From Krugman's "Notes on Deleveraging"

Krugman writes:

My preference is to leave financial-sector debt out of the picture, because it’s conceptually very different from nonfinancial debt. Think of it this way: compare two banking systems, one in which banks directly lend deposits out to customers, another in which many deposits are lent out through the interbank wholesale market, and then lent on to nonfinancial customers. The second system will show much higher financial-sector debt, and it is in some real sense more risky than the first, but the real economy isn’t more highly indebted than in the first case. In general, financial-sector debt is about the internal organization of intermediation, and it’s not the same kind of thing as when households or business run up a lot of debt.

In the middle of refusing to acknowledge that financial debt should be counted, Krugman says the system with more debt is in some real sense more risky.

In some real sense more risky.

So Krugman prefers not to count financial-sector debt because it's conceptually different from productive-sector debt. What, it doesn't have a cost? Of course it has a cost. And the cost of it is borne by the non-financial sector, even though it is financial-sector debt. The interest of money is always a derivative revenue.

And don't forget: When we had the crisis, it was a financial crisis.

One of the big problems with excessive debt is the threat of cascade failure: One debtor defaults, causing his creditors to default, causing their creditors to default, and before you know it the whole economic system is fallen into ruin. This was the trouble with Greece of course -- not just that Greece would go, but that Greece would take down Europe, and then Europe would take down the United States.

When you consider cascade failure, it is important to consider financial debt as part of the potential problem. For the cascade will be working its way through the financial sector on its way to the productive sector.

The fundamental problem with debt, of course, is the cost of it. Now consider one borrower, me, and one lender, you, and between us a system of financial intermediaries. Maybe there are two intermediaries in the chain; or maybe there are seven. No. Consider an economy where the financial system has grown beyond its economies of scale, so that what used to be a chain with two intermediaries now is a chain with seven. What are our options?

Either it costs me more (and you receive less interest income) because of the long chain of intermediaries who make money when I borrow a dollar from you, or I pay no more and you receive no less, but the intermediaries are squeezed.

If it costs me more and you receive less interest income, this is bad for the productive economy, bad for demand, bad for growth.

If the intermediaries are squeezed, the risk of cascade failure increases.

In the real world, our world, both things happened when debt became excessive. From the start, it was bad for growth. At the end, the financial sector was in crisis.