Three Types of Debt and How to Tell Them Apart

I am becoming more convinced that much of the underlying trouble facing the economy is the large overhang of debt that remains unaddressed.  But I am not quite sure that we are viewing the issue correctly.  Basically there are three kinds of debt: the good, the bad and the ugly.  If we cannot tell them apart, we are in for a rude surprise.  The distinctions affect not only the current deleveraging of current debt in the economy but also the debate on reviving the economy by spending more on infrastructure.

First a word about debt.  Debt can be explicit or implicit.  A mortgage is an explicit debt in which a bank loans money to a homeowner to buy a house.  The mortgage documents clearly spell out the terms of the loan.  Implicit debt is much more difficult to identify because it can be hidden.  The difference between Social Security’s promised  benefits and the revenues available to pay those benefits is a form of implicit debt in which the U.S. government may (or may not) be on the hook for paying benefits even if payroll taxes are exhausted.  The distinction is in whether the debt is clearly identified and acknowledged by both sides.  It is important to remember, however, that explicit debt can be reneged on even while implicit debt is honored.

Debt is good when it is invested in an asset that generates enough of a return to pay off the debt.  In this case the borrower is clearly better off for having taken out the loan.  Note that the key distinction is not in what the investment is called but whether it generates enough of a return to pay off the loan.  This type of debt makes society better off.

Debt is bad when it is used to fund consumption.  In this case the borrower is merely transferring consumption from the future into the present.  Rather than saving up for a boat, he is borrowing the money and paying the loan off in future years.  He gets to enjoy the boat now, but his future living standard will be lower than it otherwise would be.  It is all too easy to classify spending on bridges, roads, and education as investment.  If they generate a rate of return they are.  Otherwise they are merely disguised forms of consumption which are payed for by lower livings standards in the future.  This type of debt may affect individual consumption patterns but it does not make society any better or worse off.  Lets say I lend you $100 to buy a work of art.  If you pay me back, I have $100 and you have the art work.  If you renege, you have both the $100 you were supposed to pay me and the art work.  In both cases our joint wealth is the same.

Ugly debt exists where one party believes it is going to get paid something in the future but the other party acts like it doesn’t have an obligation.  Normally a debt shows up as an asset for the lender and a liability for the debtor.  Together they cancel each other out.  But when one party acts like it has an asset and the other party acts like it does not have a liability it is possible for society to believe it is richer than it really is.  Either way, the end result is deflationary.  A classic example isunfunded pension and health care liabilities.  Either beneficiaries will have to lower their standard of living when the benefits do not come as expected, or taxpayers will have to bear higher taxes and lower services than they are used to.

A key hurdle in getting back to strong growth is to acknowledge and deal with the large amount of ugly debt in the system and the first step in doing that is to recognize it.