Silly Europe, Debt is for Kids

One of the topics economists wrangle about is whether, in a recession, governments should cut spending in order to keep outlays in line with reduced tax revenue and avoid debt, or increase spending in order to try to relieve suffering and prop up consumer spending. For the spenders, the argument is that it's much less painful to get a country out of debt by returning it to economic growth (with the result that tax revenues naturally grow) rather than cutting spending. Matters of principle aside, Megan McArdle (working off a post by Tyler Cowen) points out that the "grow your way out of it" may not be a realistic scenario for rapidly aging countries where the birth rate is well below replacement rates (read: Italy, Greece, Japan, etc.)

Strong growth by Europe’s troubled debtor nations would of course offer a different, and less painful, way out. After all, if you make $30,000 a year, a $10,000 credit-card balance is crippling; but if you make $300,000 a year, it’s fairly trivial. The faster Italy’s economy expands, the more manageable Italy’s debt becomes.

But that’s where the dearth of workers comes into play. Everyone agrees that rapid growth would be much nicer than higher taxes and slashed pension payments. The hitch is that over the past five years, growth in the Italian economy hasn’t averaged even 1 percent a year. Soaring growth will be tough to achieve, because more and more Italians are getting too old to work -- and fewer and fewer Italians have been having the babies needed to replace them.

If you do a big stimulus when the population is growing, you can expect, over time, to be able to spread debt payments over more people. The value of the debt may not change, but the per-capita debt burden will shrink.

But if you undertake a big stimulus when the population is stagnant, or even declining, then over time, the per-capita debt burden will rise … and if your society encourages long retirements, the debt burden per-worker will rise even faster.

That may change the cost-benefit calculation quite a bit when you’re considering a stimulus program. Not so much in the U.S., at least right now, because our population is growing. But this may suggest that however painful austerity has been for Europe, the austerians still did the right thing.

This is actually not unlike the considerations necessary in household finance, where a useful concept when thinking about debt is that of total lifetime earnings. The idea is that your spending during your adult life is based on an assumption of how much you're likely to make over the course of your life, not just how much you make now. When you're fairly young, most of your earning years are still ahead of you, and you'll probably make more in the future than you do now. In that situation, using debt to deal with large purchases (car, house, etc.) makes a fair amount of sense. You haven't had much time to save, and you will probably be making plenty more money in the future to deal with the obligations. For the same reasons, when you're young you often need to use debt in financial emergencies. When the car breaks down or the heat goes out, you probably don't have the savings to deal with the situation, so you need to borrow, and within reason you have a very good chance of being able to meet those obligations.

As you get older, however, you need to wind down debt obligations, because you have fewer earning years ahead of you. If you incur a thirty year mortgage at 60, you're saying you'll be paying on that debt until you're ninety, or more likely that you'll never clear that obligation. As you near what, on average, will be your peak earning years around 50, you need to be much more heavily focused on saving, and much less willing to take on debt, because you have fewer earning years left in front of you and you are less likely to make more in the future than you do now. Getting into debt on the assumption that you'll grow your way out of it will no longer work.

Of course, countries don't have a set lifespan. But to the extent that a society stops growing and starts becoming older and smaller, it has little ability to grow its way out of problems. For the US this is already a somewhat iffy proposition. For rapidly aging countries, it's not remotely possible.