Consumer Leverage and Government Deficits

The Wall Street Journal published an excellent interview of Tom Hoenig, president of the Federal Reserve Bank of Kansas City. He is the lone voice of dissent regarding the Fed’s low-interest rate and QE2 policies.

He recognizes that consumers were over-leveraged going into (causing) the financial crisis and recession. Consequently. it takes time to re-balance. He’s absolutely correct. It’s a point that is all too easily overlooked by policy makers.

When the value of things I own (assets) is low relative to the value of things I owe to others (liabilities), I am highly leveraged. I don’t own enough things to pay off my debts. In other words, I’m close to (or am) bankrupt.

To prevent bankruptcy, I need to save more/borrow less (they’re identical). To save more, I must consume less. The conventional wisdom is that consuming less (saving more) sends the economy into a downward spiral. Therefore, if I won’t consume more, the government will for me.

What gets overlooked is that my attempt to deleverage gets offset by the government’s attempt to spend. When the government initiates deficit spending, it means my tax liabilities go up.

If I consume $5,000 less worth of goods and use this saving to pay off $5,000 worth of mortgage debt, I am deleveraging. Government realizes the error of my ways and benevolently intercedes on my behalf. It decides to spend $5,000 more on high-speed rail to offset my saving. To do so, it must borrow $5,000.

Government borrowing is the equivalent of future taxation. This means I’ll have to pay $5,000 later in taxes just like I’d have to pay $5,000 later on my mortgage debt as if I never paid it down in the first place.

The ultimate result is that the action of government puts me back in the same position I was trying to escape in the first place: being too highly leveraged. It simply draws out the problem that exists in the first place and delays the rebalancing.