How Could Debt NOT Matter?

contributed by John E. Rice, CFA, CFP®

Ugly CashI want to challenge something I have heard in the popular press recently.

Over the last couple of years people have begun to question convention wisdom that taking on more debt is bad for an economy. The basic argument goes something like this. 

When an economy is functioning at a level below full employment GDP then injection of money into the system can stimulate economic growth. This will lead to more spending, more jobs, and the economy will cycle back to operating at a high growth and full employment level. If we don’t have to worry about debt then we should continue printing more money to stimulate the economy.

However, I believe this argument has been taken way too far. Some, including mainstream economists, think we should continue to increase the deficit and debt even though it has ballooned well beyond where any of them would have projected.

I have grave concerns with this. The principal argument against increased debt and spending are two-fold.

  1. Where will the money be spent? If spending is so important why is it not happening already with the systems in place now? If there are clearly “shovel-ready” projects that should happen, why do we think that government spending can efficiently allocate capital to the best and highest use and get these projects completed? There is already a system in place to repair bridges and highways that need repair. If we force changes to the current system of capital allocation we are going to end up with waste.
  2. When should the increased spending end? Perhaps the biggest argument against increased spending is when to turn the spigot off. The Fed is already talking about how to unwind quantitative easing but actually making it happen will be very difficult. People will get hurt as decisions are made to not continue funding. They might have been better off with an earlier round of belt tightening and learning to work with limited resources earlier instead of later.

Were the people that believe we should increase debt around in the late 1990s to see the tech craze? The main supposition then was that “this time it is different” People felt they could continue to bid up prices of tech stocks beyond what reasonable future cash flows could support because the new economy was upon us and we could not predict how changes would impact these companies and therefore we did not need to use sound financial modeling to evaluate current prices. I see the debt argument in the same way. Conventional wisdom says increased debt beyond what can be reasonably supported in an economy is going to lead to problems. But some people are questioning this conventional wisdom.

Common sense tells us that it is not different this time. The increase in the Fed balance sheet through quantitative easing will cause disruptions in the future and it should be reined in carefully over time as we work to balance our budget.

Some say this waste of resources will be a small price to pay for the long-term positive impact of the projects that could get done with more money in the system. I disagree. When there is too much capital to allocate, less than optimal projects get funded. The end result is never good for the organization. We would be foolish to think that it would be good for our whole economy.

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