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Debt Dualism

By James H. Nolt

Since the beginning of this blog series, I have emphasized how much the polarization of political economy is rooted in debt. One the one hand, borrowing is often irresistibly tempting; on the other, it can be dangerous. Keep in mind that no company can go bankrupt without a debt burden, while few companies can grow rapidly without debt. Debt is the power that enables bulls to leverage slim profit margins into huge gains, grow at the expense of rival companies by investing in the latest technology or large-scale production and marketing, or defeat an adversary nation with borrowed funds. Yet debt also polarizes the interests of debtors and creditors, creating a bearish interest, including many creditors, established industry leaders, and short speculators, who profit from crashing prices and thereby hamstring the bulls—they bankrupt bullish rivals or force them to sell out for pennies on the dollar. Such polarization is endemic in any credit-driven political economy.

Governments also get swept into this dualism. Historically, war was the main expense of governments; it was nearly impossible to win a war without better financing than their adversaries. Now competition for economic development has largely replaced war as the main inducement to borrow. Businesses are attracted to regions with low taxes and generous services, including excellent infrastructure, education, and public health. Governments must spend money to draw in business, but also keep taxes low to avoid driving businesses away, in search of a tax haven elsewhere. Globalism promotes easier movement of business across borders, which gives companies considerable bargaining power when cajoling governments and their citizens. Governments have a weak hand. Their principal recourse is borrowing to provide needed services without taxing business to pay for them.

It is no accident that the “tax revolt,” the sin qua non of modern anarcho-conservatism, appeared and thrived coincident with conservatism’s embrace of globalism and debt financing, instead of localism and balanced budgets. This tendency took off during the 1980s with Prime Minister Margaret Thatcher in Britain and President Ronald Reagan in the U.S. It stimulated a decades-long debt bubble that led to the financial crash of 2008, and has continued to inflate fresh debt bubbles in hot new growth centers to this day. There is really no alternative. Regions or industries that are not credit-worthy or do not borrow fall behind in global competition, yet massive borrowing creates more volatile business cycles, too. It is like a highly addictive drug: Taking it stimulates competitiveness but also increases vulnerability when creditors turn bearish, perhaps crashing one excessively indebted economy only to surge into some new region ripe for debt-fueled growth.

This recurring pattern means that today’s hottest growth champions, whether companies, industries, or regions, are often headed for bankruptcy—or at least a crash—in the near future. Stark examples include the energy firm Enron, which was the darling of the business press in 2000 just before its spectacular crash into bankruptcy and fraud convictions for top management. Japan was the growth miracle of the 1980s until it too crashed near the end of that decade. The country has never since recovered its fast growth. Even today, while Japan is in the news because the Nikkei stock index hit the highest level since the great crash, this peak is still only two-thirds the peak of 1989. Iceland and Ireland were two of the miracle growth countries early in this millennium, but they were among the most devastated by the 2008 crash. As the old saying goes, “the higher they rise the harder they fall.”

Although economists and thus most mainstream economic news dwell on the “dull gray averages” like GDP and average growth rates, these averages camouflage the stark divide between winners and losers that emerges most sharply during each crash. One story just this week shows the lingering effect of the 2008 crisis. Some homeowners were able to negotiate mortgage debt forgiveness, allowing them to stay in their homes despite the burden of mortgages now being larger than the newly depressed home values. If banks foreclose and sell the house, they might get less for it than if they permit the original owners to stay and pay some fraction of the original mortgage. However, if the mortgage is reduced, that is a tax deduction (a loss) for the bank and a tax increase for the debt-strapped homeowners because any reduction of the original mortgage is counted as taxable “income” for the debtor. The Obama administration created a special tax deduction for this situation to encourage banks to grant mortgage reductions to heavily indebted homeowners, but this is one of the deductions slated for elimination under the Republican “tax simplification” plan currently before Congress. Banks would still get to deduct the losses from loan rescheduling, but distressed homeowners would owe massive tax payments if this debt forgiveness is treated as income.

Puerto Rico is another example of this boom-and-bust debt dualism. In recent decades this U.S. territory had been touted as a business-friendly investment paradise. Wages were already lower than on the U.S. mainland, and massive tax concessions and infrastructure subsidies attracted dozens of manufacturers to Puerto Rico during the boom time of the early 2000s. Since the residents are low paid and businesses little taxed, the gap between low taxes and higher spending had to be filled by ballooning borrowing. This borrowing used to be relatively cheap for Puerto Rico’s government because its bonds are triply tax exempt for investors: Interest income was exempt from federal, home state, and local income taxes. Puerto Rican bonds were thus easy for Wall Street to market.

After the 2008 financial crash, many factories in Puerto Rico downsized or moved elsewhere. Tax concessions were often temporary. Corporations would take advantage of the tax haven while they lasted, but then move production to some new tax haven as soon as they expired. Puerto Rico was left with massive debt and reduced income to service it. Now it is effectively bankrupt, unable to pay, made even worse by the massive devastation of two recent hurricanes. The answer from creditors, like in Greece since its 2010 crisis and any of myriad other cases, is to slash public employment, education spending, and other key services, sinking the island in a vicious downward cycle of poverty and despair. President Donald Trump recently suggested that the solution may have to include debt relief, but that was quickly reversed by Treasury Secretary Steve Mnuchin after Trump’s tweet caused a sharp dip in Puerto Rican bond values. Investors, some of whom bought distressed Puerto Rican bonds at steep discounts, demand full payment of the original face value. Puerto Rico has no legal recourse; thanks to a little-noticed provision inserted to a 1984 bankruptcy law by former South Carolina senator Strom Thurmond, Puerto Rico is prohibited from declaring bankruptcy or defaulting on its bonds, the way Detroit, for example, did in 2013.

Globalism today is a little like an old-fashioned gold rush: A few folks find gold and quickly get rich, while others make money selling to these lucky prospectors, but most people get poorer both because rising prices stifle their purchasing power and because some sell their farms and tools, abandoning traditional labors to seek gold they never find. They end up dispossessed of the means of production, and thus no longer able to produce their means of life. Eventually the gold runs out and the boom moves on to somewhere else, leaving ghost towns and impoverished people in its wake. Not only are resources mined and depleted, so are people.

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James H. Nolt is a senior fellow at the World Policy Institute and an adjunct associate professor at New York University.

[Photo courtesy of Chris Potter]

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