Debt Bias

November 15th, 2009

James Surowiecki on the tax code’s debt bias:

If the benefits are illusory, the costs are all too real. Economies work best, generally speaking, when people are making decisions based on economic fundamentals, not on tax considerations. So, as much as possible, the tax system should be neutral between debt and equity, and between housing and other investments. It’s not, and, worse still, as we’ve seen in the past couple of years, debt magnifies risk: if companies or individuals rely on large amounts of leverage, it’s much easier for bad decisions to lead to insolvency, with significant ripple effects in the wider economy. A debt-ridden economy is inherently more fragile and more volatile. This doesn’t mean that the tax system caused the financial crisis; after all, the tax breaks have been around for a long time, and the crisis is new. But, as a recent I.M.F. study found, tax distortions likely made the total amount of debt that people and companies took on much bigger. And that made the bursting of the housing bubble especially damaging. So encouraging people to take on debt qualifies as a genuinely bad idea.

He is absolutely correct. The federal government’s encouragement of debt-taking, and of homeownership through the mortgage deduction Surowiecki highlights and Fannie Mae and Freddie Mac, set the stage, helped inflate the bubble, and magnified the losses in the recent recession.

Without the federal government’s involvement through Fannie Mae and Freddie Mac, and the tax code,1 the 2007-08 financial crisis would not have happened. Recession, yes; crisis, no.

Government involvement in the market distorts it, sometimes with disastrous results, no matter how good intentions are.

  1. Let’s not forget the federal reserve’s low interest rates after September 11th which, at the time, seemed prudent, but with hindsight now are very culpable for the bubble. That highlights quite nicely the problem with attempting to manage an economy as complex as ours, and provides a nice lesson for the current administration and Congress’s proclivity toward doing so. [↩]