Debt and boom

By Lorenzo

The slogan for this post is: don’t think debt, think safe assets.

(This post is partly provoked by this post by Paul Krugman responded to by Scott Sumner and by Marcus Nunes.)

In my Debt, Doom and Despair post I noted that a hugely debt-burdened post-Napoleonic Wars UK (where the national public debt was probably about 250% of GDP or about 25 times the revenue of the British government) went on to an amazing surge in population and mass prosperity.  (In fact, by far the most remarkable in all of human history up to that time.)

What if it was not a coincidence? What if the debt burden actually encouraged said surge?  After all, WWII left the British, Australian and US governments all highly indebted (at about 240%, 150% and 120% of GDP respectively) yet all experienced amazing postwar surges in population and prosperity. All surges marked by high rates of productivity increases from expanding technology and global trade.

One’s persons debt is another person’s asset. What were the British, US and Australian governments doing in running up such huge debts? They were creating a huge level of safe assets, given that none of these three governments have defaulted on their bonds, ever.  One reason why Britain went back on gold in 1925 at the pre-war (over-valued) parity was to “keep faith” with its bondholders.

So, those high levels of public debt were also creating high levels of income from safe assets. If you are, for example, 1815 Britain, and debt is 250% of GDP, then a significant amount of income, compared to total production, is flowing from said safe assets.

Expropriating risk managers
There are two basic things states do: they expropriate and they manage risk. The latter is necessary for the former and goes back to the origins of rulership–dead farmers cannot pay taxes.  In ibn Kaldun‘s definition, cited and admired by Ernest Gellner, government is:

an institution which prevents injustice other than such as it commits itself.

This the paradox of politics or the paradox of rulership–we need the state to protect us from social predators but the state itself is the most potentially dangerous of social predators. It is a paradox that can never be fixed, only managed more or less well.

One of the tricks of rulership, refined by medieval rulers such as Alfonso IX of Leon, and Edward I of England, is that, if you get consent for your taxation, you can do a higher level of taxation because it lowers the “resistance cost”. Democratic welfare states have taken the consent-benefit trade-off up to record levels (for any non-patrimonial or totalitarian polities; i.e. for societies with any free element). Welfarism is the domestic aggrandisement of the expropriating state as imperialism is its external aggrandisement. (One of the ways we can tell that welfarism is, at least in part, an excuse for state aggrandisement is how weakly expenditure is tested against effectiveness in improving social outcomes; conversely if there is less inherent nobility in welfarism than appears, there were also positives in imperialism, albeit at wildly varying levels.)

But the public goods, and latterly welfare, provided by the state in return for implicit or explicit consent for its expropriations are overwhelmingly about risk-management. And risk management is a genuine service. Consider protection of life, person and property; or mitigating the risks of unemployment, sickness, disability, old age.

Balancing risks
For any given level of risk aversion by potential investors, creating a safe income stream raises the risk threshold for further investment. People will be more willing to tolerate higher levels of risk in their other investments.

Such as in highly uncertain investment in new technology. True, that leaves one open to asset booms and busts (pdf). Nevertheless, net economic outcome is likely to be a long term acceleration in productivity (pdf). And the surge in population and prosperity such involves.

The existence of such safe assets also provides “refuge” assets when things go sour; assets to move into if risks assessments suddenly shift adversely. If you think it is a wild coincidence that, faced with a deeply distressed financial system in remarkably similar economic circumstances (pdf), the Japanese and American states both created huge amounts of safe assets, then I have a Harbour Bridge I want to sell to you. (An excellent discussion of safe assets is provided by high school student[!] Evan Soltas here.)

One might reasonably claim that, in both Japan’s bubble economy crash and in the Global Financial Crisis (GFC), the claims of stressed banks have come first. That, particularly in the Fed’s response to the GFC, Fed Chair Bernanke acted as if it was (pdf) a golden opportunity to prove that Prof. Bernanke was correct in his credit channel analysis of the 1930s. Nevertheless, both states took on extra liabilities to create safe assets with reliable income streams.

Focusing policy
Having that level of debt, and lacking any belief that some outside force will “rescue” you (such as developing states have with foreign aid or Mediterranean Eurozone states treating the euro deutschmark-for-everyone as some magic wand), tends to focus policy attention on economic prosperity. For only rising incomes will provide the revenue needed to manage the debt.  Both Britain in the C19th and the US in the postwar period encouraged free trade. Growing trade provided long-term prosperity which reduced the debt burden. Remembering that high levels of debt mean high levels of government revenue is taken up in servicing that debt.

The postwar Australian state was rather more protectionist; but it was a much more minor player than early C19th Britian or mid C20th US and had a policy regime in which protection was an integral element. The consequence was notably lower levels of per capita economic growth than other developed countries (including the US). But high population growth more than compensated.

Indeed, I would argue strongly that the post-1973 collapse in productivity growth had a great deal to do with the economic reform surge from the late 1970s onwards, as welfare states focused attention on restoring the productivity growth, and restraining the growth in welfare expenditures, that was needed to keep the (now much larger) welfare states sustainable.

This is not to say that endless creation of ever higher levels of public debt is a great idea. First, it is vital not to create concerns about the reliability of the debt. The entire effect rests on government bonds being safe assets. Second, it does reduce one’s room to manouevre–both in expenditure and in ability to raise more debt to deal with emergencies. Third, surging populations were part of what made it work; adverse demographics are not a good long-term prospect. Fourth, one does not want engage in systematic “crowding out” of investment.

The effect also rests on not having central banks destroy the effect. Such as acting like the Bank of Japan and being contractionary at any sign of surging demand. Nor like the Bank of France and the Fed imposing massive deflation on the goldzone.

Still, if you look at debt and do not also see the counterbalancing assets, your analysis will go seriously astray, as any analysis that considers only half the story will.


  1. Tom
    Posted July 19, 2012 at 10:56 pm | Permalink

    high levels of income from safe assets.

    At 1 or 2%, where are the high levels of income?
    By keeping interest rates low, all those who have some $500,000 in bonds, are getting only $5-10 000, rather than $30 000 at 6%.

    As time goes by, and more boomers retire, this reduction in interest income reduces AG from those who are retired and depend on or augment their pension with interest income.

    It might well be that the US has gone thru a tipping point where lower interest rates reduce bond income so much that it directly reduces AD more than it leads to an increase in lending and thus indirectly increases AD.

  2. Posted July 20, 2012 at 4:23 am | Permalink

    [email protected] I was talking about gross bond income compared to GDP.

  3. derrida derider
    Posted July 20, 2012 at 9:40 pm | Permalink

    Tom’s comment adverts to one thing I’ve been thinking about which really seems to have escaped a lot of people – population aging has profound, and largely unwelcome, effects on capital markets. Its linked to the old Solow-Swan stuff that ties the risk-free rate of interest (and therefore the rate of profit) to population growth.

    I worry that Japan’s experience of the last two decades is just an advance case of what will happen to the wider world economy.

Post a Comment

Your email is never published nor shared. Required fields are marked *