The Economics of Debt 101

In his NY Times blog, Paul Krugman provides a very simple statement of fact to bring home the difficulty of repairing the current financial mess:

The background to the world economic crisis is that we went through an extended period of rising debt. Now, one person’s liability is another person’s asset, so rising debt made the world as a whole neither richer nor poorer. It did, however, leave the borrowers increasingly leveraged. And then came the Minsky moment; suddenly, investors were no longer willing to roll over, let alone increase, the debts of highly leveraged players. So these players are being forced to pay down debt.

The process of paying down debt, however, must obey two rules:

1. Those who pay down debt must do so by spending less than their income.
2. For the world as a whole, spending equals income.

It follows that

3. Those who are not being forced to pay down debt must spend more than their income.

But here’s the problem: there’s no good mechanism in place to induce those who can spend more to do so. Low interest rates do encourage spending; but given the size of the debt shock, even zero rates are nowhere near low enough.

Since people who don't have excessive debt are very unwilling to spend to make the basic accounting equation work, this is the role of government. This is the Keynesian solution. The government is the agent of last resort. It can spend when agents in the private economy are unwilling to do the right thing.