Debt levels in an economy matter.  They matter a lot.  An economy that is financed primarily by debt can be like a chain of dominoes.  If one fixed claim fails, and it is large enough, many other fixed claims that rely on the first claim could fail as well, triggering a chain of failures.  This is a reason why a fiat-money credit-based economy must limit leverage particularly in financial institutions.

Why financial institutions?  They borrow and lend.  They also lend to other financial institutions.  A  big move in the value of some assets can make many banks insolvent, and perhaps banks that lent to other banks.  The banks should have equity bases more than sufficient to absorb losses at a 99% probability level.  That means that leverage should be a lot lower than it is now.

Economies are more stable when they limit fixed claims and encourage financing via equity rather than debt.  Imagine what the economy would be like if interest was not deductible from taxable income, but dividends were deductible.

• People would save money to buy homes, and would put more money down when they borrowed.
• Corporations would lower their debt-to-equity ratios, and would pay more dividends.
• Fewer people and corporations would go broke.

Pretty good, but in the short run, the economy would probably grow slower.  The debt bonanza from 1984-2006 pushed our economy to grow faster than it should have, where people and firms took more chances by borrowing more, and making the overall economy less resilient.  Debt-based economies lose resilience.

What was worse, the Federal Reserve in the Greenspan and Bernanke years facilitated the debt increases because the Fed never took away the stimulus fast enough, and offered stimulus too rapidly.  This led to a culture of unbridled debt and risk-taking.  If only:

• Greenspan had been silent when the crash hit in October 1987.
• Greenspan had not given into political pressure in late 1990, where he set up a process of cutting interest rates too much.
• Greenspan had not cut rates in 1995.
• Greenspan had not cut rates during the LTCM crisis.
• Greenspan would have cut far less 2000-2002.
• Instead of tightening 1/4% at a time 2004-6 , they would have raised the rate far more rapidly, completing the rise in one year.
• Bernanke would not have let the fed funds rate go to zero, but would have limited fed funds to never go lower than 1% below the ten-year Treasury yield.  We never need more than that to stimulate, but some patience is necessary.

What’s that you say?  The economy would have grown more slowly?  Right, and the economy should have grown more slowly, rather than gunning the engine through the overaccumulation of debt.  As it is, the economy will grow more slowly for some time a la Japan, until we delever the economy enough that it can once again grow without stimulus.

The economy is at a fork in the road.  Do we:

• Leave rates low and leave quantitative easing in until price inflation unfolds?
• Let rates rise gradually and drain quantitative easing slowly?
• Raise rates significantly and drain quantitative easing rapidly?

The third view is off the table.  No one wants to see any failure.  Bad decisions of the past must be grown out of, even if it takes a long time of subpar growth to do that.

When Eastern Europe left the Soviet orbit, the countries that did the best were the ones that freed their economies most rapidly.  Well, not in the short-run.  Letting companies fail is always a drag in the short run, but in the longer-run it leads to faster growth, because bad investments fail, and are replaced by better investments.

The same is true with monetary policy.  The US grew faster during periods where failures were reconciled and liquidated, rather than attempting to smooth the economic cycle — leading to fewer failures in the short run, much but bigger failures when the amount of debt became too large.

Before the crisis, when I was writing at RealMoney.com, I usually encouraged taking the less risky macroeconomic route, suggesting policies that would not increase debt levels.  The trouble was, that all of those ideas were losers in the short-run, and so they were not followed.  In the long run we are all dead, leaving the failures of short-run policies to our kids.

Personally, I would raise the Fed funds rate to 2% immediately, and let it shadow the 10-year rate less 1% thereafter.  But no one likes jolts, except when the Fed is loosening.  After that, I would rather the Fed allow inflation to raise collateral values and end the home and commercial mortgage crises.  But no, what we are likely to get is a Japan-style muddle-in-the-middle where they struggle with a slow raising of rates, and a slow end to quantitative easing, with a premature giving in when the economy has a negative burp before the removal of policy accommodation is complete.  I expect us to move in the direction of Japan.

What may change the story are sovereign defaults as government debt levels get too high.  In the short run, that may favor the dollar — it won’t fail rapidly.  But perhaps the euro might fail.  Even the yen might.  The era we are in is like the mid-1800s, when nations were constrained by their debt levels.

From the recent book “This Time is Different,” we know that countries with high debt levels grow more slowly, and defaul more frequently.  Ignore anyone who tells you that debt levels don’t matter.