How to reduce the mountain of debt

July 14, 2009

Nassim Taleb is right that there’s too much debt in the world, and he’s also right that debt=denial:

Debt has a nasty property: it is highly treacherous. A loan hides volatility as it does not vary outside of default, while an equity investment has volatility but its risks are visible. Yet both have similar risks. Thus debt is the province of both the overconfident borrower who underestimates large deviations, and of the investor who wants to be deluded by hiding risks.

Taleb has been saying for a while that the world “must” move to a state of less leverage; sometimes, putting on his prophet hat and coming across a bit like Karl Marx, he calls it a historical inevitability. But the thing about historical inevitabilities is that you don’t need to legislate them:

Government policies worldwide are causing more instability rather than curing the trouble in the system. The only solution is the immediate, forcible and systematic conversion of debt to equity. There is no other option.

Well, there clearly is another option, and it’s equally clearly the option which is going to be taken — an attempt to recapture as much of the status quo ante as possible, with a bit more regulation this time around. The upside of this approach is that it’s not “forcible” — attempts to do anything by force generally end badly.

My feeling is that the best option is a middle way: don’t try to force debt-for-equity swaps, since the unintended consequences could be extremely horrible. But do get rid of all the tax benefits that debt has over equity. At the moment, companies pay tax not on earnings before interest but earnings after interest — that gives them an incentive to lever up as much as possible. Last year, Steve Waldman had a great post entitled “Eliminate the business interest tax deduction“; it’s well worth (re)reading in light of what has happened since.

In general the multi-trillion-dollar edifice of debt financing is predicated on all manner of artificial tax advantages which are given both to borrowers and to fixed-income investors; tax-free municipal bonds and mortgage-interest tax relief are just two of the most egregious examples here.

Forcibly converting mortgages into some kind of shared-equity arrangement where banks get direct exposure to the house price is fraught with difficulty; abolishing mortgage-interest tax relief, however, is easy. And it raises much-needed money for the government as well.


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