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The government hearts debt

saupload_jq2.jpgThe ongoing economic crisis has been, in every way, a crisis of debt. The banks were brought down by mortgage debt. Wall Street -- and, quite nearly, the economy -- was brought down by leverage. But as James Surowiecki writes, "Debt didn’t get dangerously out of scale because the system was broken. It got out of scale, in part, because the system worked."

The government doesn’t make people go into debt, of course. It just nudges them in that direction. Individuals are able to write off all their mortgage interest, up to a million dollars, and companies can write off all the interest on their debt, but not things like dividend payments. This gives the system what economists call a “debt bias.” It encourages people to make smaller down payments and to borrow more money than they otherwise would, and to tie up more of their wealth in housing than in other investments.

Likewise, the system skews the decisions that companies make about how to fund themselves. Companies can raise money by reinvesting profits, raising equity (selling shares), or borrowing. But only when they borrow do they get the benefit of a “tax shield.” Jason Furman, of the National Economic Council, has estimated that tax breaks make corporate debt as much as forty-two per cent cheaper than corporate equity. So it’s not surprising that many companies prefer to pile on the leverage.

These policies have been around a long time, but as Surowiecki says, we shouldn't mistake longevity for permanence. "In the U.S., people used to be able to write off the interest they paid on credit cards. That tax break was abolished in 1986, and, the same year, the mortgage-interest deduction, which used to be unlimited, was capped. Great Britain, meanwhile, abolished its mortgage tax break in 2000. Similarly, there are a number of countries, including Brazil and Belgium, that don’t give corporate debt a tax advantage over equity, while, just last year, both Germany and Denmark cut back sharply on their business-interest tax breaks, limiting how much interest companies can write off."

The economic crisis has led to a lot of huge policy responses, but not much in the way of policy changes. This, however, is one change we may come to regret not making.

Graph credit: James Quinn.

By Ezra Klein  |  November 18, 2009; 7:12 AM ET
Categories:  Economic Policy , Financial Crisis  
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Are those dollars adjusted for inflation or not? The article you link to doesn't say.

Isn't that the first thing we need to know if we want to interpret this graph?

If the data is not adjusted, the graph shows that household debt actually went down in real terms.

Posted by: nycguy2 | November 18, 2009 8:34 AM | Report abuse

I recall that the team George W. Bush put together to study tax reform proposed eliminating the mortgage interest deduction, which is one reason we didn't have income tax reform. Not to blame Dubya for this one, since it never would have gotten through Congress in 2006. I hope we will eliminate the interest deduction eventually, and perhaps this crisis will serve as a spur to do it.

Posted by: Lindemann777 | November 18, 2009 9:22 AM | Report abuse

Since the y-axis on the graph is explicitly labeled "constant 2007 dollars", I think it's safe to assume that the dollars are adjusted for inflation.

Posted by: thehersch | November 18, 2009 9:40 AM | Report abuse

I've wanted to get rid of the mortgage interest tax deduction for ages. If the idea is to promote home ownership, then it's poorly targeted because it applies to anyone who might buy a home whether or not they had the deduction. And it's ridiculous that the wealthiest get the biggest breaks (since they're in higher tax brackets). And since the deduction lowers the effective price of buying a house, developers can effectively raise the selling price and pocket part of the savings themselves.

Of course, the construction and realty companies would put up a huge fight in Congress to retain the deduction--yet another reason for public campaign financing to limit their arguments to the contents of their ideas rather than their wallets.

Posted by: dasimon | November 18, 2009 9:52 AM | Report abuse

It's curious though that taking away the ability to write down credit card interest was followed by an explosion in both the amount of debt and the (real) credit card interest rates.

It's almost as if tax policies do not determine what happens, but it would be shocking to say that to a policy wonk.

Posted by: Hopeful9 | November 18, 2009 10:03 AM | Report abuse

Does that number include mortgages? My wife and I have no debt outside our mortgage, but with it, we're well above average.

Posted by: AZProgressive | November 18, 2009 10:07 AM | Report abuse

We're falling to debt because of the Three H's: Health care, Housing and Higher education. What these have in common is:

1) There's not real substitute product for people who need them
2) While they're sold in markets that are free on the demand side, the supply is limited through artificial scarcity created by the suppliers:

While our society offers myriad ways to LEARN, granting degrees is limited to a few institutions that accredit each other and close the market to new business models. Health care is similar, with its practitioners deciding what kinds of care should be allowed to exist. Housing is limited by the political clout homeowners have in local politics to affect zoning. All three markets function as if GM, Ford and Chrysler could decide who would be allowed to sell cars.

Posted by: WmarkW | November 18, 2009 10:32 AM | Report abuse

There is some explanation needed here - "Great Britain, meanwhile, abolished its mortgage tax break in 2000."

Then why GB faced vicious bout of home owner debt led recession too?

I think it is more to do with how 'securitization' of debt done rather than Congress set policies.

You have to understand we got Savings and Loans problem in late 80's which was caused because those banks carried lot of mortgages on their books. Response was make CDOs. Wall Street banks then learned to make profit out of cutting and slicing these CDOs. Rating agencies were drunk, Fed was led by a disaster called 'Sir-prints-a-lot' who openly advocated 1 year ARM in Congressional testimony, foreign countries got attached to false security by buying into American mortgage CDOs and we had an Administration which saw all this bubble creation as economic improvement as a way out of consequences of another bubble.

So where is the issue of specific policies to allow debts? It is clear and simple 'regulatory' failure. Don't read too much of 'policy' business in that.

This is on Private side of the debt. Meanwhile Congress and Administration continued to rake in truck load Public Debt in the name of 'war on terrorism', unfunded entitlement expansion and ill conceived tax cuts. Those policy blunders have pushed us over brink in terms of collective Public Debt. Go fix those.

Are you doing that? No, with Reid doubling down on entitlement expansion (end of the life care house management expansion, latest unfunded addition to his HCR); we are nowhere near to 'correct' mistakes of Bush era. Don't expect different results there.

Posted by: umesh409 | November 18, 2009 10:32 AM | Report abuse

It seems that eliminating the deduction for non-operating business debt could go a lot further toward reforming the nation's financial system that a focus on individual debt (which would just effect a stepwise drop in house prices). But without the tax subsidy for big hunks of business debt, leveraged bustouts would be much harder to engineer, and a lot of other stupid tax-focused transactions would drop by the wayside.

Posted by: paul314 | November 18, 2009 2:30 PM | Report abuse

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