Andrew Lilico is an Economist with Europe Economics, and a member of the Shadow Monetary Policy Committee.
It is normal to believe that an important duty of government is to promote national economic prosperity. It has become common in recent years to believe that one implication of this is that governments should act to prevent, or lean against, economic scenarios in which there is mass defaulting on debts. I believe this latter view reflects a serious and ancient conceptual error, which I want to explain and debunk here.
The most famous – indeed the founding – theorem in corporate finance tells us that what is called the “capital structure” of a firm (i.e. how much debt it has compared to its equity) is irrelevant to the firm’s value. (For nerds, it is called the “Modigliani-Miller Capital Structure Irrelevance Theorem”, but the name won’t matter to us.) The reason is that the value of the firm is created by the machines and workers and the demand for the products and the cost of the raw materials and the patents the company holds, and so on. These factors of production generate value. All that the capital structure does is to carve up that value between different claimants – some of the value generated by the production goes to debt-holders, and the rest goes to the equity holders. So unless the capital structure means that the assets of the company are managed in some different way (e.g. the machines are run for longer hours, or the workers fired more frequently) then since the capital structure doesn’t itself generate or change the generation of value, the value of the firm does not depend upon its capital structure. The capital structure affects only the allocation of value (who gets it), not how much value there is.
We can apply this same insight to society and the economy as a whole. The debts that people within Britain have to each other are not in themselves value. If someone take out a loan from someone else, or defaults on a loan to someone else, that does not in itself make Britain any richer or less rich. The wealth of Britain, like the wealth of a firm, is the product of the skills of its workers, the available raw materials, the accumulated infrastructure and machinery, the management methods and culture and the “management” of the economy and society as a whole via property rights and the stability of the constitution, its diplomatic connections, the tastes of its own citizens for its products, and the tastes and stability of foreigners to purchase things from us and to sell things to us. Except insofar as the balance of debts affects the management of the nations assets, that balance of debts does not change the economic prosperity of Britain – it only allocates it; it only decides who gets the lion’s share of the fruits of Britain’s prosperity; decides who is rich and who poor.
Perhaps some readers find talk of “capital structure” confusing, but might find Aristotle easier? Aristotle argued that it was a conceptual error to think of money as something that in itself could create value. “Metal is not fruitful”, as he might have put it in English. He said we should think of money as fundamentally existing only to facilitate exchange, and as in a sense “used up” in that exchange. Like debt (indeed, often as itself closely akin to debt) money does not create value – it simply allocates it. If some folk have less money, that doesn’t in itself mean there is less wealth in the country – it just means that those that have lost some money now have less of that wealth, whilst others have more.
As with a company, in principle the allocation of value via money and debt could make a difference to the management of a country’s assets. If there is mass defaulting, then some of the country’s assets get re-allocated to new owners. Might these new owners use those assets less productively than the previous owners did? Could that be why it is good for governments to try to prevent defaulting? That seems pretty implausible. After all, the old owners used the assets poorly enough that they ended up going bankrupt! Why should we believe them to be the most efficient users? Even setting aside all the longer-term issues familiar to many readers such as moral hazard, why would we assume that the people that had just gone bankrupt would be those competent to generate the most prosperity from the nation’s assets?
No. Insofar as there is a valid justification for governments to prevent mass defaulting, it does not lie in any point we have raised so far. Instead, it must be this. A company with extremely high debts has a higher chance of going bankrupt. The process of bankruptcy itself may disrupt the use of the company’s assets. For example, the machines may sit idle for some time before they are sold and then, after they are sold, they may need to be transported elsewhere and then fitted and then new workers may need to get used to using them. The process of bankruptcy may be costly.
Similarly, if people default on their mortgages and that means they move out of their houses, that may lead to houses sitting empty whilst they are sold, then the new owners may want to redecorate or add on an extension or make some other such change before using the assets. Similarly, a small businessman that goes bankrupt may need time to retrain and find and job. At a more extreme level, those that lose out in debt defaults may react badly. They may riot. They may plot revenge on those that defaulted on them. They may become depressed and take to the bottle.
All this might mean that debt defaulting can induce transitional costs. So perhaps there is some limited rationale for governments, under some conditions, to smooth the past of transition. We call such a policy “macroeconomic demand management”. That might, for example, mean keeping interest rates low for a year or two early in a recession. But governments should not be tempted, by the legitimate desire not to see avoidable transitional costs of dislocations associated with bankrupty, into the view that prosperity is promoted, over any longer-term basis, by preventing defaults. And government should not confuse the smoothing of transitions, so as to allow wealth to pass from those that had it before to those receiving it next, with the preventing of transition.
Preventing transition – preventing default or the loss of money – does not create or protect general prosperity. Debt and money are not wealth. They are allocations of wealth. If governments prevent defaulting, they prevent wealth being re-allocated from the rich that already have it to the poorer or more prudent (or just luckier) that don’t. And it is not the proper job of the government to keep the rich rich.