On Debt

In the aftermath of the financial crisis, and with a raging sovereign debt crisis in Europe, notably Greece, it’s worth stopping to consider what debt is. Even as so much is written on the subject, when I read journalistic or even some economists’ accounts of the debt crisis I’m left feeling that they don’t understand what debt is, or rather that they bring a moral frame to the concept that is unhelpful and out of touch with reality.

There are only three formulations of debt, as an economic transaction between strangers, that are moral and advisable:

  • An investment future: If you have a pile of cash, the net present value of keeping it as cash for a year is a few percent below face value, because of inflation and the risk it might be stolen or destroyed. You can give it to someone who can realize a better NPV and share some of that with you, so you both win. You could give it to Facebook in exchange of stock, or to a bank that invests in sub-prime mortgages. You could give it to the government of Germany, or of Greece. These differ in risk and return, and the market does a rough job of pricing them, but it’s always your investment decision. You can ask politically for an investment to be insured, or bailed out, and that simply means socializing losses by inflation or other means. Often, this is the right thing to do.
  • An option to sell: A secured debt, such as a mortgage, is really an option to sell the collateral to the bank at some future date, for some variable amount that’s equal to your then outstanding obligation. Again, it’s a business decision. The lenders should plan according to the possibility that they may get the full payment schedule or the collateral, presumably whatever is worth less in the ensuing economic conditions. If they forecast that poorly, well, too bad. There’s nothing moral or otherwise beholding of the borrower in a secured debt arrangement.
  • Due payment: Invoices for goods or services are a short term loan from the supplier to the client, granted as part of the cost of doing business. This debt does carry moral weight because it affects the cash flow of both parties a great deal and because only the value of the relationship, and a firm’s reputation, really compel a firm to pay it.

These are acceptable, modern forms of debt. Notice that, apart from the case of honorable business debt, there’s no moral angle to it. If you have surplus you give it to someone in the hope of achieving a better NPV, and maybe you get that or you don’t. There are no reckless borrowers or predatory lenders, and debt is not some kind of crushing moral obligation in this world.

Now let’s look at some other conceptions of debt. These are all negative, some of them illegal or prohibited by religion since ancient times, and generally inadvisable. They are set in moral language, by the strong, in defining their relationship with the weak:

  • A debt of gratitude or honor: Suppose that someone pays to really help you out, say to cover the cost of an operation, bail, or university. Surely you then owe them everything until perhaps some day you are able to repay. No. As a benefactor, only give such money if helping the other person is justification enough. As a recipient, try to return the sum but only if your circumstances permit and settling is actually appropriate. Among people who are intimately bound, such as friends or family, leaving such “debts” open deepens the relationship and is the moral thing to do.
  • An accounting score: Treating debt as a sort of eternal counter, which binds the borrower forever unless some day the counter reaches zero, is simply a construct of fiction. It may be a powerful way to control the debtor, and a very convenient way for the creditor to deny risk, but these are constraints imposed on the idea of debt by law or violence. A loan granted in pursuit of yield is an investment, and its value can go down. We have strict rules on banks to make loans and deposits appear risk-free, so that banks can perform a monetary function and are not subject to the volatility of stocks. There is also presently a right-wing push to restrain monetary sovereignty so that debt cannot be converted to inflation. If we accept these rules, that leaves debtors everywhere to bear the brunt. We don’t have to accept them.
  • A forfeit: Someone who can’t repay their debts has to surrender their livelihood, other property, or even become a slave. This ancient conception of debt has been forbidden by religions and made illegal by most societies. People flee and nations rebel rather than fall under such servitude. Yet, this is the approach that the West, through the IMF, has taken to most of the poor world and this is what Germany would like to do with Greece, or the next peripheral country that falls. You can’t pay, so sell off your assets to us. Rightly, the response is a very militant “No!”.

Let’s keep the discussion on debt on the businesslike, reasonable economic space and out of the ethically laden frame of domination. There is far too much debt in the world, arguably at all, but certainly too much to treat according the antiquated binding norms. The economic debate should be about how/whether we can architect a debt-based money economy, as ours is, in a way that’s stable and functionally desirable – in terms of the outcomes it produces. Moral arguments about borrowing and repaying do not come into it, just as they don’t come into a mature discussion of public corporation governance.

I should add at this point that I’m a net creditor (I have savings) and my family lost a good portion of their savings in the Greek haircut. Our narrow personal interests would favor hard debt. Soft debt is clearly the right way.

But what would happen if debt had less shackling power, you say? Rich people wouldn’t lend if they couldn’t pressure the borrower hard enough, and the economy would grind to a halt or at lest slow down.

That’s not what we see. The US has a very forgiving culture for financing business, where venture capital flows into startups of which some work and some fail. The people who fail, so long as they show competence, energy, vison, and so on are often funded to try again. Corporations enjoy strong bankruptcy protection (Chapter 11) and many use it to live and fight another day. By comparison Europe, with a much harder and sometimes archaic financing environment delivers much less entrepreneurship and innovation. To the extent that people (like me) have idle savings that is a brake on the economy. That money should be in venture capital, informal VC, or stocks. Moderate inflation is the means to get it there, not a draconian and safe credit system.

What then of freeloaders? Undisciplined households, city councils, or states like Greece that habitually spend more than they’re able or willing to earn.

That is a question about the present, not the past. It’s valid to ask whether to subsidize these people today, going forward. The main reason to do so, one way or another, is overall economic growth. Giving essentially free credit to a student, or a poor country, builds up capital that makes the future economy stronger. If not that, at least it boosts short term consumption. So there is a present choice whether to continue to subsidize the low earner and thus indirectly yourself, or stop doing that and have them consume and produce less as well as let bigger problems develop. The question of how much of this transfer has happened in the past is irrelevant. People, and certainly firms or countries, do not settle their balances over a real or nominal lifetime. They live, and contribute or burden the world, in the here and now. It would be worthy and just if every economic actor were a net contributor, and certainly it’s good to move in that direction through competition, creative destruction, and so on. But we don’t live in such a Utopian world.

Then what about the banking system? Our banks are exposed to debt, of mortgage holders, consumers, or countries and unspecified bad things would happen if we treat this too casually.

Yes, it’s worse than perhaps you think. Our money is debt. Modern money is not a token of gold stored in a vault, nor is it “fiat money” given value by the state. It is actually a token of debt. Someone’s outstanding debt, mortgage, or whatever, cut into small pieces, is the Dollar or Euro or Yen that you circulate. Banks are in a position to hold the economy hostage and demand a bailout not (just) because of high powered connections but exactly because the debt in their books is everyone’s money. If the bank goes down and the debt vanishes, so does the money. Poof, gone!

This world order is not appreciated by everyone, mostly because bankers set it up in the 1970s and didn’t tell us. Politicians still debate the myths of gold or fiat money from eras before. But what we have is a system of money issued by private banks and backed by debt. That is reality. It greatly enriches banks by granting them the so-called seigniorage profit that is the prerogative of the currency issuer. In its current formulation it also makes the economy extremely brittle, as there is no acceptable way to recognize a fall in the value of debt, other than inflation which the right currently is blocking.

These are very big real problems, but it’s not the abstract dirty villain of “debt” that is at fault. Debt is, wrongly in my opinion but as a matter of fact, a mainstay of our monetary system. We need to adjust to that and question this system. We need to ask again who should be the currency issuer and who should benefit. We need smaller vehicles of guaranteed debt and a more sane and long-term focused system of investment. These are urgent questions. Can we get to them rather than bashing the debtors please!

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