Over the weekend, the normally respectable The Economist published a baffling diatribe against the Western world’s noxious culture of debt. This author has much sympathy for the observation that the Western world is addicted to ever increasing debt load, and that eventually much of these would remain unpaid to savers who have lent the money (see “The Crack’s in Credit”, Asia Times Online August 25, 2007).

That said, my primary focus for concern was:

  1. The West wasn’t prepared to address the real problems of excess debt
  2. Creating more debt to solve a debt crisis was stupid (the so-called Keynesian way)
  3. Allowing and indeed accelerating bankruptcies was a more defensible route to financial stability

Using a pernicious data point of the dot com bubble in 2000 ($4 trillion of equity value wiped out) against a random figure of $2 trillion at risk during the 2008 crisis, and looking at how things have panned out since, The Economist has surmised that the problem is too much debt.

This is insanely stupid, if such a condition ever existed – rather than look closely at the cause of the relatively easy adjustment after the dot-com bubble burst which is that the U.S. government did not try to rescue Netscape and pets.com, thereby allowing equity holders to destroy themselves. In other words, a classic case of Schumpeter’s creative destruction with notably positive results for the sector: instead of learning from that, the U.S. government did rescue the pets.com equivalents of the 2008 crisis, namely AIG and Fannie Mae (not to mention the real beneficiary of those rescues, Goldman Sachs).

Prima facie, the essential principle of taxation is based on the generation of distributable profits; in other words to tax income that is derived from business operations after deducting all applicable factor costs. Capital, land, raw materials, labor are some of these factor costs. To argue that one type of factor cost – in this case the cost of debt financing – should be ineligible for tax credit whilst others such as salaries and wages should remain eligible is of course nonsensical.

As an argument, the “public good” argument underlying The Economist’s diatribe can be easily deconstructed. Most European countries as well as the USA spend billions every year educating their public and getting them through school. Such well educated people then go to companies and earn wages – by allowing the deduction of wages from revenues, the exchequer forgoes hundreds of billions in lost revenue and that too for a resource that is almost exclusively generated by the state (at least in Europe).

Why is that fair, but deduction of interest payments from debt, not fair from the tax perspective?

It is also an easy re-telling of history to quietly hide the subsequent Fed easing that followed the dot-com bubble burst, which subsequently went into people betting hugely on house prices thereby leading to the GFC itself.

The Economist compounds the error of scientific inquiry with some basic calculation mistakes that underpin its spurious claim of tax subsidies. Here are some basic worked out examples using companies, banks and individuals:

Based on the above, it appears to me that the good folks at The Economist may have indulged in more than their fair share of hyperbole.  A few key points stack up here:

Net disposable income at the hands of individuals is circulated back into the economy as either consumption or as excess savings which then realizes its own return be it in debt or equity. All told, not taxing people on their interest costs for essential items like mortgages ends up keeping consumption of other goods. Since either governments in places like Europe levy value added taxes (VAT) on consumption or else U.S. corporations make profits on purchased items when there is no national VAT; (or in the case of the UK, both), I don’t see any tax leakage from interest costs here. If anything, the tax subsidy on mortgage costs ends up benefiting the private economy as monies otherwise destined for taxes end up boosting consumption or investment.

Then the publication makes the rather tenuous point that tax subsidies have helped people to increase the size of their mortgages thereby feeding asset price inflation. Again, The Economist makes a gross error in this matter, specifically with respect to the selection criteria of mortgages – which is in the hands of the lenders, not the borrowers. To get a million dollar mortgage, you need to prove the ability to service the same.

More to the point, changes in interest rates have a higher sensitivity on size of mortgages, as the table below shows the difference between a normal 30-year mortgage at 5% on $800,000 (itself 80% of a million dollar house) against the same size monthly payment when interest rates are reduced to 2% as the Keynesians have pushed it to. In this case, the monthly payment stays the same but more of it goes to principal repayment as against interest, in turn reducing the “subsidy” element (this point the article does get correct, to be fair) while boosting house prices. So the wrong culprit has gotten blamed, as so often happens in such matters when causality is not properly examined.

There is little doubt that excess debt is a problem, but that’s in the hands of the borrowers not the savers. Removing the tax subsidies may well help to reduce the total quantum of debt in the hands of private individuals and companies, but almost inevitably will be accompanied by an increase in the debt of governments and quasi-government agencies. This “crowding” out of debt will create greater rush to risky equity investments and in turn cause greater volatility in savings.

Sorry chaps, back to the writing table with this one.

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