How economic theory came to ignore the role of debt

Michael Hudson

Starting from David Ricardo in 1817, the historian of economic thought searches in vain through the theorizing of financial-sector spokesmen for an acknowledgement of how debt charges (1) add a non-production cost to prices, (2) deflate markets of purchasing power that otherwise would be spent on goods and services, (3) discourage capital investment and employment to supply these markets, and hence (4) put downward pressure on wages. What needs to be explained is why government, academia, industry and labour have not taken the lead in analyzing these problems. Why have the corrosive dynamics of debt been all but ignored?

I suppose one would not expect the tobacco industry to promote studies of the unhealthy consequences of smoking, any more than the oil and automobile industries would encourage research into environmental pollution or the linkage between carbon dioxide emissions and global warming. So it should come as little surprise that the adverse effects of debt are sidestepped by advocates of the idea that financial institutions rather than government planners should manage society‘s development. Claiming that good public planning and effective regulation of markets is impossible, monetarists have been silent with regard to how financial interests shape the economy to favor debt proliferation.

The problem is that governments throughout the world leave monetary policy to the Central Bank and Treasury, whose administrators are drawn from the ranks of bankers and money managers. Backed by the IMF with its doctrinaire Chicago School advocacy of financial austerity, these planners oppose full-employment policies and rising living standards as being inflationary. The fear is that rising wages will increase prices, reducing the volume of labour and output that a given flow of debt service is able to command.

Inasmuch as monetary and credit policy is made by the central bank rather than by the Dept. of Labor, governments chose to squeeze out more debt service rather than to promote employment and direct investment. The public domain is sold off to pay bondholders, even as governments cut taxes that cause budget deficits financed by running up yet more debt. Most of this new debt is bought by the financial sector (including global institutions) with money from the tax cuts they receive from governments ever more beholden to them. As finance, real estate and other interest-paying sectors are un-taxed, the fiscal burden is shifted onto labour.

The more economically powerful the FIRE sector (Finance, Insurance and Real Estate) becomes, the more it is able to translate this power into political influence. The most direct way has been for its members and industry lobbies to become major campaign contributors, especially in the United States, which dominates the IMF and World Bank to set the rules of globalization and debt proliferation in today‘s world. Influence over the government bureaucracies provides a mantel of prestige in the world‘s leading business schools, which are endowed largely by FIRE-sector institutions, as are the most influential policy think tanks. This academic lobbying steers students, corporate managers and policy makers to see the world from a financial vantage point. Finance and banking courses are taught from the perspective of how to obtain interest and asset-price gains through credit creation or by using other peoples‘ money, not how an economy may best steer savings and credit to achieve the best long-term development. Existing rules and practices are taken for granted as ―givens‖ rather than asking whether economies benefit or suffer as a whole from a rising proportion of income being paid to carry the debt overhead (including mortgage debt for housing being bid up by the supply of such credit). It is not debated, for instance, whether it really is desirable to finance Social Security by holding back wages as forced savings, as opposed to the government monetizing its social-spending deficits by free credit creation.

The finance and real estate sectors have taken the lead in funding policy institutes to advocate tax laws and other public policies that benefit themselves. After an introductory rhetorical flourish about how these policies are in the public interest, most such policy studies turn to the theme of how to channel the economy‘s resources into the hands of their own constituencies. One would think that the perspective from which debt and credit creation are viewed would be determined not merely by the topic itself but whether one is a creditor or a debtor, an investor, government bureaucrat or economic planner writing from the vantage point of labour or industry. But despite the variety of interest groups affected by debt and financial structures, one point of view has emerged almost uniquely, as if it were objective technocratic expertise rather than the financial sector‘s own self-interested spin. Increasingly, the discussion of finance and debt has been limited to monetarists with an anti-government axe to grind and vested interests to defend and indeed, promote with regard to financial deregulation. This monetarist perspective has become more pronounced as industrial firms have been turned into essentially financial entities since the 1980s. Their objective is less and less to produce goods and services, except as a way to generate revenue that can be pledged as interest to obtain more credit from bankers and bond investors. These borrowings can be used to take over companies (―mergers and acquisitions‖), or to defend against such raids by loading themselves down with debt (taking ―poison pills‖). Other firms indulge in ―wealth creation‖ simply by buying back their own shares on the stock exchange rather than undertaking new direct investment, research or development. (IBM has spent about $10 billion annually in recent years to support its stock price in this way.) As these kinds of financial manoeuvring take precedence over industrial engineering, the idea of ―wealth creation‖ has come to refer to raising the price of stocks and bonds that represent claims on wealth (―indirect investment‖) rather than investment in capital spending, research and development to increase production.

Labour for its part no longer voices an independent perspective on such issues. Early reformers shared the impression that money and finance simply mirror economic activity rather than acting as an independent and autonomous force. Even Marx believed that the financial system was evolving in a way that reflected the needs of industrial capital formation.

Today‘s popular press writes as if production and business conditions take the lead, not finance. It is as if stock and bond prices, and interest rates, reflect the economy rather than influencing it. There is no hint that financial interests may intrude into the ―real‖ economy in ways that are systematically antithetical to nationwide prosperity. Yet it is well known that central bank officials claim that full employment and new investment may be inflationary and hence bad for the stock and bond markets. This policy is why governments raise interest rates to dampen the rise in employment and wages. This holds back the advance of living standards and markets for consumer goods, reducing new investment and putting downward pressure on wages and commodity prices. As tax revenue falls, government debt increases. Businesses and consumers also are driven more deeply into debt.

The antagonism between finance and labour is globalized as workers in debtor countries are paid in currencies whose exchange rate is chronically depressed. Debt service paid to global creditors and capital flight lead more local currency to be converted into creditor-nation currency. The terms of trade shift against debtor countries, throwing their labour into competition with that in the creditor nations.

If today‘s economy were the first in history to be distorted by such strains, economists would have some excuse for not being prepared to analyze how the debt burden increases the cost of doing business and diverts income to pay interest to creditors. What is remarkable is how much more clearly the dynamics of debt were recognized some centuries ago, before financial special-interest lobbying gained momentum. Already in Adam Smith‘s day it had become a common perception that public debts had to be funded by tax levies that increased labour‘s living costs, impairing the economy‘s competitive position by raising the price of doing business. The logical inference was that private-sector debt had a similar effect.

How national debts were seen to impair economic competitiveness prior to Ricardo

An important predecessor of Adam Smith, the merchant Mathew Decker, emigrated from Holland to settle in London in 1702. In the preface to his influential Essay on the Causes of the Decline of the Foreign Trade, published in 1744, he attributed the fall in Britain‘s international competitiveness to the taxes levied to carry the interest charges on its public debt. These taxes threatened to price its exports out of world markets by imposing a ―prodigious artificial Value . . . upon our Goods to the hindrance of their Sale abroad.‖ Taxes on food and other essentials pushed up the subsistence wage level that employers were obliged to pay, and hence the prices they had to charge as compared to those of less debt-ridden nations.

The tax problem thus was essentially a debt problem, which in turn reflected royal military ambitions. Eight centuries of warfare with France had pushed Britain deeply into debt. Interest on the government‘s bonds was paid by levying excise taxes that increased prices. The cost of doing business was raised further by the high prices charged by the trading monopolies such as the East India Company (of which Decker himself had been a director) that the government created and sold to private investors for payment in its own bonds.

Adam Smith’s views

Smith‘s protest against government profligacy and taxation was essentially an argument against war debts. He saw that new wars could be financed only by running further into debt, as populations were unwilling to support them when they had to pay taxes to defray their costs directly on a pay-as-you-go basis and thus felt the full economic burden immediately. The landed gentry, whose members formed the cavalry and officer corps, supported wars out of patriotism but opposed the proliferation of public debts whose interest charges were defrayed by taxes that fell ultimately on their own property. When the barons had opposed royal taxation in medieval times, rulers avoided the tax constraint by borrowing from Italian bankers and other lenders.

By the 18th century, governments had turned to more anonymous Dutch and domestic investors. This created a vested interest of bondholders. And it was only natural for them to portray their lending in as patriotic and economically productive a light as they could, claiming to provide capital to the nation. However, Smith wrote (V, iii; Cannan ed. pp. 460ff.): ― “The opinion that the national debt is an additional capital is altogether erroneous.‖ Debt was just the opposite of an engine of development. A nation‘s real wealth lay in its productive powers, not its money or the build-up of financial securities. These were only the shadowy image of real wealth. In fact, Smith explained, the policy of funding wars by bond issues diverted money that taxpayers could use more productively for direct investment. Taxes to pay debt service were ―defrayed by the annual destruction of some capital which had before existed in the country; by the perversion of some portion of the annual produce which had before been destined for the maintenance of productive labour, towards that of unproductive labour.”

How Ricardo’s value and trade theory ignored the impact of debt and interest charges

The debt discussion peaked at a time before most modern readers imagine that economic theory began. It was the bond-broker Ricardo that ended the discussion rather than moving it forward. His labour theory value focused only on the direct costs of production, measured in labor time. Credit and interest charges did not enter into his model. Workers earned the subsistence wage, and capital was valued in terms of the labour needed to produce it. The land was provided freely by nature, and its natural fertility (and hence, economic rent) was not a cost of production. As for the taxes to which Ricardo referred in his 1817 Principles of Political Economic and Taxation, they were the tariffs levied on agricultural products, not taxes levied to pay bondholders. Yet as the economic historian Leland Jenks has observed (1927:14ff.), Britain‘s government paid out some three-fourths of its tax revenue as dividends to bondholders in the typical year 1783. ― “Nine million pounds were paid to rentiers when the entire annual turnover of British foreign trade did not exceed thirty-five millions.”

How Keynes discussed saving and investment without citing the role played by debt deflation

Keynes distinguished himself in the 1920s by defining the limits that existed to debt-servicing capacity,4 above all with regard to the Inter-Ally debts and German reparations stemming from World War I. By 1931 he was pointing out that ― “the burden of monetary indebtedness in the world is already so heavy that any material addition would render it intolerable. . . . In my own country it is the national debt raised for the purposes of the war which bulks largest. In Germany it is the weight of reparation payments fixed in terms of money. . . . In the United States the main problem would be, I suppose, the mortgages of the farmer and loans on real estate generally.” He criticized deflationary monetary proposals as threatening to derange the financial superstructure of ― “national debts, war debts, obligations between the creditor and debtor nations, farm mortgages [and] real estate mortgages,” throwing the banking system into jeopardy and causing ― “widespread bankruptcy, default, and repudiation of bonds.”

But by 1936, Keynes was concerned mainly with the shortfall in consumption resulting from people‘s propensity to save. Pointing out that new investment and hiring would not occur without stronger markets, his General Theory of Employment, Interest and Money described the solution to lie in getting people to spend more. The countercyclical government hiring that he advocated would lead to budget deficits, which would have to be financed by debt. Yet Keynesian macroeconomics ignored the role of debt and its carrying charges. This was its major loose end, and the blind spot that has led to the most confusion.

How debt and interest rates are autonomous from the “real” economy

Keynes was not the first economist pointing to savings as not being an unalloyed benefit. Marx had described how the ―new aristocracy of finance, a new sort of parasites in the shape of promoters, speculators and merely nominal directors . . . demands . . . precisely that others shall save for him‖ (Capital III:519f.). The saving in this case take the form of debt repayment with interest, much as British money lenders advertise that buying a home helps buyers save by building up equity via their mortgage payments each month. The liquid savings of course accrue to the lenders, not the debtors. But it was mainly fringe groups that warned of the collision course between the debt overhead and the ―real‖ economy‘s production and consumption trends.

The reality is that credit has no cost of production beyond a modest administrative overhead. Interest rates have no determinate foundation in the ―real‖ economy‘s production and consumption functions, although they intrude into that system‘s circular flow. Such charges therefore cannot be assigned to labor or other ―real‖ costs of production, but the administered prices for interest and underwriting fees are akin to economic rent, out of which the financial sector‘s bloated salaries and bonuses are paid.

Ignoring the role of debt leaves it free to devastate the economic system. Beaudelaire famously remarked that the devil would defeat humanity at the point where he was able to convince it that he did not really exist. Financial interests have promoted the idea that money and credit are merely a veil, passively reflecting economic life as ―counters‖ rather than actively steering and planning economies. The study of debt and its effects have all but disappeared from the curriculum. In an academic version of Gresham‘s Law, the financial sector‘s approach to the debt problem has driven other perspectives out of the intellectual marketplace. Policy-makers take the financial and banking system for granted rather than discussing what kind of a system best would serve society‘s long-term development and best cope with debts that grow too large to be paid without fatally polarizing economies between creditors and debtors.

Prof Michael Hudson works at the University of Missouri at Kansas City, USA.

This article is an edited extract from a much larger paper published in the real-world economics review, issue no 57, 6 Sept 2011, pp. 2-24 http://www.paecon.net/PAEReview/issue57/Hudson57.pdf