Daniel Altman / Concerning debt, how and why you borrow matters - pressofAtlanticCity.com: Commentary

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Daniel Altman / Concerning debt, how and why you borrow matters

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Posted: Saturday, January 19, 2013 12:01 am

Daniel Altman / Concerning debt, how and why you borrow matters

Debates about government debt, whether in the United States or elsewhere, have been missing one fundamental point: The composition of debt and spending matters as much as the size. This is such a basic notion, yet it seems to have eluded many of the politicians, pundits and credit-raters who have been obsessing about debt.

For American politicians, the big numbers are the ones that get top billing, as they did at President Barack Obama's Monday-morning press conference on the debt ceiling fight. Yet whether it's $970 billion (the projected deficit after the "fiscal cliff" deal) or $11 trillion (the debt held by the public), these numbers say nothing about how money is borrowed and spent. In Washington, the only difference between good and bad spending is usually "spending in my district" versus "spending somewhere else," as Obama mockingly remarked. It doesn't take much brainpower to see how much important information such a simple, shortsighted distinction omits.

Imagine two people with similar assets and incomes who are both seeking to borrow $100,000 for 10 years. One plans to spend it on a master's degree that will improve her options in the labor market. The other plans to take a luxurious vacation with his family and buy a pleasure boat. To whom would you charge the higher interest rate? By investing the money in her ability to repay, the first borrower is increasing her credit-worthiness. She should be able to obtain a lower interest rate. She should also be able carry more debt.

Now imagine that two other people with similar assets and incomes both plan to carry $100,000 in debt for 10 years. One has a fixed interest rate of 3 percent for the entire period. The other has borrowed for two years at 2.5 percent and plans to roll over the debt - repay and then borrow again - four times. Which borrower has the bigger risk of default? Since interest rates can fluctuate a lot over the years, and they seem pretty low right now, the long-term borrower probably has the safer strategy.

The lesson is clear: How you borrow and spend can make as much difference to your credit-worthiness as how much. And it's no different for governments. A government that uses borrowing to invest in its economy's future growth - and hence its ability to repay - should be able to borrow more than one that doesn't, all other things equal. And a government that borrows at low, fixed rates for the long term should be able to borrow more than one that constantly rolls over short-term debts.

In the past several years, the national debt of the United States has undergone a tremendous change. Long-term securities - those with maturities of seven years or more - have gone from about 30 percent of the debt in 2009 to about 40 percent today. By 2018, according to the Treasury's own estimates, they'll make up 50 percent of the debt, a proportion the Treasury expects to maintain from then onward. The United States is doing what any smart borrower would do: locking in low rates for the long term. As a result, its probability of default for any given level of debt has dropped.

The nature of government spending is undergoing a dramatic shift as well. For a decade, the United States spent roughly $100 billion a year on wars whose value to creditors - in terms of enhancing the nation's ability to repay its debts - was not exactly clear. Reducing spending in this area will make the United States more credit-worthy. Even if this spending were simply replaced by programs that invest in the economy - infrastructure, scientific research, education - it would still make the United States a less risky borrower.

There is a powerful argument that we can and should borrow more for these long-term investments. Yet the idea of spending more, increasing deficits and adding to the national debt makes politicians, pundits and credit-raters recoil in horror. They do not seem to understand that the country, despite its national debt growing to about 75 percent of GDP, may actually be a better risk now than it was in, say, the early 1990s.

The markets seem to understand this. Interest rates on Treasury securities have fallen steadily. Of course, the Federal Reserve has been doing its best to keep rates low, and other countries have been in even worse shape fiscally than the United States. But had those been the only important factors, rates on longer-term securities - 10-year and 30-year debt, for example - would have recovered more by now.

In the next couple of decades, the United States will indeed have to reduce its budget deficits. Medicare costs and historically low tax rates are likely to be an unsustainable combination. But in the meantime, the nation can do much to improve its credit-worthiness through changes in the composition of its borrowing and spending. Indeed, it already has.

Daniel Altman teaches economics at New York University's Stern School of Business and is chief economist of Big Think.

Posted in on Saturday, January 19, 2013 12:01 am.

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