Switzerland was singled out in this week’s Economist cover story on the dangers of tax-free debt. The article however, skips over essential detail and overlooks the elephant in the room.
Debt is more dangerous than equity. When crises strike the fixed obligations associated with it send shock waves through the financial system as lenders panic over the possibility of borrowers not returning their money. Slow painful negotiations, bankruptcies and restructuring take place and get in the way of economic recovery.
Equity on the other hand inflicts quick losses on shareholders who are forced to take it on the chin. Life then quickly moves on to rapid economic recovery. Compare the fast dot-com crash and recovery to the long painful period that followed the collapse of Lehman Brothers in 2008.
Making loan interest tax-deductible encourages borrowing instead of share or equity issuance. Essentially favouring more risky rigid finance over the good flexible stuff.
So far this makes good sense.
Switzerland singled out on home loans
What is true for business is also true for individuals. In a crisis big mortgages can leave homeowners stuck unable to sell or refinance, sometimes facing bankruptcy.
The Economist singles out Switzerland (and the United States) as a nation suffering from the curse of tax-deductible interest on home loans. The UK, which got rid of the policy in the 1990s, seems to get a gold star.
What is not mentioned is Switzerland’s policy of large home deposits, a much more effective brake on mortgage growth than the removal of tax-deductible interest. Unlike the UK, Switzerland requires home buyers to put down deposits equal to at least 20% of the bank’s valuation of the property, which is sometimes lower than the purchase price.
Another element missing from the Economist’s analysis is Switzerland’s imputed rent. Owner-occupiers must add an imputed rental value to their taxable income based on the floor area of their home. This mechanism negates much of the tax benefit of tax-deductible mortgage interest.
The elephant in the room
If tax incentives to borrow encourage dangerous levels of debt, then surely creating very low interest rates such as those we see today is even worse.
Central banks have worked hard, with stern talk and Quantitative Easing (money creation), to drive interest rates down. And it has worked. The US Federal Reserve got busy after the dot-com crash in 2000 and other central banks, through uncompetitive exchange rates, have been forced to follow suit or see themselves priced out of global markets by strong currencies. As a result of this global knock on, Switzerland’s central bank now charges 0.74% interest on money deposited with it.
The lure to borrow resulting from tax-deductible interest is tiny compared to that from declining interest rates. On 2 January 2008 Swiss 12-month Libor was 3.0%. On 15 May 2015 it was -0.6%.
The most important drivers of debt growth are not tax deductibility but very low interest rates, and in the case of home loans, low mortgage deposit requirements.
Lessons not learned
A recent McKinsey study entitled: Debt and (not much) Deleveraging, shows how far world debt levels climbed between 2007 to 2014. Total global debt has mushroomed from US$144 trillion to US$199 trillion. This 38% increase, helped along by increased government borrowing, has outstripped global economic growth.
An over-sized boost to billionaires
Low interest rates are great for those who own things and are able to borrow. Cheap loans can be used to turbo charge returns on equity. Private equity firms sometimes use this trick to pay themselves dividends at the expense of the companies they own – in a New York Times article the former president of a company owned by a private equity firm explains “…the mind-set was, since the money was practically free, why not leverage the company to the maximum?”
Low interest rates also push up stock prices as investors shift out of low return loan assets into shares. This drives up the value of companies owned by billionaire families.
And those who own the most get the biggest boost from this, helping to drive the narrow concentration of wealth at the very top.
This distortion is fast becoming the poster child of inequity, driving a slow-burn increase in resentment across much of society.
Yes and no….oh no
The Economist’s call last year for more low-interest-rate-inducing Quantitative Easing or QE in the Eurozone is inconsistent with its call to remove interest tax deductions. If one is dangerous then surely the other is too.
In 2000 and 2008, low interest rates were a response to economic decline and the job losses that came with it. Low interest rates did boost business and eventually job numbers, but unfortunately the medicine comes with its own pernicious challenges: increased financial fragility and an increasingly dangerous concentration of wealth at the very top.
When and how society deals with these issues has to be one of today’s most important and increasingly urgent unanswered questions.