The double standard in debt relief that favored large merchants, present at the creation of bankruptcy law in 1706, persists today in many different forms. It gets surprisingly little attention in the debt debates. Despite the tacit assumption that “surely one has to pay one’s debts,” the evasion of repayment is both widespread and selective. Corporate executives routinely walk away from their debts via Chapter 11 of the national bankruptcy law when that seems expedient. Morality scarcely enters the conversation—this is strictly business.
Even more galling is the fact that the executives who drove the company into the ground often keep control by means of a doctrine known as debtor-in- possession. A judge simply permits the company to write off old debts, while creditors collect so many cents on the dollar out of available assets. Every major airline has now been through bankruptcy, and US Airways has gone in and out of Chapter 11 twice. In this process, all creditors are not created equal. Since banks typically have liens on the aircraft, bankers get paid ahead of others. Major losers are employees and retirees, since Chapter 11 allows a corporation to break a labor contact or reduce pension debts. Shareholders also lose, but by the time bankruptcy is declared, the company’s share value has usually dwindled to almost nothing. Much of the private equity industry uses the strategy of acquiring a company, taking it into bankruptcy, thus shedding its debts, and then cashing in on its subsequent profitability. Despite the misleading term private “equity,” tax-deductible private debt is the essence of this industry, which relies heavily on borrowed money to finance its takeovers.
Homeowners, however, are explicitly prohibited from using the bankruptcy code to reduce their outstanding mortgage debt. White House legislation proposed in 2009 would have allowed a judge to reduce the principal on a home mortgage, as part of the effort to contain the economic crisis. Congress rejected the measure after extensive lobbying by the financial industry. Consumers may use bankruptcy to shed other debts, but a revision of the law signed by President Bush in 2005 subjects most bankrupt consumers to partial repayment requirements, while bankrupt corporations get a general discharge from their debts. Thanks to the influence of the same financial lobby, the rules of student debt provide that the obligations of a college loan follow a borrower to the grave.
Nor is there Chapter 11 for nations. The “relief” provided by the European Union or the IMF typically takes the form of additional loans that the debtor nation uses to pay interest on old debts. The government ends up deeper in debt. Ireland, with low public debt levels in 2008, became in effect a ward of Brussels because the Irish state assumed the debts of insolvent Irish banks that had irresponsibly funded bad debt. The European authorities used a similar double standard in the case of Cyprus, condemning ordinary savers to lose up to 60 percent of their assets, in order to pay for the speculative sins of financiers.
Large banks, meanwhile, have benefited from extensive debt forgiveness thanks to governments. In the fall of 2008, every major US bank was on the verge of insolvency because banks had recklessly incurred debts to finance speculative investments, often using derivative instruments such as credit default swaps that had been created by the same group of large banks. When their debts overwhelmed their assets, the government did not permit these banks to fail (except for Lehman Brothers), or even to use Chapter 11 (which would have wiped out shareholders). Government simply made the banks whole, through the Troubled Asset Relief Program (TARP). The Federal Reserve has continued relief through extensive purchases of dubious bonds from banks. The entire economy gains from the stimulus to demand, but bankers who would otherwise lose their jobs are the immediate beneficiaries.
Despite the shift in the thinking about debt from a purely moral question to at least partly an instrumental one where business is concerned, the earlier emphasis on sin lingers when it comes to common debtors. Proposals for debt relief for homeowners, college graduates, or Greece encounter resistance cloaked in the language of moral opprobrium and “moral hazard,” the danger that debt relief will reward and thus induce reckless behavior.
Public policy remains stymied on the question of how to clean up the two large, now nationalized entities that hold or underwrite most of America’s mortgages, Fannie Mae and Freddie Mac. The answer is not to conclude that the United States put too much faith in home ownership, which remains a fine way for the nonrich to accumulate financial equity. The original Federal National Mortgage Association (FNMA), nicknamed Fannie Mae, was a public entity. It used government borrowing to purchase mortgages and replenish the working capital of lenders. Public FNMA had no scandals, and when it was working effectively, from its founding in 1938 to its privatization in 1969, the US rate of home ownership rose from about 40 percent to over 64 percent. The trouble began when Wall Street invented complex, exotic, and easily corrupted mortgage bonds, and private Fannie began purchasing high-risk mortgages in order to protect its market share. The remedy is to restore Fannie to a public institution with high lending standards, not to kill it.
Thanks to a small number of insurgent voices and evidence from Europe and the US about the negative effects of austerity policies, the double standards of debt relief are beginning to command skeptical attention. Stiglitz and Krugman, both Nobel laureates, have long questioned the prevailing assumptions about the wisdom of austerity, and they have lately been joined by more orthodox economists.
Carmen M. Reinhart and Kenneth S. Rogoff, whose 2009 book, This Time Is Different: Eight Centuries of Financial Folly, was reviewed in these pages by Krugman and Robin Wells,4 are best known for demonstrating that the most severe downturns of the entire economy typically follow financial crashes. In passing, This Time Is Different mentioned a provocative concept, “financial repression.” The idea was that when debt is strangling an economy, it may make sense to hold down interest rates, and let inflation decrease debt, or otherwise constrain financial burdens on families and companies to help the rest of the economy realize its potential. The Federal Reserve, under Ben Bernanke, has kept interest rates exceptionally low, incurring criticism that it is risking inflation. Rogoff, formerly chief economist of the IMF, goes further. He would have the Fed deliberately set as a target an inflation rate of 4 or 5 percent as an open strategy of reducing debt burdens by inflating them away, an idea that horrifies the bond market.
Reinhart, in a subsequent paper co-written in 2011 with M. Belen Sbrancia,5 reviewed the experience between 1945 and 1980, and found that there had been continuing financial repression. Real interest rates (i.e., adjusted for inflation), they calculated, were negative on average for the entire period, helping to “liquidate” public debt, partly because the Federal Reserve had a policy of financing the large expenditures of World War II at low costs. During the same era, tight regulation limited speculation by large financial institutions and other investors, so that cheap credit could flow to the real economy without inviting financial bubbles. The 1933 Glass-Steagall Act, for example, prohibited commercial banks from underwriting or trading securities. Yet despite a controlled bond market whose investors suffered negative returns of -3 to -4 percent, the years between 1945 and 1980 were the era of the greatest boom ever.
These findings defy a core precept of conservative economics, the premise that economic growth requires financial investors to be richly rewarded, an idea disparaged by critics as trickle-down economics. The postwar era, by contrast, was an age of trickle-up. Some creditors lost in the short run, but broadly shared prosperity stimulated private business. Eventually, the rising tide lifted even the yachts.
Another former IMF official, Anne O. Krueger, an appointee of George W. Bush, recently reiterated her call for Chapter 11 bankruptcy for indebted countries. When she first proposed the idea as deputy managing director of the IMF in 2002, Krueger was fairly shouted down by officials of the US Treasury and leading bankers. In January 2013, she argued that “a clear mechanism [to allow nations to use bankruptcy] could have prevented all sorts of problems in the eurozone.” With a Chapter 11 law, Greece could have written off old debt and used new borrowing to finance new growth, just like a private corporation. Even acknowledging past bad behavior (as in the case of many corporate bankruptcies), a Chapter 11 for countries could sensibly combine incentives for honest bookkeeping with macroeconomic policies that write off old debt for the sake of recovery.
The discussion about relief of private indebtedness, however, is still mostly offstage. The particulars no longer involve the sequestering of sheep or the seizing of vineyards. But the ten million Americans at risk of losing their homes to foreclosure, or recent graduates who cannot qualify for mortgages because of their monthly payments on college loans, have become modern debt-peons. At the same time entire economies abroad, indentured to past debts, find themselves in a metaphoric debtors’ prison where they can neither repay creditors nor resume productive livelihoods.
These debt traps are not immutable. Government could refinance mortgages directly using the Treasury’s own low borrowing rate, as was done by Franklin Roosevelt’s Home Owners’ Loan Corporation. Fannie and Freddie, remade into true public institutions, could provide the refinancing. The Obama administration’s existing mortgage relief program, run through private banks, excludes the most seriously underwater homeowners. The terms largely prohibit significant reductions in mortgage principal owed, and these limitations should be liberalized by the administration.
For students, an Obama administration program permits about 1.6 million of the 37 million college borrowers to finance education costs by paying a small surcharge on their future income taxes, instead of incurring debt. This option could be made universal. The group Campus Progress proposes allowing college debtors, who currently pay an average of almost 7 percent interest, to refinance their debt at the ten-year Treasury borrowing rate of about 2 percent. This would save young adults $14 billion this year alone. The EU could refinance the debts of small, depressed nations using eurobonds, and the European Central Bank could make clear that it will buy as much sovereign debt as it takes to defend government bonds from speculative attacks.
The crack in the intellectual consensus on public and private austerity is the beginning of a more realistic national debate about debt. But such debt relief policies are a long way from being enacted. The sheer political power of creditors and the momentum of the austerity campaign suggest that more damage to the economy may be done before any large change takes place.
5 Carmen M. Reinhart and S. Belen Sbrancia, “The Liquidation of Government Debt,” National Bureau of Economic Research Working Paper 16893, March 2011; see www.nber.org/papers/w16893. ↩