Debt is Worse than You Think

Toban Wiebe, a brilliant young economist of my acquaintance, writes In Praise of Consumer Debt:

Debt is a wonderful thing. But many intelligent and responsible people have debt aversion, believing that the optimal level of debt is zero. They proudly brag when they’ve paid off their mortgages that they are debt-free. This is flat out stupid.

Toban makes excellent points about consumption smoothing and debt-savings equivalence, points that I agree with. Nevertheless, I am not so cheerful about debt, either as a matter of personal finance or in terms of macroeconomics.

Think about personal finance in terms of the Capital Asset Pricing Model (CAPM). What CAPM says is that differences in expected rates of return are driven by differences in risk premia. Arbitrage across different asset classes drives out any excess returns. This just means that there is no free lunch in tradable investments—if you expect a higher reward, it’s just because you are taking on more risk.

So let’s look at a person who expects “a large increase in future income (with a high degree of certainty),” Toban’s subject. Let’s assume that because of the expected large increase in future income, this person is highly unlikely to go bankrupt, and that he is smart enough not to buy a house at the top of a bubble, so he is highly unlikely to default on a mortgage. And then let’s look at some scenarios:

  1. The person takes out a mortgage at 4% to pay for a house. He pays off the house per the mortgage agreement, as slowly as possible. He accumulates additional assets which he puts into Treasurys that pay out 1%.
  2. The person takes out a mortgage at 4% to pay for a house. He pays off the house per the mortgage agreement, as slowly as possible. He accumulates additional assets which he puts into a well-diversified stock portfolio.
  3. The person takes out a mortgage at 4% to pay for a house. He pays off the house as quickly as possible. As he accumulates additional assets, he plows them into the mortgage to reduce his liabilities.

I think that Toban would agree that given my assumptions, the person in scenario 1 is “flat out stupid.” This person could earn an excess return of 3% by putting additional assets into the mortgage, as is done in scenario 3. But what CAPM claims is that there is a kind of equivalence between scenario 1 and scenario 2. The higher expected return to a well-diversified stock portfolio is merely compensating the asset holder for additional risk. That means that there is still an excess return of 3% to paying off the mortgage in comparison to holding stocks. This means that scenario 3 dominates the other 2 as an investment strategy.

There are a lot of caveats to this: maybe you underestimate the probability that you will default on your mortgage, maybe there is an equity premium (does anyone still believe this?), or maybe risk tolerance is all you have to sell (3% seems like a bad price, though). But the bottom line is that paying off your personal debts as quickly as possible is often a very good investment strategy. This is not to contradict Toban’s point about consumption smoothing—such smoothing often makes sense, and I have nothing against mortgages or debt per se. Just be smart about comparing the rate of return on your liabilities to the rate of return on your risk-equivalent assets.

The debt-averse attitude that Toban is combatting is a widely-held folk belief, and finds its strongest expression in traditional religions, especially Islam. Say what you will about the truth of folk beliefs, but even if they are false, they are often socially useful and approximately efficient. Even if it’s not “morally wrong” to take on debt, it may be efficient for people to believe that it’s morally wrong to take on debt.

In fact, it does seem that it would at least be efficient if people were a little more squeamish about debt. Our current macroeconomic problems are pretty severe—but would they have been so bad if people were not so levered up? I think the answer is pretty clearly not. Nominal shocks are amplified by fixed-value nominal claims. Hail Hyman Minsky!

A debt-averse society is a more robust society. If this robustness has value to Toban, then it is rational for him to encourage debt aversion, not discourage it. It is morally wrong and foolhardy to take on too much debt, Toban should claim. Those of us who understand the economics of debt should be more Straussian.

8 replies to “Debt is Worse than You Think

  1. Toban Wiebe

    I totally agree with your point about the 3 scenarios. Paying off debt is often a great investment: zero risk and a pretty solid return. My point still stands though: in the low-income stage it’s optimal to borrow; in the high-income stage (when one earns enough to save) it’s often optimal to invest in paying off the debts. That’s just good income-smoothing.

    As to the robustness point, this would be a public good. If everyone were debt averse, the financial system would be very robust, and so each individual would benefit by taking on debt since there is no risk of financial system collapse. Because of this tragedy of the commons effect, I’m skeptical that the debt aversion ingrained in many cultures is the result of Hayekian spontaneous order (i.e., that it evolved via its efficiency). Instead, I’d look to evolutionary psychology for the roots of debt aversion.

    So I think smart conscientious people should be more open to using debt for income smoothing. Fools will still need to tie themselves to the mast, lest their impulsiveness bankrupts their future selves.

  2. Diego Espinosa

    Toban,
    You pose an interesting question: whether traditional personal finance heuristics are unnecessary or adaptive behaviors. A set of finance heuristics (“neither a borrower nor a lender…”) enforce hedging behavior. They imbue a system with natural “dampeners” that keep shocks from cascading into catastrophic losses. There is a trade-off between efficiency (coupling) and hedging (dampening) in the system, but the fitness rule favors the hedging adaptation. Typically technocrats benefit as they convince agents to abandon heuristics, which produces efficiency gains from tighter coupling and reinforces their influence. Until recently, technocrats tended to have more sway over the hedging behavior of firms and wealthier households; as a result, households were still able to weather periodic losses imposed by financial crises through savings and family networks. The difference in the past thirty years or so has been their ability to convince a much broader swathe of households to abandon personal finance heuristics — specifically debt aversion. The result is arguably an extreme level of systemic fragility.

  3. Eli Post author

    Toban, I’m confused. Don’t Hayekian norms evolve precisely to provide public goods? Why is the fact that robustness is a public good evidence against a Hayekian explanation?

  4. Toban Wiebe

    Perhaps I’m confused about precisely what Hayekian cultural evolution is. Let me clarify: there are two classes of emergent social norms; (i) those that emerge because they are in each individual’s interest to adopt, and (ii) those that emerge because they are in the group’s collective interest, but are contrary to each individual’s interest. My claim is that (ii) is a very small class, for the same reasons that evolutionary biologists are skeptical of group selection (within group competition almost always outpaces between group competition). So I suspect that Hayekian norms almost all belong to (i).

  5. Eli Post author

    Whether or not Hayekian is the right word, I don’t think (ii) is a small class. It feels weird to me to even talk about (i) as a set of social norms when its members just constitute rational behaviors. In any case, I think many traditional and folk beliefs have efficiency explanations. See Leeson’s many papers on superstition.

  6. Wonks Anonymous

    Surprised we’re assuming CAPM, since Fama already showed that a joint hypothesis test with it and the EMH is inconsistent with the data.

  7. Eli Post author

    We’re not using CAPM in a strong sense, the point is that excess returns get arbitraged away to a large, if not infinite, degree.

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