Good Debt, Bad Debt


For a while, I have been meaning to post on the subject of good debt and bad debt; and a fellow blogger's comment earlier this week gave me the opportunity to get my writing juices going. Here's an excerpt from my response:

Debt is good when you can do one of two things: 1) use the money you've borrowed to do something to improve your future income (examples: an individual going to college, a business buying more efficient machinery), or 2) spread out the cost of an asset over time to match the life of the asset (examples: house, car).

The problem is when people pile on debt that does neither of those two things, but instead is used to increase present standard of living with no regard to future decrease in standard of living on account of having to pay it back. (Of course, peoples' illusion that their house prices and stock portfolios could only go up and therefore they could keep flipping their mortgages and using their equity as a no-downside piggy bank was what caused, oh, only the worst global economic meltdown in the last 75 years.)

Compound the pain in this particular case in that federal subsidies of house (mortgage interest deduction) and car (highway construction) cause already irrational consumers to buy even more house and car than is socially optimal, with adverse consequences borne by the rest of us.


While the whole notion of "the government's budget is like my family's budget" is a little too simplistic, I do think it is correct to say that we should hold our federal government to similar standards as far as whether and when it is good to take on new debt. Optimists will say Obama's moves save us from a worse economic crisis and lay the foundation for an increased economic productivity and energy efficiency that helps us pay off the debt we're incurring to do all of this. Pessimists will say Obama's moves represent an increase in our government's "standard of living," which is to say a higher level of public expenditures with no commensurate enhancement in our ability to pay for them.

Time will tell whether we ought to have been optimistic or pessimistic about all this. And that's what we're all holding our breath about, both here in the US and around the world, and both us and generations to follow.

Comments

Eric Orozco said…
Insightful post, LH. I often wonder how to estimate which projects have a greater return on investment (or positive Net Present Value). Who takes the time to calculate these things for cities and municipalities?...Are there really any economic types out there who truly usefully estimate the value of, say, creating a sidewalk to connect A to B? How much decreased transit headways impact local economies, etc.? There just seems to be a very loose handle of these things out there, and it is often hard to dissect empirical analysis from politics. There's so many ways to whitewash capital improvement projects. There needs to be a way we can empirically step back and look at the entire city as a economic system and map out what is really needed to create immediate benefits. I'm not aware of any place that actually does this. Do you?
LH said…
Eric, our firm (www.econsult.com) does a lot of studies that try to help make this case for governments. For example, comparing the upfront tax subsidies for a proposed development with the ongoing spike up in tax revenues as a result of the new activity it represents, to see if the jurisdiction is better off making the investment and reaping the benefit or not making the investment in the first place.

But we recognize that there is more to a decision than just NPV. On the one hand, a project could have a negative NPV but generate other, intangible benefits (environmental, aesthetic, equity, civic pride) that make it worth spending the money. On the other hand, a project could have a positive NPV but the opportunity cost it represents is too great to green-light (the jurisdiction is maxed out on debt, or other projects have even higher potential NPVs and we can't do all of them at once).

Nevertheless, as you noted, decisions are often just as much about politics as analysis. Which isn't necessarily a bad thing: analysis has its limits, as we understand that our projections are merely guesses, while the political process, if done well, can be an effective way to balance many interests when making a decision. Selfishly, we want governments and the private actors that intersect with them to hire us to add numbers to the mix; but we get that decisions can't be boiled down to just numbers.

The best case scenario is to not pit politics against analysis, but to honor the role of both in making a decision. After all, we're talking about public dollars and public space. We wouldn't want some eggheads to crunch out a number that is the end all and be all of the discussion; nor would we want to make a decision without exploring its likely NPV consequences.
Daniel Nairn said…
I really like the way you put those two rules for evaluating good debt. Simple enough to base decisions on, but still comprehensive.

But I'm still a little shaky on the second one though. In my mind, it would be good to see enough expected appreciation in the value of the asset to compensate for at least the interest on the loan. Otherwise, I'm not sure if I would characterize it as good use of debt.

The story would be different if, say, the car would be a necessity for work or some other important function. In this case, it would fall under your first condition for good debt.
LH said…
Daniel, you're absolutely right. The interest on a mortgage can be seen as the expenditure associated with "consuming" the house: when you buy a house, you're trading one asset (cash in the form of principal payments) for another (house), and one expense (rental payments) for another (interest payments). So homeownership's benefits are that when you're done paying off your house, you have an asset that is hopefully worth just as much if not more than what you originally paid for it; in other words, it hasn't depreciated to zero where you now have to go out and buy a brand new house and start the process all over again.

Versus with a car, after its useful life, the asset has depreciated to zero, so you have start all over. But remember that there's a benefit to smoothing out your payment of something, even if it involves paying interest: if you need a car and can't afford $15K all at once, instead you pay $4K a year for five years, or whatever the number is at today's rates. From a public sector standpoint, it's like paying for a bridge by borrowing $10M over 30 years, rather than socking today's taxpayer with all $10M in costs. (Btw, this is also an important and basic accounting principle: matching revenues and expenses appropriately, from a timing standpoint. Good God, I've just used lessons from both my undergrad and grad degrees in the same paragraph!)

So I would still say there's some justification for using debt to smooth out your payments to match the life of the asset. But you're correct when you say that how costly the borrowing is and to what extent the asset holds its value over time makes a big difference as far as how prudent the loan is.

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