How to reduce the mountain of debt

By Felix Salmon
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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I don’t see how Taleb’s plan is workable, but I very much agree with ditching the mortgage interest rate reduction. It will cause more Americans to put their savings into smaller houses and hopefully larger stock portfolios. One other benefit is that smaller houses are better for the environment.

STOP FEEDING the TALEBS! This is all over the blogosphere now, and it’s nothing more than more Taleb condescending tripe with no actual solution presented. Sure, lognormal is wrong, sure onerous debt is bad, and so is excessive foie gras, red wine, and smoking. (Though, to your credit Felix, you seem to have brought reasonable insight, as opposed to others who praise Taleb nonchalantly.)

And offtopic (or on topic of popular discussions w/ no solutions presented), why is nobody lambasting the lawyers/malpractice insurance costs w/r/t US Healthcare? HC in the US isn’t expensive b/c the services are first-order-expensive. It is because of the secondary costs of malpractice insurance, lawsuits, and lawyers.

It’s my impression that municipal bonds are tax-free for constitutional reasons and not due to any enacted tax code provisions.

Posted by Benedict@Large | Report as abusive

@Benedict: There was a Supreme Court decision in the 1800s suggesting constitutional reasons for muni bond tax exemptions, but it was reversed in the 1980s (when it was rescinded for bearer bonds, as a way of pushing munis toward registration systems).

In the short-run, one of the touted benefits of generating a bit of inflation is the effect it would have on over-leveraged balance sheets. A future of encouraging releveraging with a pattern of inflating out of overleverage would simply raise interest rates; the way to eliminate (or at least reduce) overleverage is, as Felix says, not to give tax incentives for incurring debt.

Maybe I’m being selfish (as a home owner currently enjoying mortgage interest tax relief) or only looking at the short-term, but wouldn’t repealing the mortgage interest deduction only serve to further depress home prices as well as increase defaults? It will most definitely decrease leverage overall, but the cost could be quite large given the low equity levels many homeowners currently have in their homes. Yes, using a no money down mortgage isn’t a great idea, but that decision was made knowing that the interest on the loan was tax deductible. Changing those rules in the middle of the game seems overly harsh on people who can’t really afford it. A phase in on new mortgages seems a bit fairer to me (though probably impossible to administrate), but that still leaves the issue of depressed home values once the non-deductibility of the mortgage interest is phases in.

Posted by Nathan | Report as abusive

I have to echo the comment immediately above. Pulling the mortgage interest deduction out from under homeowners, at least at this moment, would be an unmitigated disaster since many owners would immediately dump their properties on the market. If something like this is to be considered, it may have to be phased in with new buyers, who could at least clearly calculate the effect on their budget and decide whether to buy or not. I do not think this merely applies to ‘marginal’ buyers and those with low equity; anybody who can not afford the payment once the tax deduction is taken away would be vulnerable.

Posted by A Man A Plan | Report as abusive

@Nathan: I’m in your position, so I basically agree. But I have 2 issues. First, if the value of mortgage interest deduction is the difference between someone being able to make their payments and not, they are in over their head anyway.
Second, home values need to correct to a financially sustainable level anyway. The interest deduction was a gov’t carrot invented to encourage home ownership, (which may or may not be the right thing do). Again, if the few thousand dollars (I’m not talking about $million plus mortgages here) in deduction is propping up values, I’d say it’s a yet stronger argument to get rid of it.

Posted by Rockfish | Report as abusive

BTW, you can just as easily phase it out for everyone as for some. Give everyone 5 years to get over it. The upside consequence is that you’ll ENCOURAGE sales while the full deduction is still in effect, if that’s what you want to do.

Posted by Rockfish | Report as abusive

One can’t really eliminate business interest tax deductions. Instead lending just goes underground, destroying debt markets but not debt in any real sense. Instead of a borrower receiving a deduction and a lender paying tax, the two combine into a zero net debt entity that pays tax on earnings but not on distributions if not an S corp. For an S corp, a division into operating and capital/debt entities achieves the same result. This makes debt slightly more expensive, but by nothing like the nominal interest deduction, which is not really much of a subsidy at all.

It’s fine to argue the merits of the deduction. But it’s silly to pretend that repealing it wouldn’t have catastrophic consequences. The deduction makes a huge difference in affordability and that also affects the value of your home. For example, at a 33% marginal rate (state+local+fed) your $250,000 loan (5% and 1.25% property tax rate) would cost $1600 the first month, but only about$1260 after it.

If there were no deduction, that same $1260 payment would buy you only about $195,000 worth of house. This translates into about a 22% reduction in home value, enough to send many homes under water (if they’re not there anymore). This is back-of-the-envelope, and the savings obviously go down as you pay off more of the loan, so 22% is probably exaggerated. It’s nonetheless going to be a significant effect.

Aside from the massive political fallout, one effect would probably be to send a lot of people walking away from their mortgages. We’ve already seen how defaults can skyrocket when enough people are doing it that it becomes socially acceptable. Now instead of being confined to certain geographical areas, you could have people all over the country doing it. Not to mention retirees facing huge losses in the expected value of their main investment.

Spreading that reduction over five years doesn’t make it go away or even cause the reduction to smear out evenly, since rational 30-yr mortgage purchasers would price the future loss into their current bids. Maybe if you reduced the deduction over a really long time span (say 30 years) you slow down the effect enough that it would be hidden by normal price appreciation (even the pros often fail to price things in when they’re that far in the future.) But nobody’s going to be “getting rid of” the deduction. We need to look elsewhere for our income— like, say, a new tax bracket for very high earners, or restrictions on offshore tax havens.

Posted by The Reuters Cleaning Staff | Report as abusive

(I meant a C corp.)

The reason that we have tax incentives and govt guaranteed lending is because, in the US, we have an aversion to giving people money. With a tax credit, you can tell that they paid taxes, and aren’t freeloaders. With subsidized debt, you can hope to get paid back,and, possibly even make money.

The reason that we have incentives for home ownership is that we want more people to own homes, as opposed to renting. Presumably, we’re trying to spread the wealth, instead of focusing more wealth in the hands of landlords. The same is true of tax credits and loans for college. We don’t want to limit education simply to those that can afford it.

You could cut all these subsidies, and just accept the negative social consequences, assuming that there would be some in your view. On the other hand, you could institute simple transfers of money, like a Guaranteed Income, or giving the less well off the money for a down payment of 20% say. Of course, this would mean that you’re just giving people money.

My solution is just that: give people money. The current system of competing incentives and disincentives is inefficient and, because it’s so complicated, impossible to figure out what is effecting what. We should aim for simplicity and ease of supervision. We should simply transfer money to people through a Guaranteed Income, Down Payment Subsidy, etc. However, the goals of these programs make sense to me, and we shouldn’t forgo aiding the people addressed by these programs.