Private Debt Can be Dumb, Too
We are an over-leveraged nation
This is Part 3 of Rule 9: Debt is Dumb.
Dave Ramsey has made quite a career telling private individuals that debt is dumb -- and often he is obviously right. But some of his advice bothers me. Going into debt to go to college is quite rational if you are college material, if you are going to do the work, and if you are majoring in a field that pays well. Stretching the college years out by having a side job instead of going full time is an expensive waste of time. And then there is the advice to live dirt cheap and have a two or three job family while having kids in order to get rid of that student loan debt. This disturbs me greatly. If this is good advice, then there is something terribly wrong with our system.
And there is yet another problem with Ramsey's advice: our government loves debt! The government guarantees all sorts of loans. The government gives homeowners a tax deduction for keeping their home mortgaged. Use your extra income to pay off your home, and you not only reduce your home mortgage deduction, but you also lose tax deferrals from putting that money into retirement accounts. And finally, there is monetary policy; as I write this, mortgage rates are considerably lower than inflation -- this is a pretty powerful incentive to go into debt and buy real goods with both hands.1
The government loves business debt as well. Dividends are double taxed; corporate bond interest is not. Corporations can treat bond interest as an expense for corporate income tax purposes. And investors in corporate stocks can deduct interest from buying on margin.
All this government encouragement encourages some really dumb debt, debt which crashes the economy every several years.
Take buying stocks on margin, for example. When a stock goes down, the highly leveraged get margin calls, forcing them to sell -- which pushes the stock down even further. This is an ugly positive feedback loop, the exact opposite of Adam Smith's Invisible Hand. Recall the stock market crash of 1929, which kicked off the Great Depression. Short selling is also a form of borrowing. When a stock goes up, the shorts need to buy back shares -- yet another positive feedback loop. Recall the recent short squeeze in GameStop stock.
Similar things happen in the housing market. If you only need to put down 5% to buy a house, you triple your money if the price goes up 10%. When you sell, you have enough for a down payment for a house three times as expensive -- or you would if commissions weren't so high. Commissions and the general illiquidity of the housing market provide some dampening, but the positive feedback exists nonetheless. Today, housing prices have been driven ludicrously high, too high for most of those who don't already have an overpriced home to sell.
Those who rent are restless for good reasons.
And let us not forget the 1980s, when hair-gelled Harvard MBAs looted America's classic corporations by mortgaging their future via junk bonds. Our once great companies were loaded down with debt; a dip in the economy or a bit of fresh competition from abroad and bankruptcy followed. Republicans blamed unions; Bill Clinton got elected.
Corporations funded with equity can gracefully shrink when their market shrinks; The Invisible Hand can turn the knobs and adjust size and activity. Corporations loaded down with debt are committed to a rosy scenario; their knobs are frozen in position; The Invisible Hand grabs a large hammer...
So what is to be done? For starters the government should get out of the business of loan guarantees. (See Proverbs 6:1-5, 11:15) Margin interest should not be tax deductible; disrupt the economy on your own nickel. (Buy call options if you want leverage as well as a tax write-off when things don't work out.) And perhaps there should be some limit of the deductibility of corporate bond interest. Or perhaps we should handle dividends differently. This is tricky business. I'll dwell on it more deeply in a future Rule.
As for individuals, I want to alter the tax code so that Dave Ramsey's advice makes more sense. Young people should be paying down debt, saving to start a business or put a solid down payment on a home. These things should take priority over saving for retirement! Saving for retirement when you are in your twenties makes sense if either:
You don't intend to start a family.
You have a high enough income that you can comfortably save aggressively for early retirement. (See the Mr. Money Mustache or Early Retirement Extreme blogs.)
Our current system is family unfriendly! Between the need for excessive college, favoring investments over work, overpriced housing in safe neighborhoods, and encouragement to lock early savings into retirement accounts, is it any wonder that a decade of debauchery before marriage has become the norm? A more natural and family friendly financial plan would be to live off of one income while young and invest in the kids. When the kids grow up, that's when it's time to go two-income: one income to live off of and the other to save.
I want a tax code which is friendly to such a plan. For starters, if we are to have deferred retirement plans, unused deductions should be carried over to future years. Those who invest in their kids while young should be able to cram money into retirement funds when they get to that point in life. Better yet, just get rid of tax deferred savings plans entirely; let people mix rainy day money and retirement money. Fewer accounts mean fewer fees. Also, the need for certain types of insurance goes down. Instead of deferred retirement plans, I suggest making the income tax tiny for the 99 Percent and tax them instead via consumption taxes. Those who save get an automatic tax deferral. Simple!
Then there's that pesky home mortgage deduction. Encouraging home ownership is a very good thing -- at least where people have room to live in standalone homes. But do you truly own your home if the bank holds the title? On the third hand, if individuals don't get a deduction for home mortgage interest, and investors do, this gives the appearance of favoring renting over owning. (I wrote "appearance" because investors pay tax on the rent so renting is taxed more than owning.) Maybe we should get rid of the mortgage interest deduction and the interest deduction for investing in rental homes (which is a kind of margin buying, after all). However, perhaps this should apply only to single-family homes. Buying and running apartment buildings without debt might be problematic. And for such multi-family structures, I see less point in encouraging home ownership, as you don't truly own a condo.
Given how some Wall St. firms have discovered the joys of buying up single-family homes for renting out, I think we need a different subsidy for home ownership, in order to stave off that Great Reset thingy. I believe that the proper tool is property taxes. Tax individuals less than corporations. Furthermore, give individuals and families a homestead exemption for the home that they live in. For example, let the first $50,000 in home value be tax free for a married couple. Such a move would throttle the Wall St. firms which are buying up America. It would hit individual real estate investors, albeit less. And oops! It would hit Dave Ramsey. Then again, rumor has it that Dave Ramsey is doing better than he deserves...
I originally wrote this Rule a year ago. Mortage interest rates are now closer to official inflation rates. But are they up to the real inflation rate? The Science isn’t settled…
For the record, the tax exemption for mortgages vanishes quickly unless you have other deductions you can leverage. In all the years of my home ownership it always has and still does make more sense for me to claim the standard deduction. But still I prefer to pay my mortgage than to pay my landlord's mortgage. But Dave Ramsey has a point, saving up and paying cash would have been better.