05/06/2013 10:18 pm ET Updated Jul 06, 2013

Debt Derangement

Bob Kuttner has been among the country's most visible advocates of stimulus, having written several books and numerous columns arguing the case for an aggressive program of public investment as the best way to deal with the economic crisis. His new book, Debtors' Prison: The Politics of Austerity versus Possibility (Knopf, 2013) is his latest shot at the austerity gang.

The central theme is the morality tale around debt. The proponents of austerity insist that the debtors be forced to suffer. This is part because of the obvious moral hazard problem, if people think that debtors can get off easy, then no one will pay their debts. It is also partly appeals to our sense of morality, we want people to work hard and meet their commitments.

As Kuttner points out, there are two big problems with the debt hardliners' agenda. First, it is often bad economics. The book goes back to the days of debtor prisons in England, pointing out that throwing debtors in jail not only was cruel to debtors and their families, it generally was not good policy from the standpoint of creditors either. Once the debtor was in prison they had little opportunity to earn back any of the money needed to repay their creditors.

Kuttner shows how this desire for punishment has played a central role in shaping attitudes toward the crises countries in the eurozone as well as underwater homeowners in the United States. This attitude has helped to prevent an effective policy response in both places. In Europe the debtor countries have seen their unemployment rates soar even as their debt to GDP ratios continue to increase. Shrinking economies have reduced tax collections and increased demands on the budget. In the United States many homeowners have ended up in foreclosure when it would have been possible to arrange principle write-downs that would have both kept them in their homes and given creditors more money.

The other problem with the debt hardliners' agenda is that is doesn't get applied consistently. While poor countries and underwater homeowners are supposed to pay the price for their mistakes, other troubled debtors, like Citigroup and Bank of America, can count on a service with a smile as the government comes to their rescue. It is impossible to miss the fact that the people most directly responsible for this crisis have almost invariably come out fine because they were able to use their political power to get government handouts.

The book provides many fascinating insights on the history of debt as well as a solid account of the current crisis. While I agree with most of Kuttner's argument, there is one serious quibble that I would raise that starts as a pet peeve and rises to an important point.

At one point Kuttner discusses U.S. policy toward China. He argues that the United States has not cracked down on China's various trade offenses, including currency manipulation, because it can't afford to piss off the country's biggest creditor. While this is a common assertion, on closer examination it is self-contradictory.

The way that China keeps down the value of its currency against the dollar is through buying up dollar assets, most importantly U.S. government debt. In other words, China's "manipulation" of its currency is its purchase of U.S. government bonds. We have to decide whether we are angry at China for buying our bonds or we need them to buy our bonds, but it doesn't make sense for both to be true.

As a second point here, I would argue that it is not concerns about China that prevent us from cracking down on Chinese practices that are harmful to the U.S. economy. Rather it is the power of the U.S. interests that benefit from an under-valued yuan that prevents us from cracking down. Wal-Mart does not want to see all the goods it imports from China rise in price by 20 percent. Neither does GE nor any of the other manufacturers that have set up operations there. The financial industry is happy to have its dollars go farther in their efforts to penetrate China. And Microsoft and Pfizer would rather have our chits with China devoted toward increasing respect for their copyrights and patents in China than in rebalancing trade. The enemy in this picture is here, not in China.

Finally, there is an important point about our trade imbalance that is overlooked in this picture. The trade deficit was actually relatively small until the East Asian financial crisis. The punitive measures imposed by the Gang of Three, Alan Greenspan, Robert Rubin, and Larry Summers, led to the developing world to accumulate massive amounts of foreign exchange (i.e. dollars). This sent the value of the dollar soaring and gave us the huge trade deficits of the last decade.

These trade deficits were the basis of our economic imbalances. In mainstream economic theory, rich countries are supposed to running trade surpluses with fast-growing developing countries. The Greenspan-Rubin-Summers bailout magic reversed these flows. This was the basis of the havoc we suffered through in the last decade and that we continue to suffer through at present.

Okay, enough of my digression. This is a well-written well-researched account of the current state of the economy. It is worth reading.