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Weekly Standard Online

The Debt Overhang

The upcoming election will match low-tax, high-spending Donald Trump against high-tax, higher-spending Hillary Clinton. By all responsible reckonings, the next president will preside over rising deficits, funded by increased borrowing. That, of course, is what latter-day Keynesians such as Harvard’s Larry Summers are calling for. With monetary policy seemingly having done all it can to boost growth, and the economy moribund—mired in secular stagnation is Summers & Co. would put it— he argues not unreasonably that it makes sense to borrow to invest in projects that produce jobs and have a social return in excess of the nil-to-low borrowing cost. Call it infrastructure. What if the rating agencies are unhappy? No matter. When the agencies downgraded US bonds from triple-A to double-A there was hardly a ripple in money markets, and borrowing by the government remained cheap by historic standards.

In the household sector, the logic is similar.

* With mortgage rates low now is the time to borrow to buy that new home -- which the latest figures show is precisely what is happening: pending home sales in April were at their highest level in ten years.

* With interest rates low, now is the time to get that new car or light truck, because manufacturers and dealers are offering to lend the needed cash at interest rates often below 1%. Sales are on track to equal last year's record.

* With interest rates low, and jobs not easy to come by, borrow from the government to finance a longer stay in college: student loans account for about 10% of total household debt, double the pre-crisis level.

True, U.S. households owed $12.25 trillion at the end of the first quarter, and by continuing to borrow at the current rate are set to drive outstanding debt to pre-2008 crisis levels by the end of this year. But with interest rates so low, the cost of carrying that debt as a percent of household income is down from around 13 percent in 2008 to 10 percent now.

If it's good enough for our government and consumers, it must be good enough for our corporations. So borrow money to finance acquisitions, or to keep shareholders happy by buying-back shares, thereby increasing earnings-per-share even if earnings are declining. So what if the rating agencies are unhappy about this increased ratio of debt to equity, so-called leverage. As indeed they are. In the 1980s some 60 companies had triple-A ratings; by 2000 that number had dropped to 15; now only two companies, Microsoft and Johnson & Johnson, can claim that exalted status. But interest rates paid by double-A rated companies are only a sliver above their higher-rated counterparts, making the advantages of more borrowing outweigh the higher interest cost. At least up to the point where earnings are insufficient to cover interest costs.

There's more, and better. In many cases borrowers don't really have to repay the lender, at least not in full, if it seems too costly to do so. Puerto Rico issued $3.5 billion in IOUs in 2014, and its governor announced that the constitutional obligation to repay was reinforced by a "moral obligation" to do so. That was then, this is now. With its debt and pension obligations at 172 percent of its GDP, Puerto Rico will default. Lenders, who apparently ignored 14-pages of warning in the prospectus, profess themselves shocked, shocked although they must have perceived a risk of non-repayment when they were able to command what at the time looked like a whopping 8.7 percent interest rate on the $3.5 billion loan.

Nothing new here. By one count, between 1980 and 2012, 19 countries in Africa, 22 in the Americas, 14 in Asia and 9 in Europe have failed to repay their debts in full. Orange County in California and Detroit have already taken that route, with state and municipal governments lined up for possible reductions in the amount that will be repaid—so-called haircuts. And the International Monetary Fund has opened a new barber shop, to make further aid to Greece contingent on a write-down of what that country owes its European creditors, the haircut to be administered after the German elections in 2018 so that Mrs. Merkel can until then hold to her view that the piper must be paid—in full. Which she knows is impossible. Donald Trump suggested such a barber shop visit for the U.S. before retreating in the face of outrage at such a suggestion of credit unworthiness.

Besides, we can accomplish the same result by seeming to repay in full, no tresses trimmed, without actually doing so. All the government has to do is print money and repay with dollars worth a lot less than those it borrowed. Of course, future lenders will factor that risk into the interest rate they demand, but as any sensible politician would put it, that's for the next guy to worry about.

So, debt, where is thy sting? Lurking in our future.

* If the risk-management programs developed by too-big-to-fail banks and their regulators are flawed, so many borrowers will be unable to repay their (energy? commercial property?) loans that we will be treated to a rerun of 2008.

* Low interest rates force investors, desperate for some return on their money, to make riskier and riskier bets that divert resources to uneconomic ventures.

* Low interest rates shrivel bank profits, already under pressure from new regulations, inducing lenders to expand their profitable credit card businesses. They have mailed cards to millions of subprime borrowers, and raised customers' credit limits. Credit-card balances should hit $1 trillion at year-end, just about the 2008 total.

Most important, low interest rates allow politicians to put a low cost tag on their favorite projects, which they always dub investments, never expenses. (So when an agency splashes on a lavish spa weekend for its top executives, it is not spending, it is investing in their morale. But in liberal usage the cost of an adequate military is "military expense".) In any case, the borrowing needed creates a claim on future income. If the Fed does raise interest rates in the next few weeks, and mounting deficits require the government to step up its borrowing, the carrying cost of debt will rise and with it taxes that future consumers and businesses would otherwise have available for spending and investment. We party, future generations pay. That will make breaking out of the 0-2 percent growth pattern more difficult than it need be.