Debt & Our Financial Legacy

Lecture 20 – Tuesday, 22 November 2011J A Morrison 1

Al Pacino as Shakespeare's Shylock

“The pound of flesh, which I demand of him,Is dearly bought; 'tis mine and I will have it.

If you deny me, fie upon your law!There is no force in the decrees of Venice.

I stand for judgment: answer; shall I have it?”-- Shylock (The Merchant of Venice)

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Our Financial Legacy

I. Sustainability & Our Financial Legacy

II. Indebtedness in TheoryIII. Indebtedness EmpiricallyIV. Debt & Development

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Our Financial Legacy

I. Sustainability & Our Financial Legacy

II. Indebtedness in TheoryIII. Indebtedness EmpiricallyIV. Debt & Development

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Remember that we’re discussing sustainability.

“sustainable development is development that meets the needs of the present without compromising the ability of future generations to meet their own

needs.” -- UN Brundtland Commission

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Last week, we discussed population growth—which is

necessarily multi-generational—and the global environment.

Today we’ll cover our financial legacy.

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Clearly, the financial decisions we make today have implications for “the ability of future generations

to meet their own needs.”

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One the one hand, we might saddle future generations with

mountains of debt.

But, on the other, we might also bequeath to them capital:

infrastructure, expertise, and resources.

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Obviously, we often borrow money to develop capital: to build bridges across Lake Champlain, to pay for

training & education, and to finance investments.

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Middlebury Comprehensive Fee: $50,400

So, we know that there is a trade-off between borrowing and

accumulating capital.

But what ought to govern the amount of debt we bequeath to

our grandchildren?

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Our Financial Legacy

I. Sustainability & Our Financial Legacy

II. Indebtedness in TheoryIII. Indebtedness EmpiricallyIV. Debt & Development

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II. INDEBTEDNESS IN THEORY

1. Basics of Debt2. Classic Perspectives on Public Debt3. Modern Perspectives on Public Debt

The Three US Deficits• Balance of Trade Deficit

– We buy more from world than world buys from us

• Budget Deficit– Federal government spends more than it gets in

revenue (taxes, fees, &c.)

• Savings Deficit– Americans spend more money than they earn

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Each of these deficits is distinct; and there is no necessary relation among the three.

It does happen, though, that the three are currently related: Americans are

borrowing money to buy imported goods, they want considerable government

services without raising taxes, and the Chinese are buying US treasuries to hold in

reserve.16

We’ve already discussed the trade deficit.

Today, we’ll talk about the other two deficits, which lead to

indebtedness.

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Govt Budget Deficits Public/National Debt

Americans’ Saving Deficits Private/Personal Debt

From Deficits to Debts

If expenditures exceed income, then the difference must be made up through

borrowing.

II. INDEBTEDNESS IN THEORY

1. Basics of Debt2. Classic Perspectives on Public Debt3. Modern Perspectives on Public Debt

The United States was a country born into massive debt.

To finance the revolution, Congress had not only borrowed from

abroad. But it also printed millions of “continental dollars” and

directly requisitioned materials and supplies.

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By the end of the war, the new country owed more than $80 million.

And the burden of debt threatened to tear the country apart.

The US Constitution was created almost entirely toward the end of securing the revenue needed to manage the debt.

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As the French Revolution unfolded around him, Secretary of State

Thomas Jefferson developed his own revolutionary views on

indebtedness…

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“I set out…that the earth belongs in usufruct to the

living; that the dead have neither powers

nor rights over it.”

-- Jefferson to Madison (6 Sept 1789)

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The term usufruct had a well-established legal meaning:

“the right to make all the use and profit of a thing that can be made without injuring the substance of the thing itself.” (Sir Robert

Chambers)

Does that remind you of our definition of sustainability? It should!

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Estimating the average length of a generation to be 19 years,

Jefferson applied this principle to the policy of contracting large, permanent public debts…

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“[N]o generation can contract debts greater than may be

paid during the course of it’s own existence…19 years is the

term beyond which neither the representatives of a

nation, nor even the whole nation itself assembled, can

validly extend a debt.”

-- Jefferson to Madison (6 Sept 1789)

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Opposite Jefferson stood Alexander Hamilton, the Secretary

of the Treasury...

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“A national debt, if it is not excessive, will be a

national blessing; a powerful cement of

union; a necessity for keeping up taxation,

and a spur to industry.”

-- Hamilton to Robert Morris (30 April 1781)

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In his first major report to Congress in 1790, Hamilton made

similar allusions to public debt as a “blessing.”

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When he received Jefferson’s letter, James Madison—the Speaker of the House—was in tense negotiations

with Hamilton to determine how the revolutionary war debt would be

financed.

Ever the pragmatist, Madison issued a practical response to Jefferson’s

musings…30

“The improvements made by the dead form a charge against

the living who take the benefit of them…Debts may even be incurred

principally for the benefit of posterity.”

-- Madison to Jefferson (4 Feb 1790)31

In the end, Hamilton prevailed.

Madison traded control over the location of the national capital in

exchange for his support for Hamilton’s plan.

And, of course, Jefferson saw fit to borrow heavily (roughly $12m) to

make the Louisiana Purchase in 1803.32

II. INDEBTEDNESS IN THEORY

1. Basics of Debt2. Classic Perspectives on Public Debt3. Modern Perspectives on Public Debt

The positions staked out in the 1790s persist today.

(Although I don’t know of anyone who goes quite as far as Hamilton!)

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Congressman Ron Paul (R-TX) has led the charge against the US’ growing

public debt…

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“The politicians who get reelected by passing such

incredibly shortsighted legislation will never have to answer to future generations

saddled with huge federal deficits. Those generations are the real victims, as they cannot object to the debts

being incurred today in their names.”

-- Ron Paul (5 March 2007)

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Paul has gone so far as to suggest that our indebtedness poses a threat to our

national security…

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“Ultimately, debt is slavery. Every dollar the

federal government borrows makes us lesssecure as a nation, by

making America beholden to interests outside our borders.”

-- Ron Paul (24 Oct 2004)

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The current financial crisis, however, has prompted many to be more

tolerant of massive budget deficits…

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“[U]nlike the private sector, the federal government hasn’t

slashed spending as its income has fallen…this

means that budget deficits—which are a bad thing in

normal times—are actually a good thing right

now.”

-- Paul Krugman (10 August 2009)

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So, following Jefferson, Paul fears saddling future generations with

mountains of debt.

And, following Madison, Krugman has argued that our current additions to

the debt are being used to ensure that future generations have an economy

worth inheriting.41

How does indebtedness look across time and space?

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Our Financial Legacy

I. Sustainability & Our Financial Legacy

II. Indebtedness in TheoryIII. Indebtedness EmpiricallyIV. Debt & Development

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III. INDEBTEDNESS EMPIRICALLY

1. The US Public Debt2. Private Indebtedness3. Regulating Indebtedness

This is a big issue.

And Patrick Creadon has done a better job presenting it than I

could…

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(Watch 3:14-11:29)

(Remember that you can get a 30 minute clip online and the whole thing on Netflix.)

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“This issue represents the potential fiscal meltdown of our

nation, and it absolutely guarantees, if it’s not addressed,

that our children will have less of a quality of life than we have had.”

-- Senator Judd Gregg (R-NH)

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III. INDEBTEDNESS EMPIRICALLY

1. The US Public Debt2. Private Indebtedness3. Regulating Indebtedness

So, our government appears profligate.

Are we any better than our representatives?

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US Gross Private Savings as a Percent of GDP, 1950-2000

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Source: Wm Emmons, “What’s behind the falling U.S. private savings rate?” 2000

The trend continued almost unabated until the recent

financial crisis.

In 2005, it fell to about 1% of national income!!!!

(Down from ~ 15% in 2000)51

How does this compare to the experiences of the rest of the

world?

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What explains private savings?Variable Correlation with

World SavingsCorrelation with US

Savings

Interest Rate Uncorrelated Uncorrelated

Better Govt Budget Positive Positive

Low Inflation Positive Positive

Domes Credit to Private Sector

Positive Positive

Curr Acct Deficit Positive Positive

Growth Rate Positive Negative

Currency Appreciation Positive Negative

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Source: Wm Emmons, “What’s behind the falling U.S. private savings rate?” 2000

We might also return to our old question:

Is US savings low because foreigners are giving us cheap capital?

Or are foreigners giving us cheap capital because none of us are saving?

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III. INDEBTEDNESS EMPIRICALLY

1. The US Public Debt2. Private Indebtedness3. Regulating Indebtedness

Traditionally, indebtedness has been the subject of considerable

government regulation.

There were at least two categories of regulations: usury and

bankruptcy.

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Usury• Regulation of the rate of interest charged on

loans• Religious/moral underpinnings: Islam,

Christianity• Premises

– Limit profits of moneylenders– Protect borrowers from themselves

• Limits continue today: no loan sharks!

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Bankruptcy• Traditionally favored creditors

– Asset seizure– Debtors’ prison– Transfer to colonies

• 19th C reforms enhance position of debtors• Modern plan: “restructuring” to advance

interests simultaneously

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Debtors’ prison was not a pleasant place…

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“Annual income twenty pounds, annual expenditure nineteen nineteen six, result happiness. Annual income

twenty pounds, annual expenditure twenty pounds

ought and six, result misery.”

– From David Copperfield by Charles Dickens

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Our Financial Legacy

I. Sustainability & Our Financial Legacy

II. Indebtedness in TheoryIII. Indebtedness EmpiricallyIV. Debt & Development

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So, indebtedness has huge intergenerational implications.

Clearly, we can’t consider “sustainable development”

without also considering debt.

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The problem is that many developing countries are forced to service debts contracted by previous regimes rather than reinvesting their profits into

advancing their development goals.

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Nobel Prize winner Joseph Stiglitz has pressed for reform,

hoping to see domestic bankruptcy practices applied to

the international system…

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“We must now recognize that debt forgiveness and debt restructuring

make as much sense for governments—benefiting debtors and creditors

alike—as they do for companies and individuals.”

-- Joseph Stiglitz, “Odious Rulers, Odious Debts”

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Stiglitz, of course, is not even the most prominent advocate of

debt forgiveness…

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Bono with Kofi Anan (fmr Sec General of the UN)

There are, however, several stumbling blocks here…

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First, these debts are owed to foreign governments, private

entities (banks, &c.), and international organizations

(World Bank, IMF).

Restructuring would require considerable coordination.

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Second, such “restructuring” will likely affect the credit rating of these developing countries, which raises the cost of getting

subsequent loans.

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Should the debts be forgiven?

What effects do you expect would follow?

How should the US approach its debts?

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