How to Think About Debt

Summary:  Balancing the budget is a good idea and receives a lot of press. However, the budget is far less important than the steady growth of debts, unfunded obligations, and entitlements. These items are stealthy future deficits. To really understand whether or not we have financially sustainable government budgets, we have to go to the balance sheet, where debt is recorded. There are a lot of misconceptions about debt. In the interest of simplifying a complex subject, this report focuses on government debt, but the primary concepts discussed apply to all debt, public and private. They are all claims against future income.

What about California’s debts, state and local, and unfunded obligations? Are they large enough to affect the state’s growth rate? It’s hard to tell. Our recent study for the California Policy Center, “Calculating California’s Total State and Local Government Debt” (April 2013) summarized the state’s debts and unfunded pension and retiree healthcare obligations as follows:

Estimated Total California State and Local Government Debt
As of June 30, 2012   ($=B)


California’s total state and local government debts and unfunded obligations are about $18,000 to $23,000 per citizen depending upon what investment return assumption you use in valuing unfunded pension obligations. This data is for 2011 and 2012 and debts and unfunded obligations are higher today. This only refers to California’s state and local debt and does not include any estimate of entitlement obligations for welfare and Medicaid, or the private debts of companies and individuals. U.S. federal debt now exceeds $17.0 trillion or about $54,000 per citizen. This doesn’t include unfunded liabilities for Medicare, Social Security, or Medicaid.

When do these debt and other obligations become a serious problem?

The Debt Supercycle

We are at the end of a 30-year debt supercycle. How will it end? All debts and entitlements can’t be paid. Who gets stuck with the bill? So far, we’re leaving the check on the table and pretending the dinner was free.

Will all this debt come due with a bang one day or will it dissipate slowly over time?


The debt cycle begins when debt levels are fairly low. The government determines that they can stimulate economic growth by adopting policies to encourage people to borrow to increase consumption and investment. The Federal Reserve facilitates this process by keeping interest rates low and taking other actions to avoid slowdowns in the economy. As debts increase, so does the cost of servicing these debts, interest and principal payments. At some point it becomes crucial to maintain low interest rates to make it easier for private and public debtors to service their debts and avoid bankruptcies.

Low interest rates and easy credit further stimulates economic growth as well as excessive speculation such as in housing and the stock market. These assets increase in value beyond what they would be worth without easily available credit at low interest rates.

These overvalued assets are used as collateral to secure additional borrowing that increases debt burdens even more. As debt levels grow, it takes more and more borrowing and other stimulus to keep the economy growing, and to maintain asset prices.

At some point, debt burdens become unsustainable in spite of low interest rates and easy credit, and investors lose confidence that future growth of the economy and asset prices can be sustained. We then have a market correction or recession such as the 2008 mortgage bubble collapse. The triggering event may be the collapse of the Lehman Brothers investment bank or some other event. However, the house of cards that collapsed was assembled over many years.

When the economy contracts in a recession and incomes fall, the debts and other obligations remain.

Shouldn’t we be mainly concerned about the deficit, and balancing the budget? Who looks at balance sheet entries anyway?

Balancing the budget is a good idea and receives a lot of press. However, the budget is far less important than the steady growth of debts, unfunded obligations, and entitlements. These items are stealthy future deficits.

To really understand whether or not we have financially sustainable government budgets, we have to go to the balance sheet, where debt is recorded. That is where the bodies are buried. This is further complicated by the fact that some obligations aren’t reported at all and are largely ignored on official government financial statements.

The real problem is the steady under reported growth of debt at the federal, state, and local level, the growth of unfunded pension and retiree healthcare obligations at the state and local level, and the seemingly out of control growth of entitlement obligations for welfare, Social Security, and government provided medical care, Medicare and Medicaid.

These are balance sheet items and can’t be fully grasped by looking at annual budgets. GASB, the Government Accounting Standards Board, will improve reporting of unfunded pension obligations starting with the fiscal year beginning in June 2014. However, this is only a start in honestly reporting these obligations. Reporting of unfunded pension obligations is inadequate in that pension funds such as CalPERS are still free to use optimistic investment return assumptions in calculating unfunded obligations. They assume an average investment return of 7.5% per year. If actual returns average less than 7.5%, unfunded pension obligations will be larger than reported under the new GASB regulations. For example, as shown on the first table above, if average returns to the pension funds are 5.5% instead of 7.5%, the unfunded liability increases by over $200 billion, from the officially recognized $128.3 billion to $328.6 billion. For much more on how changes in rates-of-return affect California’s total state and local unfunded pension obligation, refer to the CPPC study “How Lower Earnings Will Impact California’s Total Unfunded Pension Liability.”

Retiree healthcare expenses are largely unfunded and must be fully paid out of future tax revenues. GASB doesn’t currently require this future obligation to be reported.

Why can’t we just write off debts we can’t pay?

Debt forgiveness is a fiction. Someone always pays in full.

According to the economist Michael Pettis, author of “The Great Rebalancing,” “Debt always matters because it must always be paid for by someone –even if the borrower defaults, of course, the debt is simply “paid” by the lender… It must cause a reduction in demand elsewhere, most probably in household consumption. This reduction in demand implies slower growth in the future and, of course, a more difficult rebalancing process.”

What’s the relationship between debt and growth?

Borrowing increases the rate of GDP growth (gross domestic product) on the way up and reduces GDP growth on the way down. Debt stimulates growth when it’s spent and depresses future growth when it is paid back. Debt is essentially borrowing future consumption.

Over-indebtedness is probably the main reason that the world’s major economies are growing slowly. This is in spite of massive efforts by the U.S. Federal Reserve and other central banks to stimulate their economies by keeping interest rates very low and adding to bank reserves to stimulate borrowing.

When we were adding to our debts, borrowed money allows a higher level of consumption than could have been supported based on the earnings of individuals and corporations alone. This effect may have added as much as 0.5%/year to GDP growth over many years. However, this is stealing consumption from the future when the debt has to be serviced (make the principal and interest payments).

So, on the way up, if we assume that the economy would grow about 3.0%/year without increasing debt, we’d get 3.5%/year growth instead. On the way down, we’d have to subtract the negative effects of servicing high debt loads and deleveraging (paying off debts) to reduce debt burdens. A guess is that we’d see growth of 2.5%/year or so (3.0%/year normal growth less something like 0.5%/year due to debt service and deleveraging). Interestingly, the U.S. real GDP growth rate was 3.4%/year on average until the 2008 recession, and an average of 2.3%/year since the recovery started in mid-2009. This could be a coincidence.

According to the economist Gary Shilling, the U.S. economy is likely to have low growth for another five years or so before deleveraging reduces debt loads enough to allow the economy to grow at its normal long-term average rate. So far, all the deleveraging has occurred in the private sector, companies and individuals reducing what they owe, while government debts continue to grow.

Is there good debt and bad debt?

There are several broad types of debt, some good and some bad. The form of the debt is less important than what it is used for. The California Policy Center’s debt study listed several broad categories of debt:

Good debt is:

1. Debt that is an investment in an asset that generates a future income by way of taxes or fees sufficient to pay the interest and principle on the debt. A toll road or water treatment plant would be examples.

Debt to fund investments that grow the economy with a corresponding growth in tax revenues sufficient to service the debt also qualifies as good debt. However, not all debt-financed investments qualify. Government debt requires tax increases or fees to service the debt and these tax increases and fees reduce funds available for consumption and investment in the private sector, the source of tax revenues. Both of these effects need to be considered in deciding if a government expenditure funded by debt is worthwhile.

2. Debt that is an investment in a long-lived asset such as a new highway or government building that would be used by the future taxpayers who are responsible for paying the interest and principle on the debt by way of taxes or fees.

Bad debt (and unfunded obligations) is debt that is used to cover current expenses but paid for by future taxpayers. This form of debt is essentially deferred taxation and passes a current expense to future taxpayers, inter-generational theft.

Are growing unfunded obligations the same as debt?

They are similar with some differences.

The growing future cost of paying for unfunded obligations takes funds that could have been used for future consumption and investment and has the same effect as servicing or paying down debts.

Some entitlements are responsible and desirable transfers to those who need help from those who can afford to help. This can include publicly funded K-12 education to welfare and Medicaid payments. However, we shouldn’t spend more than the economy can support.

All entitlements, current and future are different from debt in that changes in laws and regulations might be able to reduce these future costs while the cost of debt service can’t be altered without a bankruptcy or mutually agreed restructuring of debt. Future entitlements, because they aren’t funded, qualify as debt to the extent we are not setting aside enough money today to pay for them in the future. These unfunded liabilities for future entitlements are particularly troubling with respect to pension benefits that are difficult to modify even in bankruptcy.

In some ways, entitlements and unfunded pension and retiree healthcare obligations are a bigger problem than debt. Debt typically is for a fixed amount to be repaid at a specific interest rate over a specific time period. Entitlements are open-ended obligations such as for unemployment, welfare, or medical care for low-income families. The taxpayer, via the government, is obligated to pay whatever the formula for the entitlement says is due without regard to ability to pay. Timing can also be a problem. In a recession, unemployment and welfare payments go up as more people lose their jobs at a time when tax revenues are declining.

The future cost of underfunded pension obligations and retiree healthcare expenses are hard to predict. If pension funds suffer investment losses such as during the 2008 recession, or if investment returns are less than assumed, the taxpayer is responsible for any shortfall. Retiree healthcare expenses are largely unfunded and have to be paid out of future tax revenue.

It’s the authors’ opinion that post retirement benefits should be fully funded while the employee is working and providing a public service to taxpayers. To the extent that these benefits aren’t fully funded, we are asking future taxpayers to pay for current expenditures that they are not gaining any benefit from, the equivalent of bad debt.

Entitlements such as Social Security, Medicare, and Medicaid are promises of future payments that are totally the responsibility of future taxpayers since these entitlements are not funded. Even Social Security is not funded even though there is a Social Security trust fund. Social Security payments in excess of current benefit payouts are spent by the federal government. The government deposits an IOU in the trust fund to offset the amount taken. When these IOUs are due in the future, they will have to be paid for out of future taxes or by additional borrowing by the government.

What’s the relationship between debt, inflation, and deflation?

Debt is future consumption denied as taxes have to be increased and other spending has to be cut to service the debt. Ditto for entitlements and unfunded obligations. Servicing debt is deflationary. It depresses future consumption by the amount of the debt service.

The cost of servicing a high level of debt or paying down your debts takes funds that could have gone to consumption, the major portion of GDP, or private sector investments needed to grow the economy. In the U.S., consumption makes up almost 70 percent of GDP. This loss of consumption leads to lower prices and slower GDP growth. Lower prices, overall, constitutes deflation.

If the cost of servicing debt is high enough, demand is so depressed that the economy could experience a depression, chronic negative growth with falling prices, high unemployment, and ongoing budget deficits – possibly a deflationary spiral that is very hard to break out of to get the economy growing again. This is Japan today, and possibly countries such as Greece, Spain, and Italy.

Why is growth so important?

By far, the best way to reduce indebtedness is to increase tax revenues by growing the economy faster. However, high levels of debt work in the opposite direction as we’ve seen and lead to lower, not higher growth of the economy. If debts are too high, one can enter a death spiral where debts are growing faster than tax revenues so that debt service costs continue to grow as a percent of GDP. This could also be caused by interest rates increasing to exceed the rate of revenue growth, or by having to add to already high levels of debt to fund a budget deficit or increasing entitlements.

When lenders lose confidence in the ability of a government to service its debts, they can stop lending or increase the interest rate they charge to account for the risk of non-payment. If the interest rate exceeds the country’s growth rate, their debts will continue to grow faster than their economy and tax revenues and become an ever-increasing burden.

Can’t governments avoid repaying their debts or reduce what’s owed?

Governments, national, state, or local can take steps to reduce their debt burdens. However, they can’t make their debts disappear. They can only transfer part or all of their debts to others either publicly or secretly if they can get away with it. Special interests such as large financial institutions also try to transfer their debts to others, often with government help.

Not surprisingly, the prime target to receive the unpaid government debt is the taxpayer who is not well represented in the transaction. Savers and high-income taxpayers are best because they at least have some money.

Growing the economy faster to increase tax revenues would be a positive way to reduce debt burdens. However, governments that have high debt levels usually have other problems that prevent them from being able to grow their economies faster, or lack the political will to make hard choices in favor of policies that promote growth.

Some favorite alternatives to transfer debts to others are:

1. Financial repression:  This is underway in the U.S., Europe, Japan, and China. The central bank takes actions to keep interest rates below their normal long-term averages to make it easier for debtors to service their debts. Savers pay the difference via lost income between normal interest rates and the lower repressed rates they are earning on their savings. These low interest rates also make it more difficult for pension funds to meet investment targets.

Financial repression and inflation are essentially hidden taxes on savers and bondholders. It’s estimated that financial repression is costing savers about $400 billion/year in lost interest income. This discourages savings and reduces the amount that people can save making them more dependent on the government in old age. This is not a policy objective of financial repression but is an unintended consequence.

2. Inflation:  Inflation reduces the value of a currency and makes it easier for governments to repay their debts in cheaper currency. Who pays? The saver whose savings and interest and dividend payments lose value due to inflation. Also, consumers who have to pay higher prices for goods and services.

3. Default:  This isn’t very practical for major economies. However, it’s not inconceivable that countries such as Greece or even Italy could be forced to default at some point. Banks and other lenders will get stuck with the bill and will have to be bailed out by their governments if their losses are large enough to threaten their solvency.

4. Restructuring:  Under the threat of default, sometimes a borrower can convince lenders to revise the terms of the debt to stretch out payments and reduce the interest rate. Again, the lender pays the difference between what they would have received in interest and principal payments and what they get under the new terms.

5. Devaluation:  An outright default can be replaced by efforts to devalue, lower the value, of a county’s currency. This doesn’t work for those countries using the Euro because they don’t control the value of their currency. Other countries such as Argentina frequently resort to devaluations to pass on their debts to foreign lenders.

6. A wealth tax:  Why not tax wealthy persons’ assets, not just their income? Why not, for example, impose a one-time tax of 5 to 10% of a person’s net worth in excess of $1.0 million? It would all be “applied” to debt reduction and the government would promise to do this only once. This would be a very destructive and unfair tax in that a persons’ wealth was already taxed when the money was earned or inherited. However, this idea was suggested recently by the International Monetary Fund (IMF) and could have some appeal to desperate politicians and voters who would be in favor of more taxes on those with substantial savings.

What did Keynes really say?

Shouldn’t the government increase spending during recessions even if that leads to deficits and increases debt? They have to make up for the slack in the private sector.

People forget what Keynes said. They remember that, according to Keynes, during recessions you should increase government spending even if that results in deficits and increased debt. What they forget is that during good times you need to run a surplus and pay off the debt.

Unfortunately, it’s easy for politicians and others to agree to run deficits (such as for “stimulus” spending) and increase debts during recessions but impossible for them to agree to run a surplus in good times. During recessions we run deficits, during good times we spend it all and sometimes a lot more.

Another crucial point made by Keynes was the importance of incurring “good debt” when stimulating the economy during recessions. Good debt, well exemplified by the many projects undertaken by the U.S. government in the 1930’s – dams, highways, rural electrification – is investment in infrastructure that yields long-term economic returns to society.

“Keynes, as opposed to some of his interpreters and predecessors, did not recommend constant budget deficits. Instead, he advocated cyclical deficits, counterbalanced by cyclical budget surpluses. Under such a system, government debt in bad times would be retired in good times. However, Keynes’ original proposition was bastardized in support of perpetual deficits, something Keynes himself never advocated.”  –  Hoisington Investment Management report

Can you solve your debt problem by taking on more debt?

Many governments are trying to solve their problems by adding debt to fund budget deficits, and entitlement spending, and public works projects. They are using deficit spending to attempt to stimulate their economy to grow faster. They are digging a bigger hole on the assumption that their economies will eventually grow fast enough to service their growing debts. Some are probably cynically assuming that they will be able to default or devalue their currency sometime in the future and never have to repay what was borrowed. It won’t work.

What if the borrower can’t pay, defaults?

The borrowed funds have already been spent and will never be recovered. The lender can wait forever to get paid. It will not happen. In this case the lender can pay off the bad debt slowly over time via lost income or recognize this loss immediately and write down the bad debt, taking the loss all at once. Some may avoid a write down hoping for a government bailout or are waiting to leave the problem to a successor.

Can’t we sell assets to pay off debts?

This works if there sufficient valuable to assets sell. Examples could be drilling permits for oil and gas, or public land. This can work for some countries that, for example, have state owned companies that can be sold to the public or to a private company. However, this is usually not a practical solution since what can be sold is greatly exceeded by what’s owed.

How will it end?

Nobody knows for sure.

Will we have inflation or deflation? It is quite possible we will experience deflation over the next several years as debt burdens become unsustainable and as some defaults become inevitable. This could be followed by inflation if central banks can’t unwind the massive bank reserves they’ve created, and if governments remain addicted to deficits and growing debts, unfunded benefits, and expanding entitlements.

Have central bank actions actually done some good following the 2008 mortgage bubble collapse and given economies time to heal? Or, are they just postponing inevitable harsh adjustments when governments are forced to live within their means? It is generally agreed that aggressive action by the Federal Reserve following the collapse of the Lehman Brothers investment bank in 2008 prevented a credit crisis and an even more severe recession.

A concern is what are the practical limits of what the Federal Reserve and other central banks can do to stimulate growth. Will the Federal Reserve be out of bullets when the next recession hits?

In the U.S., fiscal policy, the use of budgets, taxes, and spending to deal with the situation is not available due to gridlock in Washington D.C. We don’t need another stimulus bill anyway. The last one, The American Recovery and Reinvestment Act of 2009, was sold as being for “shovel ready” projects but was later determined to be primarily for entitlements and aid to state governments. The full burden of dealing with the situation falls on the central bank, the Federal Reserve, and their tools to influence money supply, borrowing, and interest rates.

Will fiscal or monetary stimulus help much anyway? Are we just avoiding the real work associated with real reforms that make a difference? Are we trying to get an out of shape athlete to run faster by loading him up with Red Bull? To grow the economy faster and create more jobs and tax revenue, we need to make changes to taxes and regulations at all levels of government to lower the cost of doing business, to promote private sector investment in the economy, and to encourage business growth and new business formation. We also need reforms to improve job training and education. We are in competition with workers, companies, and governments around the globe. There isn’t any place to hide.

Genuine investments in public infrastructure could help. These investments would qualify as good debt if they made real improvements that lowered costs and improved productivity, or were for essential public works projects such as rebuilding levees to avoid flooding. However, our ability to add debt has already been compromised and we’d need to carefully consider any additions even if it is good debt.

Politicians are in denial when it comes to dealing with deficits, debts, and unfunded pension benefits and entitlements.

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About the Authors:

William Fletcher is an experienced business executive with interests in public finance and national security. He retired as Senior Vice President at Rockwell International where most of his career was spent on international operations and business development for Rockwell Automation. Before joining Rockwell, he worked for Bechtel Corporation, McKinsey and Company, Inc., and Combustion Engineering’s Nuclear Power Division, and was an officer and engineer in the U.S. Navy’s nuclear program. His international experience includes expatriate assignments in Hong Kong, Europe, the Middle East, Africa and Canada. In addition to his interest in California’s finances, he is involved in organizations dealing with national security and international relations. Fletcher is a graduate of Tufts University with a BS degree in Engineering and a BA degree in Government. He also graduated from the U.S. Navy’s Bettis Reactor Engineering School.

Ed Ring is the executive director for the California Policy Center. Before joining the CPPC, he worked in finance and media, primarily for start-up companies in the Silicon Valley. As a consultant and full-time employee for private companies, Ring has done financial modeling and financial accounting for over 20 years, and brings this expertise to his analysis and commentary on issues of public sector finance. Ring has an MBA in Finance from the University of Southern California, and a BA in Political Science from UC Davis.

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