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. Continue reading