In a working paper, Hudson Institute Scholar and former AEI President Christopher DeMuth argues that debt has become a means of pleasing and placating voters while avoiding democratic accountability.
In the debates surrounding today's sovereign debt problems, many politicians and pundits, including European socialist, profess that (a) government debt is a bad thing and balanced budgets should be our goal, but (b) for the time being, we urgently need to defer that goal or to move further away from it. It is very confusing to speak of a goal that we should not pursue, and of a bad thing that we should pursue instead. Perhaps it would be more productive to try to specify when debt is good and when it is bad. My analysis will describe the three virtues of debt in the private economy, then extend them to the more problematic public sphere and try to see where things have gone awry. An important theme of my remarks is that debt has become a means of pleasing and placating voters while avoiding democratic accountability, and that the leading efforts to resolve our debt problems are seeking above all to preserve this electoral project.
The first function of debt is investment—to bridge the span of time between a plausible idea and its productive realisation. The social utility of debt must go all the way back to the discovery of the social surplus, when agriculture began to replace hunting and gathering.
“Debt has become a means of pleasing and placating voters while avoiding democratic accountability.”
For humans to progress from a world where everyone had to kill his lunch every day, someone had to be spotted many lunches in order to try his hand at cultivating the soil. One of the earliest laws regulating debt was Deuteronomy's prohibition of charging interest on loans of victuals to one's brother.
Debt is not only the original but also the most entrepreneurial form of finance. Many of history's greatest creative geniuses, from Mozart to James Watt to Sam Walton, were big deficit spenders, chronically in debt. Not because they were profligate but because they were consumed by ideas with no immediate return.
“Perhaps it would be more productive to try to specify when debt is good and when it is bad.”
Artists and authors, if they are successful, will in time find patrons and audiences, and entrepreneurs will find shareholders and customers. But at the start, when their ambitions may be so speculative that they themselves cannot describe them with any coherence, or so revolutionary that they sound like cranks, they are usually confined to the microfinance of loans from friends and relatives. And many find it advantageous to borrow even as they prosper.
In the modern world, the provision of credit has become fantastically specialized and reticulated, and supports investment in tandem with equity and various hybrids of the two. But as societies achieve higher levels of wealth, income, and division of labor, credit markets acquire lives of their own and find a second and a third distinctive function.
The second is a consumption function—to bridge time in consumption as well as production. This includes credit cards (which also serve a transaction function) and longer-term loans for purchasing homes, vehicles, and durable goods. Here we are borrowing not for future production, but because we are confident enough of our future production to borrow against it. We are redistributing income from our future self to our present self. Love may be wasted on the young, but, in a wealthy society, material comforts need not be wasted on the old.
The third is a pre-commitment function—to demonstrate honesty, fidelity, and diligence to strangers. Some large firms eschew debt, such as Hewlett-Packard under its founders and Apple today. But most find it useful to borrow and would do so even absent the tax bias (found in most of the advanced economies) for debt over equity financing. Contracting to pay out a substantial sum of cash on a regular basis assures stockholders that management is doing at least a few things right, and is collecting at least some of the earnings claimed on its financial reports. Dividends also serve this purpose, but dividends, unlike interest payments, are at the discretion of management and are therefore a weaker market signal.
Each of the functions of private debt has a close analogy in the public sector. The difficulty is that, in each case, debt is not only a tool of good government but also an inducement to bad government. And, in the absence of (a) market competition and (b) the ability of political representatives to make contracts that bind the government over time, we have no neutral institutional mechanism for sorting the good from the bad. Download the full paper: The Debt Threat To Democracy