A Nation in Debt: How We Got Here and Where To Go

Garry Canepa

While difficult to imagine at present, for decades after WWI the US was the world’s largest creditor nation, running balanced budgets, consistent trade surpluses, and manageable levels of household debt. However, as post war prosperity diminished in the 1970s, debt became an increasing concern. The large fiscal deficits of the 1980s turned the US for the first time in decades from a creditor to a debtor nation. With the 2008 financial crisis leading to an upsurge in spending and a free fall in revenues, federal debt held by the public as a portion of GDP skyrocketed from 35% to over 70%. Debt, once only being a concern for stable interest rates and growth, has put the solvency of the United States into question. In addition, the rise of foreign competition (augmented by the fiscal deficits’ effect on the dollar) has led to large import flows surpassing our exports.  As Americans consume more than they produce, mounting trade deficits become more dependent on foreign savings to finance them.

And this isn’t just the cause of government profligacy. The theory of rational expectations tells us that if a government is running deficits, private citizens will respond by increasing saving, recognizing the inevitable taxes required down the line. However, despite the persistent deficits and a higher return on savings, the savings rate of Americans have actually fallen to below 4% over the decades, with 1984 being the last year it was in the double digits. Private household debt has risen from 20% of GDP at the end of WWII to about 80% currently, made up primarily of mortgage debt which has risen exponentially. Rising debt is more than just a manifest of financial irresponsibility but poses a severe threat to the macro economy. The macro imbalances of high debt in the US along with high savings elsewhere, such as in East Asia, creates not only harmful trade deficits but economic instability, as shown by the “Global Savings Glut” that preceded the Great Recession. High and persistent trade and chronic government deficits along with mounting private household debt are unsustainable in the long term and these imbalances have serious macroeconomic consequences. If this trend continues, the economic prosperity of the US will continue to be undermined by slow growth, financial instability and more frequent and deeper economic downturns. These obstacles make paying off and even just servicing the debt an ever greater challenge, creating a vicious cycle of weak growth and a greater debt burden.
There have been many explanations put forward to account for this low, persistent savings rate and high levels of debt: consumer culture, the expansion of credit, a “keeping up with the Joneses” mentality as inequality rises. Yet along with these factors, government policy deserves its fair share of blame and is arguably the easier to reform. As expressed by economist Jeffrey Frankel, the government’s encouragement of homeownership through the tax code by allowing mortgage interest to be deducted from taxable income, has had serious consequences for not just debt burdened families but the macro economy. The government effectively subsidies greater debt, encouraging households to borrow more than they otherwise would. And this tax loophole is highly regressive, benefiting the rich far more than the poor. As the mortgage interest deduction is averaged at over $14,000 for households earning over $200,000 annually, the deduction is averaged at below $1,000 for households earning less than $30,000. It is also expensive to maintain, costing the government $77 billion annually, all for the sake of homeownership.

While encouraging mortgages to less than worthy borrowers brings one’s memory back to the 2007 housing bubble, the government has been active in encouraging homeownership since the 1930s. And for quite a while it has proven quite successful in this end, as shown by the “suburbanization” of America of the 1950s. Homeownership became a staple of the American dream in the post WWII era and public policy created the opportunity for many to achieve this dream, allowing millions of Americans to leave the cities to make a new life in the suburbs. Long term fixed interest, low down payment and amortization, what we would associate as normal mortgage financing practices today, was pioneered by government policy (DeLong and Cohen, 2015). However, current policy is having the opposite effect, serving instead to raise housing prices, benefited the already wealthy homeowners while making homeownership even more unaffordable for first time buyers. As the tax code favors housing over other investment through loopholes like the mortgage interest deduction and favorable capital gains treatment, more investment in channeled into the real estate sector, which raises home values for homeowners and makes home buying less affordable. According to the Congressional Budget Office while the effective tax rate for business investment is around 30%, for owner-occupied housing it’s -2%, essentially a subsidy rather than a tax. This large difference in tax treatment has serious impacts on economic incentives, which leads to overinvestment in housing and underinvestment in business. And while business investment can be used to finance physical capital, which increases productivity, profits and worker’s wages, homeownership has none of these effects except for increasing the profits and salaries of realtors and developers. While there may be some benefits to homeownership, there are also its consequences.

One of course is the encouragement of debt. Increasing homeownership may seem like a noble goal, but the debt levels potential homebuyers would have to take on may outweigh any benefit derived from owning a home. And with the mortgage interest deduction, homebuyers are even more willing to take on greater debt, despite the consequences. If we aim to reduce our high level of private debt, which poses serious risks to our economy, reforming this deduction should be a first step, reducing the encouragement of home indebtedness.

And there are also macro distortions from homeownership, which can also lead to geographic immobility, as workers may be unable to move to another area to find employment if they are unable to sell their home. If a region is plagued with harsh unemployment, like if local factories close down, homeownership makes it difficult for the laid off workers to move to areas with better employment prospects. This can leave workers stuck in regions with low employment prospects (think rust belt states). Homeownership can also be a severe financial burden. With the cost of maintenance and property taxes, one’s home can be more of a liability than an asset. Homeownership may not be so righteous a goal as politicians praise it to be.

Although encouraging homeownership may be seen as encouraging a more egalitarian distribution of wealth, providing opportunities for asset ownership to the least fortunate of society, homeownership may actually perpetuate inequality. Housing wealth is highly concentrated and increases in home values, which special tax treatment augments, serve to perpetuate wealth inequality rather than reduce it. Encouraging homeownership through the tax code may sound nice, but in effect it does more to benefit wealthy homeowners than it does to accomplish its goal of increasing homeownership. The lack of effectiveness of this tax provision is shown by the similar rates of homeownership across other developed countries which do not allow mortgage interest to be deducted from taxable income. In the US, Great Britain, New Zealand, Canada and Germany and the rest of the developed nations, homeownership is about 65%, with or without a deduction for mortgage interest (Reid, 2017). However, in addition to ending the subsidization of mortgage debt, the government should instead direct its focus to the distribution of capital income. While debt, both public and private, play important roles in our economy, what also deserves attention is the other side of the balance sheet: Assets.

As income from capital assets (the dominant portion of income for the wealthy) constitutes a growing portion of national income relative to income from labor  (the dominant form of income for the not-so-wealthy)  policy debates should give greater attention to the distribution of capital and less so on the ever popular jobs and income. As capital becomes more important in our economy, crowding out the income received from labor, the narrative from lawmakers should change from creating jobs to expand access to income generating assets. With the rise of automation and globalization, capital income has constituted a growing share of not just US, but global income while labor income has been crowded out. Replacing workers with machines or outsourcing a factory may be good for the business owner, the financier, and a nation’s GDP, but harms the displaced laborer who will likely be made to rely on a permanently lower income. While we are accustomed to discussing raising incomes and creating jobs, as capital begins to take center stage in our 21st century economy, policy makers must figure out how this form of income can be better distributed. Former World Bank Economist Branko Milanovic makes this case, arguing that “much greater attention should be paid to policies that would redistribute ownership of capital and make it less concentrated” (Boushey et al, 2017). Policy centered on asset distribution would allow all Americans to be asset owners, reaping the gains of national growth rather than bearing the burden of it. The benefits of public policy to encourage asset building through homeownership tax preferences and retirement savings vehicles have been accruing to the wealthiest households, exacerbating already growing wealth inequality. While appearing to be a radical proposal of distribution, the goal of encouraging a more egalitarian distribution of wealth has long been an American tradition.

In 1862, with the Homestead Act, the government granted 160 acres worth of land in the western frontier to all adult citizen applicants, even women and immigrants, who were willing to work on the land for at least 5 years. Rather than a simple auction, risking the creation of an aristocratic landowning regime on the frontier, the US pursued instead a policy of egalitarian land distribution, encouraging small farms rather than large elite owned plantations.  Similarly, under the Roosevelt administration during the 1930s, the US took on the new goal of encouraging homeownership through government policy as explained above and government enterprises like Fannie Mae helped to facilitate this goal(Delong and Cohen, 2015). The distribution of financial assets would simply be the next step in American policy of encouraging widespread wealth accumulation and broadening economic opportunities.

One method for capital income distribution proposed by Yanis Varoufakis, Former Greek Finance Minister is something like a sovereign wealth fund, holding stock of domestic IPOs which distributes a “Universal Basic Dividend” to all citizens. Or as recommended by the late Anthony Atkinson, a minimum inheritance paid to all at adulthood, financed by a wealth tax.(Atkinson, 2015). Milanovic proposes going in a similar direction, to encourage small wealth holdings while penalizing large wealth holdings (Boushey et al, 2017). Especially now as income inequality has allowed inheritance to play a significant role in wealth generation and concentration, with over 50% of U.S. household wealth being “earned” by inheritance, do proposals such as these for financial asset distribution become more pertinent. As explained earlier, while promoting homeownership had proved successful in expanding American wealth and opportunity, currently the same policies have been having negative effects, benefiting the wealthy while crowding out everyone else. Switching focus from homeownership to financial asset ownership would be a more effective goal at encouraging a more fair distribution of wealth, allowing the benefits of finance to be dispersed rather than concentrated. Instead of fighting over the shrinking piece of the pie (labor income), the growing piece of the pie (capital income) should become more accessible and better distributed.

This should also appeal to conservatives, as a wider distribution of assets would make business-friendly policies more politically feasible, since the increase in profits from these policies would be more widely dispensed and thus would garner more public support. The distribution of financial assets may also generate positive externalities, such as encouraging financial literacy and a greater public awareness for financial markets and world events.

Based on current trends, the US is on the road to wider inequality and greater financial debt, which risks undermining the strength and stability of the macro economy. Changing our focus from encouraging housing to financial assets would be an appropriate policy to counteract the negative effects of this route. American history has shown that asset distribution, rather than a radical proposal of socialist redistribution, would just be following the set trend of encouraging the shared prosperity of American wealth. As capital income becomes more widely distributed, all Americans would be able to enjoy the fruits of American growth and affluence, rather than being burdened by it.

 

Sources:

 

Atkinson, A. B. (2017). Inequality: what can be done? S.l.: Harvard University Press

Boushey, H., Delong, J. B., & Steinbaum, M. (2017). After Piketty: the agenda for economics and inequality. Cambridge, MA: Harvard University Press.

Cohen, S. S., & DeLong, J. B. (2016). Concrete economics: the Hamilton approach to economic growth and policy. Harvard Business Review Press.

Reid, T. R. (2017). A Fine Mess: a global quest for a simpler, fairer, and more efficient tax system. S.l.: Penguin Books.

 

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