How Much Debt is Too Much Debt?

David Beckworth and Ramesh Ponnuru recently penned a piece for The New Republic on nominal income targeting. In response to this Joe Weisenthal and Nicole Gelinas have posted the following graph:

Each of the authors posted the graph and said (essentially), “see we have too much debt” and subsequently suggested that the monetary policy advocated by Beckworth and Ponnuru would make things worse. David and Ramesh have responded to this criticism by defending nominal income targeting. However, I would like to put monetary policy aside for a moment and talk about data and how we should use data.

The graph illustrated above shows the path of household debt as a percentage of income. Joe and Nicole each say that there is too much debt. Okay, but how much is too much? In other words, even if I were to agree with Joe and Nicole as to idea that there is too much household debt at present, how would I know when it had sufficiently fallen to an acceptable level? Saying there is too much debt presumes that there is an optimal amount of debt and that current levels exceed that optimal amount. In order to assess whether or not there is too much debt, it is therefore necessary to have some type of framework for assessing debt levels. Such a framework would presumably require a sufficient understanding of banking, intermediation, liquidity, household preferences, etc.

When reading this, I couldn’t help but to think of this quote from Milton Friedman:

I don’t believe that statistics, as somebody has said, statistics do not speak for themselves. Alfred Marshall once said, “There is no person, no theorist so reckless as he who says that the facts speak for themselves.” The facts never speak for themselves. They have to be interpreted in terms of some understanding of where they come from and what the relation between them is.

8 responses to “How Much Debt is Too Much Debt?

  1. Debt against income is always a somewhat strange juxtaposition. Debt servicing against income or debt against assets make more sense.

  2. Maybe I’m being silly here, but surely CETERIS PARIBUS the optimal amount of debt is zero debt, or rather redundancy for robustness. I understand that when you relax ceteris paribus, it may be more optimal to take on debt in certain situations, but that’s another issue.

  3. Lorenzo,

    Precisely. If one is interested in such metrics, debt as a percentage of net worth would be substantially better than debt as a percentage of income.

    In addition, according to the “debt/income” metric, and the authors’ assessments of sustainability, buying a house is unsustainable. For example, suppose that somebody who earns $30,000 per year buys a $100,000 house with 40% down. In this case, their debt/income metric is 200% (and over that when you factor in interest). However, it is entirely reasonable to think that they could pay back the loan.

    Brito,

    Why would zero debt be better? In a world with finite income and wealth, it is certainly optimal to have some level of borrowing, isn’t it?

  4. In the real world it is optimal to take on debt for consumption smoothing and to finance projects which pay out in the future, yes, but isn’t that relaxing the ceteris paribus assumption? I guess my point is, debt on its own is inherently negative. I guess this is irrelevant when I think about it though.

    Still, it’s probably optimal to have less debt than what some sort of optimal maximisation problem over say a 3 decade horizon would suggest, so as to be robust to unforeseen shocks.

  5. I don’t know how much debt is too much; probably less is better.

    That said, if you find yourself over-indebted, the right thing to do is to increase output, and pay down debts. Work more.

    Not reduce output and work less (A recession).

    Exactly the wrong macroeconomic policy is one that would reduce output and prevent any debt-cutting inflation.

  6. Pingback: How Much Debt is Too Much Debt? « Paying Debt

  7. Pingback: Someone Help Me! I Have Too Much Debt « Debt Elimination

  8. Too much debt means that the people lending the money no longer believe you can pay them off. The trick is to figure out when that is going to happen.

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