Debt in Just Societies: A General Framework for Regulating Credit

Courtesy of John Linarelli

In my recent article, “Debt in Just Societies: A General Framework for Regulating Credit,” published in Regulation and Governance, I address the question of how we regulate access to credit (or debt markets) in a way that addresses inequality concerns. My focus is on inequality as a moral concern. In other words, how credit should be distributed or allocated to meet the moral demands of justice.

Almost all of the interdisciplinary work on this subject is economic in approach. This article takes a different path. Its insights come from a longstanding normative tradition in moral and political philosophy about justice and equality. These are often described as theories about distributive justice or egalitarianism. Sometimes you hear the question ‘what is fair’ asked when these theories are in play. The point of these theories is that some inequalities in a society are not justifiable from a moral point of view and institutions should be designed to eliminate or minimize them. The usual suspect for these theories is John Rawls, though a number of competing theories are on offer. This article relies on Ronald Dworkin’s theory of equality.

The overriding normative principle in designing debt regulation is financial stability. Financial stability has become increasingly important since the global financial crisis. The problem with financial stability is that it’s insensitive to equality or justice concerns. It is meant to develop rules to stabilize the macroeconomy. Suppose a society could achieve some maximum or optimum level of financial stability, by, say, depriving everyone with an annual income under $250,000 access to home mortgages. A regulation like this might produce financial stability. However, such a blanket rule will likely be problematic from the standpoint of distributive justice. This is an obvious example but pick a less obvious one. We might be able to show empirically that less drastic rules do not cut lower income people off from an important resource in society. However, that result is merely accidental if there is no principle at work to guide regulators – it is not a result of any design feature intended for debt regulation. The regulatory outcome could just as well go the other way. When we regulate something as important as debt or access to credit, we don’t want to rely on contingencies to ensure people get a fair shake at access. We should not give up on financial stability. However, we should consider the least harmful ways of achieving it.

This article takes a “resourcist” approach to justice and regulatory evaluation, usually seen in opposition to a “welfarist” approach. A resourcist asks: A bundle of social goods is required for each person to live a decent life, what is in that bundle? In contrast, a welfarist asks: How does society maximize the welfare of people, usually on the basis of some agreed standard on people’s preferences? The most influential approach to welfarism is probably normative welfare economics.

Dworkin’s resourcist approach to equality combines both individual responsibilities for one’s choices with social or collective concern about justice. Some have characterized Dworkin as the first luck egalitarian. Luck egalitarianism holds one responsible for the outcomes they choose, but a principle of equality applies to outcomes beyond their choice. Dworkin distinguishes between option luck and brute luck. Option luck is the result of our choices. It is our responsibility. Inequalities associated with option luck are left where they are. Brute luck comes from our circumstances, things beyond our control, such as whether you were born into a rich or low-income family, the region of the country in which you were raised, race, gender, sexual orientation, age, disability, health states of affairs beyond your control, and so on. In other words, luck egalitarianism seeks to neutralize brute luck lotteries: birth lotteries, geography lotteries, demography lotteries, health lotteries, household wealth lotteries, and so on.

Theories of justice have not figured much if at all in the design of financial regulation. The UK Financial Conduct Authority has sought to build on welfarist approaches in measuring preferences and well-being. There has been an agenda on financial inclusion, both at the international and national levels. This article could broadly be seen as contributing to the financial inclusion discussions, though it is very different in approach than the usual ones.

Debt is a resource in society. This means that debt is something subject to the moral demands of equality because some allocation of it to people is necessary for people to lead decent lives in societies as they have evolved. Access to credit is a resource that people can use to achieve important life goals such as buying a home or paying for a college or university degree. Home ownership has a statistically significant relationship to increases in household wealth. Homeownership also opens opportunities for children to attend good schools, for families to live in a clean environment, and for access to transportation. Even some corporate debt is equality sensitive to the extent that it facilitates entrepreneurship. Sovereign debt relates to equality to the extent that it funds public goods and social welfare programs designed to benefit the unlucky. There are a number of indirect beneficiaries of debt, such as those who benefit from the public goods aspects of an educated workforce. Of course, resources do not have to be provided through debt. However, we have to take society as we find it and many societies, in particular the U.S. and the UK, require the use of debt to acquire important resources. In these societies, the poor, moreover, tend to need debt more than the rich for access to home ownership, education, and even health care in some cases.

This article is meant for policy entrepreneurs. I specify three operating principles to apply in the design of debt regulation.

First, avoid financing public goods primarily through private debt. The state should not require persons to take out significant debt to further a policy aim unless that policy aim has no role other than to benefit the debtor, the debtor can make an unbiased choice about the debt, and the debt does not substantially impair the life projects of the debtor. A classic example of such debt is student debt. Any amount of tuition fees for education and requiring students to take on debt to pay them is problematic at the outset on equality of opportunity grounds because it bases access to higher education on the ability to pay. Plenty of data shows that students from richer households with lower academic indicators get into better colleges and universities than students from poorer households with higher academic indicators. The data also tells us that the poorer you are, the more likely you will use debt to finance education. A society that takes equality of opportunity seriously would not use debt to finance education at all. However, let’s leave aside that more fundamental question and assume we have to live in a second-best world with student debt. We could neutralize bad brute luck by ensuring that (1) debt is less rigid through schemes like income-contingent repayments, and (2) students are only partly burdened by debt because education is a mixed public and private good. A more flexible version of a hybrid debt that is for only that part of a student’s education that will directly benefit the student privately should form the moral limits for student debt.

Second, do not unreasonably restrict “equality sensitive” access to credit. “Equality sensitive” refers to debt likely to neutralize bad brute luck inequalities and that relates to distributing important resources in a society. The home mortgage is an example. This does not mean that we need to return to the pre-crisis profligacy of subprime mortgages. It does mean that regulators should be sensitive to how their regulation of home mortgages affect the less well-off and should choose more equality friendly policies when feasible. For example, regulators could nudge lenders to offer more innovative and less rigid mortgage products. Some debt will not be equality sensitive at all, such as corporate bonds, which are best left to regulation that complies only with the financial stability principle and economic efficiency rationales.

Third, relax the rigidity of debt in appropriate cases. Debt represents a fixed claim for repayment regardless of the change of circumstances for the debtor or to changes in the market value of any asset serving as collateral for the debt. This rigidity makes debt entirely insensitive to bad brute luck. Debt in its pure form serves equality aims poorly. The way around this is to add equity-like features allocating risk across parties to the transaction or to link payment streams to some external index such as a local variant of the Case-Shiller Index for home mortgages or to GDP rates of growth or some other macroeconomic indicator for sovereign debt.

Finally, I don’t see my methods as entirely incompatible with a welfarist approach. I think you can probably combine some elements of luck sensitivity into CBA. Focusing on resources and luck make the points more salient – they help us develop reference points for regulators that may get ignored or de-emphasized when more purely economic methods such as cost-benefit analysis are deployed.