How Democracy Magnifies Debt
All this, however, is only to say that liberal democracy’s commitment to economic growth mandates the existence of the money and bond markets. But my point is stronger than that: democracy is inclined to magnify debt and implicate the bond market in the process. This remains to be shown. To begin this task, then, it is no historical accident that the origins of the modern-day bond market are to be encountered in the Northern Italian republics of the late Middle Ages and Renaissance. Monarchs were able to obtain loans during this era, but only from merchants and banks. 1 9 These would often regret extending the credit. The most notable instance of this was the fatal losses that overtook the Bardi and Peruzzi banks in the mid-fourteenth century. These Florentine banks had lent Edward III, the English king at the time, a substantial sum to finance what historians would subsequently call the Hundred Years War. Suffering a series of early defeats, Edward III reneged on his debt. That set off an international financial crisis, culminating in the bankruptcy of the Peruzzi and Bardi banks in 1343 and 1346, respectively.  Edward Ill’s conduct exemplified the risks of lending to monarchies. With only a single individual ruling in a monarchy, there are fewer constraints on that person’s conduct. So, whenever it becomes tempting to stop making debt payments, little can be done to dissuade a sole ruler. The situation is different where authority is shared, as it was in the Renaissance Italian republics and is now more so in today’s democracies. Anyone vested with executive authority in such regimes is forced to think twice before giving into the beguiling course of debt repudiation. They are accountable to others. More than a few of these other parties will have an interest in seeing that the state preserves its reputation in the eyes of creditors.
Bond investors recognize this. It makes them more willing to lend to democracies than autocracies. A further consideration is that bond markets lack the specialized knowledge and oversight capabilities that banks are able to cultivate through their close relationships with governments. Not being equally positioned to develop such relationships, bond markets shy away from autocrats and lean toward democracies, where close ties to government matter less. Another edge that democracy has when it goes asking the bond market for money is that its leaders have been voted into power. This makes the public apt to accept the state’s liability as its own. Debt racked up by an authoritarian figure is more likely to be viewed as not imputable to the people. Though the exact nature of the advantage is contested, there is a scholarly consensus that the democracies of our epoch have more favorable access to the bond market than autocracies. Democracies thus start with a greater capacity to magnify debt, having a more willing partner with which to do it.
A bit of reflection on corporate taxation leads us to another reason why democracy is given to the aggrandizement of debt. One of the peculiarities of corporate taxation is that interest expenses, which proxies the cost of debt, are deductible from income in most jurisdictions. Dividends, representing the cost of equity, are not. Insofar as dividend payments receive any compensation for this separate treatment, the tax imposed on those monies usually occurs at the individual level among the shareholders receiving them, who are assessed at a lower rate than ordinary income. Yet all this does is reduce the extent of the double taxation incurred by shareholders. For they do not simply pay the government a share of their dividend proceeds. Shareholders also pay indirectly, inasmuch as the pot of available money for disbursement to them from the corporation is reduced by the non-deductibility of dividends. In the USA at least, the government’s privileging of debt over equity seems to have originated in the late nineteenth century with the railway industry’s intense opposition to a law that would have taxed interest expenses and dividends equally. Railway companies—then a political force to be reckoned with—insisted that a charge on interest would destroy their businesses, given the leverage they
were forced to assume to finance large up-front capital costs. Admittedly, this is an interesting historical point, but it does not explain why the same favored treatment of debt prevails elsewhere outside the USA.
A more plausible explanation is that accounting methods initially reflected the interests of creditors. These were the earliest suppliers of financing to limited liability corporations. Creditors are especially concerned to determine how much of a margin of safety a firm has in fulfilling its debt obligations. To do that, they prefer to see interest alone deducted as a financing expense from revenue in calculating profit. This accounting practice also benefits creditors by underlining their priority over shareholders. Were dividends to be subtracted as well, it would give the impression that shareholders have the same claim on the firm’s cash flows. Subtracting interest alone makes it clear that debt holders have first rights over revenues. Perhaps when governments beefed up their tax collection structures in the twentieth century, they simply ended up adopting the prevailing modes of accounting.
Even if this conjecture is true, it cannot explain why the practice of favoring debt persists. After all, governments have not been averse to imposing accounting rules for tax purposes different from those that otherwise guide corporate reporting. Arguably, the most credible solution to this puzzle appeals to the same kind of factor that led to the legalization of interest-based lending to begin with. That is, more investments receive the green light with the privileging of debt, which tends to raise the economy’s over-all growth rate. Nor should one overlook the fact that debt is more of a spur to generate value than equity. Interest payments have to be made no matter what the circumstances may be if a company is to avoid bankruptcy. But dividend payments can always be suspended if a company runs into a tough patch. Debt concentrates the minds of management to seek efficiencies, forge new markets, and develop fresh products.
This type of argument was used to support leveraged buyouts (LBOs). In an LBO, an investment company or a management team buys control of a company, financing the bulk of the purchase with debt. LBOs were the talk of corporate finance in the late 1980s. Back then, LBOs were often financed with the issuance of junk bonds, a security pioneered by
Law Review 18, no. 1 (2014), 33.
Michael Milken at Drexel Burnham Lambert. Junk bonds involve a lower likelihood of repayment than ordinary bonds. In return for taking on this risk, holders of junk bonds are compensated with the prospect of higher yields—hence, why those securities are also referred to more politely as high-yield bonds. LBOs were heavily criticized for loading huge debt burdens on firms. It was alleged that this load forced companies to cut costs through mass firings of workers, while rendering them more vulnerable to economic downswings. Many LBO firms did indeed go bust in the recession of the early 1990s. LBO transactions then became sparse, until being resuscitated again in the form of private equity in the mid-to-late 2000s. After peaking in 2007, LBO activity collapsed with the financial crisis in 2008 and 2009, but has since recovered.
Interestingly, under this reincarnation, the use of leverage has attracted noticeably less reproach than before. Perhaps this is because investors in private equity include pension funds, insurance companies, and university endowment funds. They are all more respectable than the corporate raiders identified with LBOs during the 1980s. They are also more influential in political circles as lobbyists. Whatever the reason might be, the sanctioning of LBOs underlines how democracies eventually reconcile themselves to the presence of significant debt in the economy.
In this, just as in the original legitimization of debt, democracy’s adherence to the principles of freedom continues to make itself felt. Plato, the fifth-century-BCE Greek philosopher, described the typical citizen of democracy as someone who:
lives along day by day, gratifying the desire that occurs to him, at one time drinking and listening to the flute, another drowning water and reducing; now practicing gymnastic, and again idling and neglecting everything; and sometimes spending his time as though he were occupied with philosophy. Often he engages in politics and, jumping up, says and does whatever chances to come to him; and if he ever admires any soldiers, he turns in that direction; and if it’s money-makers, in that one. And there is neither order nor necessity in his life, but this life sweet, free, and blessed he follows it throughout
Fig. 4.4 Total US household debt as % of GDP, 1952-2014. Source: St. Louis Fed
No doubt, Plato’s depiction of the democratic personality exaggerates the flightiness and lack of discipline beyond what an impartial observer in our day would see. But he does capture the fact that, empowered by the right to liberty, people who live in democracies use their freedom in a myriad of ways to express and gratify themselves. To fund all of this, of course, individuals can work hard and save their money until they can afford what they want. Among a people dedicated to autonomy and self-realization, however, this will inevitably seem overly constraining. Instead, they will hearken to financial strategies that allow them to give substance to their freedom now by assuming debt. They would rather not wait until later. They will still work, but not so much to save, as to keep up with their debt obligations. In this way, democracy tends to shift people’s time preferences, such that the present is given greater weight than the future.
There is a rival set of explanations for the secular rise in consumer debt, pictured for the USA in Fig. 4.4. Instead of attributing that rise to a democratically induced demand for credit, as I do, opposing accounts emphasize the supply side of the equation. A commonly held variant is that financial institutions, having been deregulated since the 1970s and 1980s, have sought to maximize their profits by pushing consumers into debt. This effort has succeeded, so the argument goes, thanks to the aggressive marketing of mortgages, credit cards, auto loans, and home equity lines of credit. Encouraging this, purportedly, was the advent of securitization in the fixed income markets. By allowing commercial banks to package loans into bond securities that could be sold to investors, those banks were afforded more room on their balance sheets to lend further to individuals. Moreover, the banks did not have to be careful about the credit worthiness of borrowers. Able to move the loans off their books, the banks figured that they would not be the ones ultimately suffering losses. These would now be borne by someone else—namely, the holders of the bonds containing the loans that the banks first originated.
Another alternative explanation to mine for the escalation of consumer debt was advanced by Daniel Bell. The influential American sociologist argued that the emergence of installment debt, combined with a mass- consumption economy, vitiated the Protestant work ethic. Following Max Weber, Bell held that this ethic formed the moral foundation of capitalism in North America and Northern Europe from the eighteenth century into the early twentieth century. The Protestant work ethic promoted savings and deferred gratification. But it first came under attack by avant-garde elements of the culture celebrating instinct, impulsivity, spontaneity, and hedonism. After World War II, however, these attitudes spread beyond the avant-garde, and were co-opted by the wider community, including by corporations as general affluence increased. In Bell’s eyes, it is capitalism that fuels the growth of debt, not democracy.
It must be conceded that banks can do a lot to promote their credit products with all the ingenuity and allures at their disposal. But nobody is going to take up their offers unless they are already predisposed to do so. A mortgage broker may have a compelling presentation with teaser interest rates and all sorts of other inducements. Still, he will be hard- pressed to arrange any mortgages, if he is speaking to a group of penny- pinching, future-oriented disciples of Benjamin Franklin. By publicizing their services and making their terms more attractive, suppliers of credit can indeed affect the level of debt that is assumed in the community. Yet the willingness itself to assume debt, reflecting the personal trade-offs that have to be made between present and future consumption, comes first. Demand, what people subjectively want, is the determinative factor. Nor is the plentiful supply of goods in general decisive. This is what Daniel Bell implies when he goes beyond the introduction of installment credit in pointing the finger at the prosperity generated by capitalism. Bell, it must be said, is right that a suspicion of debt characterized the earlier stages of liberal democracy. A popular ethics guide during the nineteenth century was a book entitled Self-Help by Samuel Smiles. He inveighed against the assumption of debt, approvingly quoting the proverb, “Who goes a-borrowing, goes a-sorrowing”. Bell is also right to think that the subsequent reversal of that attitude is an epochal change that needs to be explained. Even so, the mere addition of wealth, though it does give individuals greater means to engage in various forms of selfindulgence, does not necessarily make people more present oriented. In fact, all the evidence suggests that the wealthy save a greater proportion of their income than do those with smaller fortunes. Not capitalism, then, but democracy is that which raises what economists like to call individual time preferences.
-  Sidney Homer and Richard Sylla, A History of Interest Rates, 94-95 & 135.
-  James Macdonald, A Free Nation Deep in Debt, 110.
-  Emily Beaulieu, Gary Cox, and Sebastian Saiegh, “Sovereign Debt and Regime Type:Reconsidering the Democratic Advantage”, International Organization 66, no. 4 (2012),
-  Steven A. Bank, “Historical Perspective on the Corporate Interest Deduction”. Chapman
-  Michael C. Jensen, “Agency Costs of Free Cash Flow, Corporate Finance, and Takeovers”,American Economic Review 76, no. 2 (1986), 323-329.
-  Steven N. Kaplan and Per Stromberg, “Leveraged Buyouts and Private Equity”, NationalBureau ofResearch Working Paper, NO. 14207 (2008), http://www.nber.org/papers/14207
-  S&P Capital IQ, “Online Loan Market Primer”, (July 15, 2015), http://www.spcapitaliq.com/insights/lcd-s-online-leveraged-loan-market-primer-almanac-updated-with-2q-data
-  Plato, The Republic, 561c-d.
-  Robert W. Kolb, The Financial Crisis of our Times (Oxford: Oxford University Press,2011), 187-225.
-  Daniel A. Bell, The Cultural Contradictions of Capitalism (New York: Basic Books, 1976).
-  Samuel Smiles, Self-help: With Illustrations of Characters, Conduct, and Perseverance(New York: Harper and Brothers, 1871), 329.