What the debt ceiling debate missed

Debt is an everything, everywhere, all at once problem. Both public and private debt has been crucial to growth creation since pretty much the beginning of civilisation. But too much of it (particularly when it’s private) slows the economy. The burden of servicing debt depresses real incomes and it also creates greater inequality, since the owners of capital benefit disproportionately as debt tends to fuel higher asset prices — at least until bubbles burst. 

We’ve heard a lot about this topic recently thanks to the wrangling in Washington over the debt ceiling. Republican concerns about US government deficit levels were belied by the fact that they focused so much of their negotiations on highly political issues such as defunding the Internal Revenue Service.

In any case, the areas of the federal budget up for grabs represented only 15 per cent of total spending. The upshot is that instead of federal debt rising to 119 per cent of gross domestic product in a decade, it will rise to 115 per cent.

So far, so small. What got lost in the heat and noise of the debate is that the debt created by the government sector turned into growth in the household sector. This is a point made by former banker Richard Vague, now the Secretary of Banking and Securities for the Commonwealth of Pennsylvania, in his upcoming book The Paradox of Debt.

Vague notes that in 2020, during the Covid pandemic, the US federal deficit reached $3tn as the government acted to help rescue America’s economy — and to some extent the world’s. At the same time the wealth of the country as a whole increased by around $11tn, thanks largely to the fact that the net worth of US households rose by $14.5tn that same year.

In fact, if you look at the full three years of the pandemic from 2019 to 2022, government net worth went down $1.7tn dollars (it was down $6tn at the federal level), while household net worth went up $30.9tn. This is true even when you account for the stock market decline of last year.

Why? Because government debt became household income, as well as rising asset wealth from stocks and home values, which have increased along with debt — public and private — since the 1980s. “Debt is, quite simply, required to create GDP growth,” says Vague, who lays out why total debt to GDP ratios in the US, and in all but two of the world’s seven largest economies, have risen in tandem since the 1950s.

He refers to this as a “government debt and spending model” in which the benefits of government spending flow to non-financial businesses as well as households. This occurs to varying degrees — in the US for example the benefits go mostly to households, while in Japan they go mostly to non-financial businesses. The notable exceptions to this model are Germany, which relies on trade surpluses to drive growth, and China, where debt from the non-financial sector bolsters household income.

The takeaway is basically that debt begets growth. So then, why worry about it, be it public or private? Because debt also comes with problems. 

Problem number one is that rising debt causes inequality to go up. This is because higher asset values are mostly captured by the wealthy. In the US, this has been particularly true since the late 1980s, when financialisation really took off. Even if incomes are rising, you may get a cost of living crisis (as is evident right now in the US and many other parts of the world) when the price of homes, healthcare or education outpaces wages. 

Problem number two is that rising private debt becomes a drag on economies, as household debt servicing becomes an increasing burden for those who are less well off. 

The cycle of debt-driven growth has been with us for centuries. Governments use debt to fund wars, and in their aftermath there tends to be a private sector resurgence which leads to greater financial lending. Eventually, there is too much lending, which leads to debt excesses. Those in turn require government bailouts.

It’s a process that is not only exhausting, but leads to economic and political fragility — from stock market collapses and housing crises to debt ceiling debacles and popular revolts against the rich.

We don’t yet know how to move beyond the cycle of debt-driven growth but Vague offers up thoughts on how to curb the most dangerous debt excesses and prioritise different stakeholders when the inevitable defaults happen. The key lesson is that, in many cases, the speed of a debt run-up matters as much as the total amount of debt itself. He advises policymakers to watch this metric across both the public and private sector. 

Debt forgiveness should be thought about less in moral terms than as a practical economic fix. Vague deems jubilees in areas such as student loans and healthcare debt worthy, since they encourage spending. Reducing large trade deficits is another way to deal with debt issues, something that will bolster the arguments from those in the US who want to better balance consumption and production. This goal has been prioritised by both the Trump and Biden White Houses.

Of course, one country’s deficit is another nation’s surplus. Just as public and private sector lending are intertwined, so is the debt of the US and the world. 

rana.foroohar@ft.com