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How Democracy Enables Debt

Despite this impressive record in pricing yields, one is hard pressed to contain the gnawing suspicion that the bond market’s acuity and prescience are limited—indeed, perilously limited. Though numerous facts can be summoned to corroborate this suspicion, nothing feeds it more than a striking anomaly that has played out over the past three decades. Since the early 1980s, government bond yields throughout the developed world, as mirrored in interest rates, have steadily declined. Meanwhile, the weight of government debt has pretty much done nothing but trend upward. How can this be? Has not the likelihood of full repayment fallen? Should not yields increase to reflect that reduced likelihood?

This anomaly does not go unnoticed, though it is rarely probed. The decline in yields is typically chalked up to the success of the world’s central banks, led by the US Fed, in bringing down inflation. But this cannot explain why real current yields—the yield on a ten-year US government bond minus the prevailing US rate of inflation—has fallen as the debt has escalated. In 2001, the last time the USA ran a budget surplus, that inflation adjusted yield was 2.29 %. Then move forward to the end of 2014, by which time the country’s public debt had nearly doubled as a percentage of GDP. By then, the ten-year Treasury bond was trading at a 0.61 % above the going rate of inflation. The bond market was charging less real interest to a much more indebted customer.

what is going on? Recall the tax consumer versus taxpayer dynamic from the previous chapter. There, we had emphasized how, in a democracy, the class conflict between tax consumers and payers leads politicians to run deficits. To finance these deficits, democratic states are propelled to secure full control over the money supply and unshackle themselves from any constraint, such as the gold standard, on printing the money necessary to pay its obligations. This same imperative, in tandem with the mores and culture of democracy, presses it to rely on the debt financing offered by the bond market. With this credit tap on hand, democracies are able to indulge its natural proclivity toward debt, stacking up ever greater amounts of it. So powerful is this attraction to debt that wherever it does not overwhelm the bond markets, it will at the very least distort the latter’s judgment of public finances. To lay this all out will take us beyond finance and economics into history, politics, and psychology.

That democracy is primed for debt is something that first comes into view when we wonder why bond markets are allowed to exist at all.

This will likely strike many readers as a strange question to raise, so for granted do we take those markets as a fact of life in advanced societies like our own. Yet the practice of lending on interest, which the credit markets embody, was, until comparatively recently, morally and legally discouraged in the Western world. It remains so in those countries influenced by Islamic teachings. As the most all-encompassing organization in society, the state can always choose to wield its coercive power and moral authority to eliminate interest rate contracts. If not that, governments can at least push such deals to the margins of the economy, as many of them do with loan sharking. It is not as if debt is absolutely necessary to finance economic activity. Societies always have the option of favoring equity financing. Under this arrangement, the owners of the firm supply the money to buy the assets and resources needed to start up and operate a business. The resulting profits and losses are then shared. Instead of incurring debt, governments could rely solely on taxes to fund its activities alongside any profits generated from its own enterprises.

To solve the conundrum, let us recount the story of how interest- based lending became morally licit. That practice only acquired full moral legitimacy, only ceased to be identified with the sin of usury, around the seventeenth and eighteenth centuries when liberal democracy was germinating. This was no coincidence. Our democracies have various features that not only permit credit markets but actually necessitate them. Before liberal democracies were born, philosophers and theologians were virtually united in giving their intellectual support to prohibitions on the charging of interest for loans. Aristotle was the greatest authority in this tradition, maintaining in The Politics that money is meant to be utilized in exchange.[1] Deployed in this way, money is used up or consumed. By charging interest, however, money does the opposite of this in reproducing itself. On this basis, Aristotle concluded that lending on interest was unnatural and, therefore, morally wrong. As part of his effort to synthesize Christian teachings with Aristotelian philosophy, St. Thomas Aquinas expounded on this argument in the Summa Theologica.[2] He drew a distinction between objects whose use consists in their being destroyed and those which can be employed while preserving their substance. A glass of water is an instance of an object being destroyed upon usage; the person who drinks it leaves nothing for others. A tract of land that is worked to cultivate corn is an example of an object retaining its substance upon usage; the land remains after harvest to be planted on again. In sympathy with Aristotle, Aquinas equates money with the first type of good on the argument that its purpose is to be spent in transactions. Hence, to sell money as if it were a good that continues to exist after its use is essentially to offer nothing to the borrower in return for something. That is hardly a fair trade, at least when construed in those terms. What about the argument, though, that both the lender and the borrower consent to the terms of the loan? Nowadays, consent serves as something of a moral trump for transactions between adults, but Aquinas thought otherwise. He argued that inasmuch as borrowers are in urgent need of the money, they are not authentically free in agreeing to a loan.

It is not uncommon for this pre-modern philosophic stance to be explained away as a mere product of the times. Bertrand Russell, for example, observes that ancient philosophers like Aristotle were tied to a landowning ruling elite. 1 5 Since land cannot be easily liquidated, any immediate need for cash could only be met by borrowing. As such, the landowning class had a strong incentive to limit what creditors could charge them. That the antipathy to interest continued to persist after Christianity acquired ideological dominance in the West can be similarly accounted for by the fact that the Catholic Church held land as its chief asset and so tended to be a debtor. After the Reformation, the climate of opinion became more favorable to interest lending, as the leading theologians and philosophers of the period were connected to the commercial classes. Prominent within this class were those whose professional occupation was to provide credit. Contemporary philosophers, Russell adds, have not generally endeavored to revive the old moral animus against interest since they are mainly employed by universities. Bonds represent a significant proportion of these institutions’ endowment portfolios.

It is admittedly more than a coincidence that conceptions of usury have altered in line with the shifting of economic interests affecting intellectuals. Even so, Russell’s brand of historicism cannot explain how some of the late Scholastic thinkers of the sixteenth and seventeenth centuries, operating within the ambit of the Catholic Church, qualified the Aristotelian-Thomist teaching. They did so by acknowledging that money [3]

can reproduce itself. Not only that, they recognized that a lender gives up the chance of profitably using the funds he or she hands to another. They saw there was an opportunity cost incurred by the lender that deserves compensation. Notable in this regard was Felipe de la Cruz, who in his 1637 work, Tratado Unico de Intereses, caught sight of the essence of interest in stating that, “the right to receive money in the future has less value than money received in the present”.[4] Granted, the late Scholastics proved incapable of completely transcending the philosophical and religious authorities of the day. Nevertheless, they managed to puncture that tradition with insights that began the evolution toward a better understanding of the phenomenon of interest.

Certainly, there emerged compelling intellectual grounds for such a development. The Aristotelian-Thomist view presupposed a teleological picture of reality, according to which the nature of a thing is properly understood by grasping its end or telos. In this way, the essence of money was defined as an object of consumption precisely because its overriding purpose was to be used in exchange. But the scientific revolution of the sixteenth and seventeenth centuries subverted this understanding. The universe came to be seen as something better understood by way of the efficient causes of things. The scientist was now to focus entirely on how things come to be. No longer were scientists enjoined to determine final causes, to wit, the purposes for which things exist. Applying all this money, it no longer made sense to view the medium of exchange simply in terms of its purpose as a facilitator of exchange. It made more sense to see money in terms of all the cause-effect relations of which it is susceptible. Money’s capacity to augment itself in the act of lending no longer appeared deviant. One could now interpret that multiplicative character as a compensation for time and risk.

Concern for the plight of the less advantaged, more pronounced in the Christian as compared to the classical pagan animus toward interest, also became less determinative. The rise of commerce from the Renaissance period forward meant that the provision of credit increasingly took place between businesspersons, or between them and members of the nobility. It was no longer so much the moneyed elite lending to the lower socioeconomic orders. The latter could be defended against predation, without impinging on the activities of the more advantaged groups, by redefining usury as the charging of excess interest. That, of course, is how usury is understood today.

By the time liberal democracy was beginning to germinate in the eighteenth century, the moral transvaluation of interest had largely been accomplished. Nonetheless, the emergence and spread of that regime served to consolidate this epochal alteration in values. What must never be forgotten is that liberal democracy is distinguished from the pre-modern polities it displaced by its neutrality toward the good life and the meaning of existence. It used to be thought that the state should endeavor to promote a particular way of life and view of the universe. In the ancient world, the warrior-statesman heedful of the many pagan deities tended to be set up as the role model. In Christian societies, that role was taken up by the saint devoted to the one, all-knowing and omnipotent God. The internecine religious conflict that ravaged Europe during the sixteenth and seventeenth centuries led the Enlightenment thinkers to conclude that social peace could only be assured by limiting the government’s role to the safeguarding of people’s lives and possessions. Everyone is left free to pursue their happiness as they saw fit, believing and doing whatever seems to them correct, on the condition that they not harm others. With the right to liberty thus established as a democratic norm, the giving of individual consent became a decisive criterion of whether or not a given action passes the moral bar. It is on this basis that Jeremy Bentham finally settled the interest question for the Western democracies. Against Aquinas, he argued that no wrongdoing occurs if both the creditor and debtor freely agree to the terms of a loan.[5]

Freed from government paternalism regarding the purpose of life, most individuals will naturally be inclined to define happiness in hedonic terms. Living a good life will be about enjoying pleasure and avoiding pain. Obviously, what is deemed pleasurable and painful will differ from one person to the next, but the vast majority naturally tends to converge on the necessities, conveniences, and embellishments of life. Hence it is that most denizens of liberal democracy put much of their energies into the pursuit of a materially comfortable existence. As this cannot be provided without the generation of wealth and prosperity, the politics of liberal democracies comes to be inevitably oriented around the objective of economic growth. One need only consider how almost every election is swayed, if not decided, by the state of the economy to acknowledge this point. Even if guilty of idealizing classical civilization, the French philosopher Jean-Jacques Rousseau was basically on the right track in saying: “The politicians of the ancient world were always talking of virtue and morality; ours speak of nothing but commerce and money”.[6] Thus does a formally neutral position on the part of democracy about the ultimate good for humanity substantively end up in a form of government biased toward a bourgeois way of life.

Such an existence would hardly be a reality for more than a minority if it were not for the widespread availability, made possible by the allowance of interest, of debt finance. In essence, finance is about managing the fundamental economic fact that revenues, be it those of a firm or an individual, do not synchronize with expenditures. The operator of a fast- food restaurant must put up the money to rent space, obtain equipment, and buy supplies, even before selling a single hamburger. A retailer specializing in Christmas goods must pay workers at regular intervals throughout the year, even should most of its sales will be concentrated in December. A newly married couple may want to buy a house for the family they are planning to have, though it might take them both 20 years of wages to earn the list price. If credit cannot be readily obtained, then the fast-food operator will have to find someone willing to invest in an ownership stake in the restaurant; the Christmas goods retailer will have to keep more cash on hand to pay workers from January to November; and the newlyweds will have to stay in their rented apartment and save their money. The upshot of all this is a decrease in economic activity. Instead of investing in value-creating projects, the Christmas retailer’s cash must lie idle in order to make payroll. Rather than having a new home constructed for the newlyweds, the existing rental stock would have to accommodate them. And while a restaurant owner can conceivably receive equity financing, the projected return on investment would have to be higher than it would with debt. Unlike shareholders, creditors legally have the right to be paid before a company’s owners and often have their loans secured by assets. For this reason, the cost of debt is generally lower than that of equity. This sets the bar higher for equity as opposed to debt for when to invest in an enterprise. The expected rate of return needs to be higher with equity to make up for the additional cost of financing. Hence, an economy that solely relies on equity will see fewer projects funded; an economy that also permits debt will see more projects funded. This last prospect suits democracy better.

  • [1] Aristotle, The Politics, Bk I, Chap. 10.
  • [2] St. Thomas Aquinas, Summa Theologica, trans. Fathers of the English Dominican Province,II.II.Q78,
  • [3] Bertrand Russell, History of Western Philosophy (London: Routledge, 2004), 181-182.
  • [4] Felipe de la Cruz cited by Alejandro A. Chafuen, Faith and Liberty: The Economic Thoughtof the Late Scholastics (New York: Lexington, 2003), 122.
  • [5] Jeremy Bentham, Defence of Usury (New York: Theodore Foster, 1837).
  • [6] Jean-Jacques Rousseau, “Discourse on the Sciences and the Arts”, The First and SecondDiscourses, trans. Judith R. Masters (New York: St. Martin’s Press, 1964), 51.
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