This is the primary question in the latest monthly letter from Bill Gross. I don’t want to get into the specifics of where I think Gross might be wrong or right in the letter, but the question he poses is an important one. Can a debt crisis be cured with more debt?
From an accounting perspective any discussion about “debt” is usually too narrow in scope. That’s because debt does not exist alone on balance sheets. Balance sheets balance. And that means liabilities have corresponding assets or contra assets. So, when someone takes on more debt someone else, by definition, is taking on more assets. It’s almost always a red herring when someone starts going on about the problems of debt without putting this discussion in the proper context.
At book value all financial assets net to zero. That is, the net worth of the entire world of financial assets at book value is zero because balance sheets balance. If you take out a $100 loan the bank has an asset (the loan), you have a liability (the loan), the deposit holder has an asset (the deposit) and the bank has a liability (the deposit). No one’s net worth increases here. No one is necessarily better or worse off. Of course, financial assets don’t exist only at book value, but that’s not important for this discussion. The point is, you have to put financial assets and liabilities in the proper context, discuss their use and how they might impact the financial world in various ways.
Now, when we look at the recent debt crisis in the USA it becomes obvious that a debt crisis actually can be solved with more debt. First, what happened in recent years? Well, it’s a fairly simple story. Basically, households took on huge amounts of debt to buy houses they couldn’t ever afford and when prices slipped and the economy tanked these households didn’t have the income necessary to service the loans. And when that happened they stopped spending on gizmos and gadgets and instead deleveraged. This was highly contractionary as it took the primary spender in the economy and turned it into a deleverager (that’s not a word, but it is now).
Now, when the US government deficit spends it takes deposits from the private sector by swapping bonds for deposits and redistributes the deposits. This adds to aggregate spending AND it adds to aggregate private sector financial assets. The reason why is because deficit spending involves the creation of a private sector ASSET, but a public liability. That means the government takes on a liability and the private sector does not. This directly adds to the net financial assets of the private sector thereby bolstering their balance sheets. During a deleveraging this is an incredibly powerful policy because it adds to spending AND improves the balance sheets of the private sector where the balance sheets need repair. The math and accounting here is very simple – private sector spends less, government spends more, private sector net worth declines, government adds to private sector financial assets. I think it’s safe to assume that all of that should contribute positively to the economy.
Of course, there are other factors that can come into play there. Is the government spending efficient, are the financial assets going to those who need it, etc, etc. There are no precise answers to those questions, but in general it should be obvious that the answer to the title of this post is “yes” at times. We don’t need to even consider the politics of all of this. We can simply answer the question by looking at the basic accounting and apply politics where needed after the fact. So yes, more debt can solve a debt crisis because the creation of government debt doesn’t just create debt. It adds to private sector financial assets. This doesn’t mean government spending is always good or that deficit spending and adding net financial assets is always a necessary positive. But during a deleveraging I would argue that deficit spending is an obvious positive. The accounting can lead to no other logical conclusion.