Growing Out of Debt

There's a room where the lights won't find you
Holding hands while
The walls come tumbling down
When they do, I'll be right behind you
--Tears for Fears

An entrepreneur has a great idea for a business. She borrows money to build the business. The business is successful. At some point, she pays off her debt. She has 'grown her way out of debt.'

So why is it unwise that policymakers justify borrowing in order to grow a country's (e.g., US) way out of debt? Why isn't it like the entrepreneur's situation?

One obvious reason is that successful entrepreneurs are rare. The vast majority of new ventures fail. Successful entrepreneurs who move to debt free positions constitute a small minority. People who like to use the entreprenurial analogy for justifying US borrowing habits forget or ignore the 'survivor bias' present in their flawed logic.

Stated differently, entrepreneurs do not typically grow their way out of debt.

Instead of stopping right there, let's, for the sake of argument, assume that the US has the stuff that successful entrepreneurs are often made of. Of course, such 'stuff' is not easily recognizeable--at least ex ante--otherwise only successful entrepreneurs would ever be funded. Overconfidence in our ability to detect successful ventures aside, assume that we have found a situation where entrepreneurial credit risk might be attractive.

The problem here is that the US is not a nascent borrower. It has been been racking up debt for years. Entrepreneurs begin borrowing from unleveraged positions and from positions where returns on investment appear favorable to creditors. If those positions apears less favorable, then borrowing costs increase or credit gets cut off.

The data indicate that the US is no longer an attractive entrepreneurial credit risk. US credit growth has chronically outpaced economic growth. The gap between growth in debt and growth in output has been widening. In unhampered markets, this situation reflected in the above graph should have driven US borrowing costs higher years ago.

So why hasn't it? Because the credit markets are severely hampered. Central banks have been suppressing interest rates below market for years. Thru their 'quantitative easing' programs, CB's have even been buying sovereign own debt (also known as 'debt monetization').

This is the most important reason of all as to why the entrepreneurial 'growing out of debt' situation does not apply to countries such as the US. Entrepreneurs cannot manipulate prices like governments can. And government capacity for market manipulation has driven capital misallocation on scales impossible to fathom in free market situations.

One group who will come to fathom the magnitude of the 'grow your way out of debt' folly: our kids.