“Neither a borrower nor a lender be,” burbled Shakespeare’s Polonius. Few of us take that advice. But it’s worth asking: why? Why do we borrow? To pay for something that we can’t afford today is the obvious answer. And we can all intuitively grasp why that can sometimes be unwise. Borrowing from Wonga at a 1,500 per cent annual interest rate to indulge a taste for Michelin star meals and breaks in the Maldives is clearly not sensible.
Yet borrowing to consume is not always idiotic. There’s nothing wrong with borrowing when we are temporarily short of cash, as long as we pay it back when we’re flush. It can also be sensible to borrow to invest in our skills, since this expands our capacity to earn money in the future. Imagine taking out a student loan to attend university or a personal loan to fund a professional training course. If you think education is expensive, try ignorance, as the saying goes. A mortgage to buy a house can also be a sound investment, provided we’re relatively confident of earning enough to repay the debt over our working lifetime. So there is good personal borrowing and bad borrowing; good debt and bad debt.
What about companies? Firms often borrow to invest in new equipment or to develop new product lines. That’s sensible borrowing, since it boosts their capacity to increase revenues and profits. But it’s not always prudent. Companies finance their activities in two ways: shareholders’ committed funds (equity) or with debt. Increasing the debt makes the return on shareholders’ equity look impressive while profits are growing, boosting the share price. But when the cycle turns, things are reversed, and too much debt can push a company to bankruptcy. Many firms borrowed too much in the boom years of the past decade simply to make the reported return on equity look better. That left them horribly exposed when the recession came. So in the corporate world, too, there is good borrowing and bad borrowing; good debt and bad debt.
Now what about the debt of governments? David Cameron was thundering about the evils of state borrowing again last week. “There’s nothing progressive about asking the next generation to pay off the debts we couldn’t be bothered to deal with; nothing progressive about robbing from our children,” the Prime Minister informed us.
That’s woefully simplistic. Just as in the household and corporate world, there can be good government borrowing and bad borrowing. While state borrowing to fund public-sector wages or welfare in normal economic times may well be unwise, borrowing to fund infrastructure investment that boosts the overall productive capacity of the economy makes sense. Investment in scientific research, which leads to commercialisable breakthroughs (think of graphene developed at the University of Manchester) is also spending well worth borrowing to fund.
But aren’t there dangers posed by the level of debt? There are potential costs from high accumulated government debt burdens. There is a risk that private investors will start to fear default and, in extremis, they may even refuse to buy any more. That can force a rapid and painful adjustment in government spending. Think Greece in 2010. And interest has to be serviced out of someone’s income today. That money could have been spent in other, more productive, ways in the economy: schools and hospitals, rather than coupon payments to bondholders.
Yet there are also costs in not borrowing, if that means under-investment in state infrastructure. Cameron invokes our children’s welfare, but future generations will not thank us if we haven’t increased the productive capacity of the economy when they enter the workforce.
Brad DeLong of the University of California, Berkeley, recently argued that governments in the US and Europe have been under-investing for the past century, given the very low borrowing rates available to developed nations. That led him to the striking conclusion that state debt levels today in the Western world are too low.
Cameron takes a different view. He says he wants to run budget surpluses to reduce the outstanding level of debt, which is currently equivalent to around 80 per cent of the UK’s GDP. Ministers say surpluses are needed to put the public finances on a permanently stronger footing and reduce the costs of future crises. But this is economically doubtful.
Analysts from the International Monetary Fund have pointed out that there are also costs from governments actively paying down debt because resources must inevitably be diverted from elsewhere in the economy to achieve this consolidation. Their view is that if a state is not under financial pressure, its debt burden as a share of GDP ought to be eroded gradually through economic growth, rather than through governments busting a gut to run surpluses. This emphasises a key difference between state and household borrowing: states live for ever, so do not need to clear all their liabilities before death.
Another important point often missed: it’s not only government debt levels that we should think about. Two other American economics professors, Atif Mian and Amir Sufi, argue that high aggregate levels of private-sector debt can make economies vulnerable to sudden shocks as over-leveraged firms and households tend to rein in their spending all at once. Mian and Sufi also argue that high inherited private debt overhangs constrain growth in the wake of recessions.
So we live in a world of good debt and bad debt – and the distinction is often unclear. High debt levels can probably be dangerous – but danger thresholds are hard to determine. We should worry not only about too much debt – but also too little.
Getting the balance right requires careful judgement. Some basic questions can help us to get the right answer: Is the debt burden affordable today given the interest rate? Is it likely to be sustainable tomorrow? And what was the debt incurred to buy? In accounting terms, this means looking at the assets as well as the liabilities side.
Sadly, politicians often tend to ignore these crucial questions, preferring instead to whine like Polonius on a bad day about the inherent evils of debt and borrowing.