnerable to a sudden loss of confidence followed by a crash. Where the limits are here is not known precisely and is a matter of psychology, but that they exist is certain.

4) Finally, when all else fails, the government itself can step into the shoes of the entrepreneurs and consumers and borrow for itself – up until the government also reaches its limit. This borrowing can either be done directly via government deficits or indirectly by either bribing or forcing entrepreneurs and consumers to borrow more. For example, if consumers have reached the limits of their willingness to take on mortgage debt, the government can guarantee their mortgage in order to tempt them with lower interest rates, and if the sweet, sweet offer of low interest rates is not enough to make them jump, then government can outright offer people an $8,000 bribe to buy a house. And if that doesn't work, try $15,000. Of course encouraging people to take on mortgage debt is a 2 for 1 deal in terms of expanding debt, since it expands household debt directly and also supports asset prices.


You can see that we have plowed our way through phases 1,2 and 3 and have reached the 4th and final option. Unwilling to allow any stones to be removed from the board (this would hurt the bankerseconomy!) the government (acting on behalf of the bankers) intends to put at least one stone of its own down for every stone that the private sector tries to remove. But sooner or later, the stones have to come off the board if we want to play again.

As I described above, we reach this final stage when entrepreneurs and their surrogates (consumers) have reached a point where they can't or won't borrow any more. The flip side of this, of course, is that it means bankers and their suppliers (people who save/lend money) have accumulated a massive amount of claims on the economy.

This relationship clarifies why we see such a strong historical relationship between inequality and debt crises. Also note that, if the government were to intervene on behalf of the entrepreneurs instead of on behalf of the bankers (e.g. by taking money from creditors and giving it to debtors), this would help to solve rather than aggravate the problem. Again, this clarifies why the period from the end of WW2 to the 70’s which had strongly progressive taxation was marked by unprecedented economic stability and the subsequent removal of this progressive taxation has brought us back to crisis. To put it simply, when the problem is that the bankers have all the money/claims on the economy, the only solution is to change this distribution.

As a society, we need to say to the bankers, ‘look, you win, let’s play again’. Either we wipe out the debts via bankruptcy or we inflate them away via bankruptcy or we redistribute income from bankers to entrepreneurs or we find some other way to reset the board. Naturally, this is not fair (Personally, I am a banker, not an entrepreneur – remember that we are including anyone who has net savings in the bank as a banker!), but fairness is beside the point – what must happen, will, and putting it off doesn't help. Of course, the bankers/savers will do almost anything to prevent this outcome, and they will try to convince us that we can grow our way out of the debts that we grew ourselves into (which we could if they were willing to accept interest rates below the rate of economic growth, but I'm not optimistic on this point, and even then it would take a long, long time).

The banker's incentive is to say that if entrepreneurs won't put any more stones on the board, then consumers will. If consumers won't do it then government will continue the game for them. Government will bribe people with low interests and cash payments for borrowing. If that doesn't work, the upper class bankers will direct the government to take the savings of the lower/middle class bankers via taxes and use that to support more government borrowing. But in the end, even holding all the political power, and controlling all the media, all the banker's kings will prove unable to keep Humpty Dumpty from falling off his wall.

The current game of 'run-up the debt' has been underway for decades. Maybe it can continue to be played, or at least held in stasis, for another year, or another decade, or even a couple of decades, I don't know. But someday, and the day is not too far off I fear/hope, we’ll hit that final, global, Minsky Moment when it’s over / it ain’t going any further.








* i.e. All money has zero maturity or pays no interest, like a $20 bill – holding it doesn’t require you to pay interest to anyone.

** I'm taking a break from the ethics series with this post, but note that the interference of bankers in government is exactly the sort of 'syndrome mixing' that Jane Jacobs identified as systemic corruption in 'Systems of Survival'.