Is debt necessary for recovery?

The chaos in Europe over Greece is the chaos of Keynesian economics in microcosm: the complete and utter explosion of the notion that over-spending and borrowing is the key to growth, progress, recovery or “stimulus.”

As Robert Murphy makes plain:

Since the crisis began, one of the dominant themes in arguments over proper government policy has been the Keynesian view that it is crucial to prop up total spending. The added twist during this particular recession is the crushing burden of private-sector debt, which allegedly makes it all the more urgent for governments to
run fiscal deficits themselves.
    In a previous article I dealt with so-called deleveraging and argued that it was a good thing, both for the indebted individual or firm, as well as the general economic recovery.
    However … it's important to revisit the topic in a more elementary fashion: [specifically, the] casual claim that debt reduction would by sheer accounting cause total spending to fall. This is simply wrong.

Not wrong in the sense you can quibble about it over a couple of jars, but wrong altogether. Wrong in fact:

Imagine a simple world with three people: Cathy the Capitalist, Larry the Landowner, and Willy the Worker. Initially we are in a stable pattern where every period, the following transactions occur:

• Larry pays Willy $1,000 to work on his land and harvest food.
• Willy pays $100 in finance charges on his outstanding debt of $500 to Cathy, which is rolling over at the interest rate of 20 percent per period. (Willy each period just pays the finance charges, keeping the outstanding carried balance intact at $500.)
• Willy spends his remaining $900 on buying some of the food from Larry.
• Cathy spends her $100 in interest income on buying some of the food from Larry.
• Larry eats the remaining food that he hasn't sold to Cathy or Willy.

In this scenario, every period $1,000 is spent on food, the only finished good or service. As officially measured — notice that it misses Larry's "home consumption" — gross domestic product (GDP) for this simple economy is $1,000 per period.
    Now suppose that Willy listens to those who say we should work hard and be debt free, and decides to become debt free. In this particular period, the following might happen:

• Larry pays Willy $1,000 to work on his land and harvest food.
• Willy pays $100 in finance charges on his outstanding debt of $500 to Cathy, which is rolling over at the interest rate of 20 percent per period.
• In addition, Willy pays another $500 to Cathy to extinguish his debt to her.
• Willy spends his remaining $400 on buying some of the food from Larry.
• Cathy spends her $100 in interest income, and her $500 in principal repayment, on buying some of the food from Larry.
• Larry eats the remaining food that he hasn't sold to Cathy or Willy.

Now in this scenario, total spending is still $1,000, and measured GDP is still $1,000. Larry the Landowner wouldn't see a drop in demand for his food. Willy reduced his consumption and saved much more out of his income this period, but this didn't affect even nominal income because Cathy's consumption filled the gap.
    Maybe our scenario isn't likely, depending on various assumptions we can make concerning Cathy's spending habits, but it is certainly possible. So we see that an economy can start out with one person having a large debt, then becoming debt free, without necessarily altering total spending or total income, even when measured in nominal (i.e., dollar) terms.

See. Simple. Even if borrowers stop spending, that doesn’t mean lenders will.

But still, if Cathy is dis-saving, isn’t that a bad thing?  And couldn’t it be said that if Cathy consumes, then there’s not real net aggregate debt reduction in the above scenario?

Yes, Willy paid down his debt by $500, but Cathy in a sense "dissaved" by letting her own financial assets fall by $500. If we like, we can say Cathy's debt started out at -$500, and then ended at $0, meaning her debt "increased" by $500.

So does that explode the argument? Well, no.

I can still show how Willy can pay off his debt without causing total money expenditures to fall, and without anyone in the community even suffering a drop in financial assets.
    To see this, revert to our original scenario, where Willy owes Cathy $500. As before, Willy decides to pay off his debt, through much higher saving. But this time, imagine the following occurs:

• Larry pays Willy $1,000 to work on his land and harvest food.
• Willy pays $100 in finance charges on his outstanding debt of $500 to Cathy, which is rolling over at the interest rate of 20 percent per period.
• In addition, Willy pays another $500 to Cathy to extinguish his debt to her.
• Cathy spends her $100 in interest income on buying some of the food from Larry, as she always has done.
• Larry issues $500 in new stock shares for his landholding corporation, which Cathy buys.
• Larry pays Willy $500 to plow a parcel of his land that was previously uncultivated.
• Willy spends $400 + $500 = $900 on buying food from Larry.
• Larry eats the remaining food that he hasn't sold to Cathy or Willy.

In this final scenario, consumption spending is $1,000 while net investment spending is $500, meaning official GDP is $1,500 — it has actually risen 50 percent! [Just another example of how risible is the GDP Delusion.] At the same time, Willy paid off his debt, while Cathy swapped a $500 bond for $500 in stock shares, so that (considering just these two) there has been a net reduction in indebtedness in the community.
    But what about Larry? Has he simply replaced Willy as the new debtor in our economy?
    No, he hasn't. Although Larry took in $500 while raising funds for his corporation, he is not indebted to Cathy, and so we can't say that his financial decision during the period somehow offset Willy's debt repayment. Cathy doesn't have a debt claim on Larry; instead she owns equity in his corporation. There is a whole literature in finance on the important differences between debt and equity, including the fact that debt financing makes a firm leveraged, whereas equity financing does not.
    It's not even the case that Larry will have to reduce his future consumption in order to make dividend payments to Cathy (to justify the initial valuation of her stock at $500). So long as Larry's $500 investment is sound, the new field will increase future harvests, possibly allowing Larry to maintain his original consumption of food even though Cathy now has an ownership stake in the net profits of the business.

Conclusion?

Contrary to the assertions of pundits like Paul Krugman [who Murphy skewers in his full post], an economy does not need mountains of debt — whether government or private — in order to grow. Corporations can still raise needed financing through issuing equity. There are pros and cons to debt financing, but it isn't necessary for a strong economy.