People often make a distinction between “good debt” and “bad debt,” in terms of both personal finances and public spending: Good debt, according to the theory, is borrowing that pays off over time, while bad debt doesn’t. So it’s OK to finance that new car that will bring you to a better-paying job, or vote for new federal borrowing that will stimulate economic growth, but try not to take out a loan to get a fancy haircut or pay for salary increases for bureaucrats.
In fact, this logic is flawed. As long as the world is uncertain, there is no such thing as good debt or bad debt. There is only good risk management and bad risk management. It’s a crucial concept to understand as the US continues to add to its public debt, which has tripled in the last two decades to almost $36 trillion.
By way of explanation, let’s pretend it is 2010, and you are pre-approved for a $200,000 loan. Do you use it to buy a new and obscure asset that does not have a clear use case, or to pay for an education at one of the world’s most respected institutions of higher learning?
If you had bought that asset — Bitcoin — your $200,000 would now be worth more than $218 billion. If you had opted instead to get your undergraduate degree — from the Massachusetts Institute of Technology — then in a few years you can expect to have made about $1.5 million more than if you had not gone to college at all. The return on the MIT degree is about 14%; on the Bitcoin, it’s more than 1,000,000%.
So it follows that borrowing to buy Bitcoin was a spectacularly good idea, while taking out a loan to go to MIT was … less good. Right?
Not necessarily. What this analysis ignores is the concept of managed risk. Almost every MIT degree pays off in terms of higher wages for life, and you can get a low-interest, fixed-rate loan (or even the possibility of government forgiveness) to finance it. Bitcoin is mere speculation — which sometimes does pay off, as all risky assets can, but also involves a big element of luck.
This logic also plays out in a political context. Democrats tend to favor debt to finance government spending on projects, such as highways or chip factories, that help sustain and grow the economy. Republicans generally support tax cuts because putting more money in the hands of the private sector boosts growth.
In both cases, the basic argument is the same: Good debt boosts the growth rate of the economy, g, enough so it outpaces r, the real rate of interest.
In the 2010s, some economists argued that since interest rates were so low, the government should take on more debt and spend more on the theory that g would be greater than r. The flaw in this argument is that both r and g change over time.
It is not enough to argue the government should take on debt to spend more or cut taxes. No matter what interest rates are, the true test of fiscal health comes down to risk management. Good risk management increases the odds that your bet pays off, or at the very least doesn’t leave you deeper in debt. That requires picking the right investments and managing the cost of your debt — that is, attempting to manage r and g in an uncertain world.
Good risk management starts with investing the borrowed money in something that will probably pay off. Some economists argue that any government spending is worth taking on debt for — even paying people to dig holes and then refill them — because it creates jobs.
This is not the case. The return on a government dollar of spending can vary between five cents and five dollars. Simply stimulating the economy in the short term does not always create value — not just because some projects are better than others, but because of opportunity costs. Spending money on digging and refilling holes means less money and labor spent on more productive pursuits that bring more growth over time.
And even if you pick a project that is projected to create value, say installing electric-vehicle charging stations, you need to ensure the execution on the project leads to a positive return. Many supporters of the Infrastructure Investment and Jobs Act, the CHIPS Act and the Inflation Reduction Act were dismayed that their value to taxpayers was undermined by excessive regulations and the need to appease different political groups, which drove up costs and time.
Many of the laws’ opponents, meanwhile, were skeptical that the government could ever execute efficiently, which is one reason so many Republicans prefer tax cuts. But the devil is in the details here too: Tax cuts can increase growth — but rarely enough to pay for themselves. It depends on what the existing tax rate is, how the tax breaks are structured, and so on. And just like spending, changes to the tax code are subject to political pressure.
Another virtue of risk management is that it accounts for time frame. An investment project might appear to pay off for the first five years, but the benefits eventually wane, and the debt is still there. Perhaps the initial wave of government investment in a favored industry immediately puts people to work and boosts GDP, but over time distortions and waste undermine the productivity of the overall economy.
Then there are details such as how the debt is structured, which is as critical as the investment itself. Risk management is rarely straightforward here. Shorter duration bills normally pay lower interest rates, so if you expect rates to be lower in the future, it is cheaper to issue short-term debt and roll it over as it comes due. But you can also bet wrong about the future of interest rates, and the government has made some bad bets lately.
The figure above shows the average maturity of government debt against the 10-year interest rate. Most of the 2010s featured interest rates below 3%, even near zero toward the end, but the average duration of government debt was just over five years. The government could have issued more, 10-, 20- or 30-year bonds and faced lower payments today. But it didn’t, and now rates are higher. Debt maturity did increase as rates fell, but not by much. The government did not take full advantage of the record-low rates.
Perhaps policy makers believed low rates were the new normal and would last a long time. If so, it was bad risk management. No market condition lasts forever, and good risk management accounts for that.
Debt enthusiasts like to argue that, when it comes to taking on debt, you can’t compare the government to a household: Governments can print their own money to pay their bills. But it does not follow that risk management is not necessary; in fact, it becomes more important, if more difficult. Unlike households, government debt spending (even on good projects) can increase inflation, which pushes up the cost of borrowing even further. So governments need to be more discerning about what investments they make and how they manage their debt — because their debt will last for many decades and can create an even bigger burden on future generations.
The US is on course to run up ever-increasing debt over the next several decades. How much to worry about this gets a lot of attention. Much less is paid to how the government is managing this risk: what it is doing to make its existing spending more productive and efficient, whether it is structuring its debt to minimize rate risk, and how it can manage risk to avoid higher rates in the future.
So go ahead, worry about the nation’s debt. But also pay attention to the nation’s risk management.
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