Ignore anyone who tells you that debt levels don’t matter.

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.


  • IF says:

    “When Eastern Europe left the Soviet orbit, the countries that did the best were the ones that freed their economies most rapidly.”

    This sounds like an unsupported ideological statement. Looking at a map of Eastern Europe the countries doing the best seem to surround the city of Vienna/Austria. The farther you go away from Austria the less well/wealthy as a rule of thumb the countries get. This includes Poland, which was a pioneer in opening its economy in the 1980s. I don’t have an explanation, but I think local culture and location play a large role.

    To return to the rest of the article, what you are supporting is a quick crash. I like strong money myself. But I don’t see how you get from raising the interest rates to the inflation needed to fix the mortgage crises. Somewhere in the middle a small miracle seems hidden. Care to explain this magic?

    I am still young, so crash and inflation seem to be better outcomes than stagnation. But we all fear the devil we don’t know the most. Soon we could be so familiar with stagnation, that we might start defending it as the new status quo.

  • But What do I Know? says:

    Amen to the raising fed funds rate to 2% immediately–then savers could start to get paid and would raise their future income expectations. Right now retirees are not spending discretionary money because they don’t think they’ll be able to earn any on their savings. Or else reaching for yield with the bad stuff, and we know how that ends.

    Bernancke’s failed academic experiment is just not working out–not that anyone at the Fed will admit it.

  • Indy says:


    I heard an anecdote about a middle-aged man and his retired father. His father wasn’t getting any interest on his savings, and the man was paying a mortgage at around 6%. They decided to split the difference. The father paid off his son’s mortgage and, and the son remortgaged the house to his father in exchange for the stream of payments at 4%. I don’t know if it was interest-only, or a 30-year amortization, or some other arrangement.

    When the father passes away then whatever debt remained in the house would vest in the son as inheritance. So long as you have a lot of reason for family-trust, it sounded like a win-win deal. I wonder if they’ll become popular.

  • Mike C says:

    I expect us to move in the direction of Japan.


    Can you be more specific here in what you are thinking, especially from a “how do I make money” portfolio management perspective?

    Are you saying that in 2020, the overall U.S. stock market level will be at 1990-1995 levels. That would be the direct comparison.

    If so, then what? Does a U.S. investor basically abandon the U.S. market and have a 75-100% International portfolio?

    Call me a cynic or selfish, but at this point I’ve given up on solving society’s economic woes and all the various structural things like the debt level which are just out of control. I want to know how I am going to make money, and get at least 6-8%+ returns no matter what.

    Your blog is awesome, and of course it is your prerogative what to write about, but lately there hasn’t been much on actionable investment topics/themes on either specific areas/assets to go long or avoid. I would hope you get back to more of that.

    Even though I think the Austrian view is the correct one with respect to debt, it doesn’t matter, because no one who matters is listening. There must be though some logical profit opportunity in the crazy path we are going down.

    • Sorry Mike,

      I sometimes get caught up in the explaining, and not the predicting, which is harder. The current investing scene is tough, and my main goal is buying quality companies that don’t need financing. I am playing defense by buying the best companies publicly available in industries that I like.

      I will have more in the next two weeks.

  • Terry says:

    What? Dick “Darth Vader” Cheney was wrong?

    OMG. We’re doomed!

  • fresno dan says:

    You can amputate an infected limb with an ax or a spoon. Both are gonna hurt. Its probably less overall pain to do it with the ax.

    A lot of what people believe is no more than their the folktales (or social milieu for the fancy) they grow up with.
    For a long time I wondered how “supposed” returns in the (overall – after all, efficient market theory said there was no advantage to try and pick stocks) stock market could exceed the GDP. I have never heard an answer I found creditable. We have been indoctrinated to believe that we always get a return above inflation. I have had doubts about that and now I really doubt it. Credit hides that you cannot consume more than you produce. What is surprising is how long it can hide that fact.

  • David, you said:
    “Personally, I would raise the Fed funds rate to 2% immediately, and let it shadow the 10-year rate less 1% thereafter.”
    Fed is setting the Fed funds rate to stabilize long run inflation expectations in the range of 1.5%-2.0%. If Fed funds rate shadows the 10 years rate, modern macro theory says that the long run inflation rate would be determined by the fiscal policy or if fiscal policy is well behaved the inflation rate will be undetermined. What facts have led you to reject modern macro theory? How do you intend to stabilize inflation expectations?

    • TMDB,

      Look, I took all of the courses that a PhD in Economics would take. The difficulty is that the macroeconomic models don’t work. They don’t predict well, and they don’t even explain well. The neoclassical economists have pulled off one of the greatest heists in history — they have duped two generations of people into thinking that they know what to do with the economy, when their recommendations have failed, as have their predictions.

      I am following the Austrians here, and Wicksell. The yield curve does not have to be so steep to get banks to lend.

  • el says:

    David, are you talking about Nobel prize winners like Stiglitz?

    http://www.youtube.com/watch?v=E4MAifsp-8E is a must watch. Hendry losses it and doesn’t make his case well but it’s amazing to see the “economist” in the room rubber stamping irresponsible politicians.

  • Jim says:


    Been reading your blog for a while now, and it’s terrific. This article was one of the best. I’ve got to start reading some Austrian economics books.

    I have a question for you. Maybe I’m nuts, but I fall in the camp of abolishing the FED. Problem is, I don’t know what to replace it with. Would you consider writing an article on this subject?

    Thanks again,


  • David,
    I’m an avid reader of your blog and I’m really interested in is the interaction of your knowledge of macro theory and your real world experience.
    In terms of Wicksellian theory your post leaves one thing unclear – if fed funds rate shadow 10year rate then what will make the interest rate equal to the Wicksellian natural rate? What is the mechanism you have in mind – gold backing, fiscal policy, management of reserves of financial industry or something else?

  • Saloner says:

    Thank you very much for the clear elucidation, and more generally, for the education you provide us.

  • Roger Venning says:


    why do you suspect a failure of the yen? I understand that their (large government) debt is mostly internally funded (by private savings). I would have thought that a country such as Australia (where I live) would be a far greater risk given the our (large, private, housing related) debt is foreign funded and only easily serviced as long as resource prices remain high.


    • Roger — Internal funding is eroding, partially due to an aging populace needing to dis-save. Japanese savings rates are pretty low, and their deficits are higher than personal savings. Whether it is higher than national savings, I am not sure.

      But even the debt, internally held, poses intergenerational issues. Older people want deflation/stagnation, the younger want inflation/repudiation. So, there are still difficulties here.

      Japan is a great example of a country that did not allow a material amount of bad investments to fail. The boom years in the 80s led to overcapacity in heavy industry and the finance sector. They are still working through that.

  • d4winds says:

    re: “The US grew faster during periods where failures were reconciled and liquidated, rather than attempting to smooth the economic cycle.”

    When did this fantasy period occur? During the Hoover administration?

    • d4 — the US grew faster in the 1800s than the 1900s. BTW, Hoover was not a liquidationist, he was more similar to FDR than Coolidge. The debts continued to build as the economy fell apart. Debts were liquidated in spite of what FDR did, with creditors and debtors both taking significant losses. Only by 1941 was the economy clear of enough debt that growth could begin again.

      When debt levels are low economies grow. Then they grow like a weed during a debt build-up (boom), only to lose it all and more during the inevitable bust.

  • Jeff says:

    David — In your response to TMDB you draw upon your economic studies to conclude that all of the macro-economists are wrong and that it is the “greatest heist” in history.

    You follow with some other comments that are even more aggressive in attacking leading economists.

    It seems fair enough to ask that you provide some evidence — and not just saying that existing predictive models have performed poorly.

    What alternative do you recommend? Is there an Austrian model that has done well? Have you looked at the discussion at Econbrowser, for example, where they talk about a review of macro models?

    It is easy to criticize — more difficult to provide data. On many subjects you take a very constructive, data-based approach.

    On the modeling issue you seem to slip into ideology. Please prove me wrong.