How to Stop Financial Bubbles by Curbing Private Debt
A Review of "The Paradox of Debt" by Richard Vague
Banker and scholar Richard Vague uses financial common sense to explain in simple terms the failures of conventional macroeconomics, such as the horrific financial crisis of 2008. All it takes is the inclusion of “private debt” as a category, plus basic accounting principles applied to national accounts. Here he is following the lead of the distinguished heterodox economist Steve Keen, though he does not cite Keen.
A basic paradox of debt is that rising debt is necessary to accommodate rising economic growth and productivity, a supposed good, yet it also brings the societal evil of rising inequality. The latter is due to how our current financial system channels new debt into the purchase of speculative assets such as stocks and real estate instead of paying for public services or infrastructure.
The most important issue not addressed by Vague is limits-to-growth. That is, when affordable natural resources, especially energy, are no longer sufficient to expand the economy, no amount of financial wizardly will do so. In fact economic contraction becomes inevitable in the case of ecological overshoot unless technological miracles yield a temporary rescue or a regenerative economy is developed.
Vague imagines a super-simple economy, called “LoanLand”, to explain how the expansion of debt, money, and growth go together. He distinguishes ordinary debt for consumption of investment as Type 1 Debt versus Type 2 Debt, which is used to buy existing assets in anticipation of asset price inflation. The latter is the key to both financial bubbles and escalating inequality.
But Vague also looks closely at tactics of the Federal Reserve, such as Open Market Operations and Quantitative Easing, also at their equivalents in other countries such as Japan. What is their historical record in regard to interest rates and economic growth? He notes that “From 2008 until 2018, both the Federal Reserve and Bank of Japan assets grew fivefold but these increases brought little or no boost to spending or lending in the economy” (p 22). He found that a more important role was as a buyer or lender of last resort in a crisis.
Like Keen, Vague emphasizes that in the US “the positive net income of households roughly mirrors the negative net income of the federal government”. This he calls “the government debt and spending model” (p 48), also used by the UK, France, India, and Japan. Uniquely different, China subsidizes businesses instead, via a “business debt and spending model”. Thus a “balanced budget” makes no sense in a growing US-style economy. By contrast China and Germany have used a “net export model” to support economic growth.
…. Vague found that in practice it is always debt, not wealth, that trickles down to the working classes in crises and during growth. Also, like Keen, he sees how easy it is to spot an impending financial crise by rapid a rise in private debt, not government debt. Note that governments of major economies can always create more debt to cover deficits (= Modern Monetary Theory) but bad debt will bankrupt many in the private sector and cascade into a rapid contraction. He advises financial authorities to also monitor private debt in significant sectors of the economy and to take appropriate regulatory action to reign in risky speculation before it gets out of hand.
….Vague has analyzed recent historical cycles of debt. Typically these begin with a war, which requires a short-lived but dramatic rise in government debt. This is followed by economic growth fueled by private debt, which soon outweighs government debt (the “debt switch”). Then lax regulation leads to a boom in private debt, followed by collapse. Then the government mounts a financial rescue package (after the 19th century). However other crises could substitute for a war, such as the recent pandemic.
Deleveraging from excess private debt (student, medical, real estate, etc.) by a carefully constructed “debt jubilee” has a long historical record of success but methods such as growth and inflation tend to be difficult and slow. Bankruptcy law needs big changes. Trade deficits need to be reigned in, though Vague does not address the role of the US dollar as the world reserve currency, nor does he address debt policy under a situation of long-term economic contraction.