Debt and the current economic quagmire

Debt and the current economic quagmire

Approximately $21 trillion dollars of wealth evaporated from global stock markets in the year to November 2008, an average of $21,000 per individual in the developed world[i]. The genesis of the problem is debt. So, one is impelled to ask: what is it about debt that it has promulgated decadence into an economic quagmire of this magnitude?

It has been postulated that debt, per se, is not the problem. It is “bad or sub prime debt” that is at the genesis of the problem. It is our proposition that attempts of governments in the 21st century to influence economic behavior primarily through the incentive or disincentive to borrow via various vigorous monetary tool instruments now appears to be confūtāre or confutable, and has engender must of the current problems.

The policy of influencing consumption behavior through the variation of lending rates leads to excessive debt fuelled consumption and inflationary pressures as compared to funding out of corpus or savings. To appreciate the point, let us suppose an economy of 4 economic units (persons). The Units are persons A, B, C and D. Further, assume that A is more endowed than B, C & D. Therefore, A has $1.50 dollars whilst B, C, and D each have a dollar. There are 4 grains for sale in the market each selling for $1.00. The grain utility of each economic unit is the same. That is, B has no more utility for grain than B, C and D and vice versa. Each person would like one or more grains. In the ordinary case, A cannot bid the price by more than his natural endowment of $1.50. C, D and E cannot bid the price by more than a dollar.

You will notice the money supply is only $4.50 and the value of goods in the market is $4.00. Also note that the seller is willing to sell at the price of $1.00 per grain which covers both his cost of production and includes a profit margin. Three grains will be left to putrefy if he attempts to sell them for more than a dollar unless the economic units are each endowed by more than a dollar. For example, suppose A bids the price up by $1.10 so he buys one grain. His residual endowment is less than the price of a grain so he can’t bid the price up any longer. His precipitance has merely resulted in the fortuitous transfer of wealth to the seller.

If A was a rational person, he will decide not to bid the price up anymore than the seller is selling for. He will then have $.50 saving. He may use this equity to invest in grain production. This will have two consequences. A is likely to hire B, C, or D as employees in the production process. So some of the $.50 ends up in their hands. The increase in the employee’s wealth is explained by a simultaneous increase in grain supply. So any increase in B, C, or D’s wealth is expiated by a simultaneous increase in commodities backing the increase. This is the consequence of equity funding or financing, as opposed to debt financing. That is, for every increase in wealth at the consumer/employee level, there is a simultaneous increase in goods backing the increase.

Now, assume, for simplicity’s sake, that when A bids the price up to $1.10, B, C, D, having the same level of utility, borrow $0.10 each to match the bid. A number of problems are created. Firstly, we know there is no increase in the quantum of grains in the market, nor is there a change in the quality of grains. It is the same 4 grains the seller, a willing seller at $1.00 per grain, is now going to sell for $1.10 each. In other words, whereas in the equity scenario the increase in the wealth of the seller was expiated by increased productivity, the increase when debt is introduced cannot be expiated by productivity or quality gains. Therefore, it results in a bubble just like water bubbles. A inflated item with no real substance to it.

This is the problem that is at the root of the current economic crisis. Let us called it debt fuelled inflation. An artificial increase in the value of the things we have, engendered by a gigantic supply of cheap credit, which was made all the more possible by the policy of engineering consumer and business spending vastly through monetary instruments like changes in interest rates.

There is another dynamic to the debt problem. Because the borrower essentially expends of what is unearned, he speculates that future earnings will be more than future expenditure requirements, thereby leaving a surplus which is used to service the debt. There is yet a deontological issue. The owner of corpus, the lender, lends his money to an individual who may use it for a productive purpose and have, opened to him, an unlimited upside. Yet the lender’s share in the upside is limited to the interest paid. This would seem unfair to the lender. From the borrower’s perspective, the lender is willing to share in his upside via the receipt of interest, but not on the downside. This seems unfair altogether. These two edges of debt make each party sit quite uneasy with the other.

Our society is now riddled with excessive consumption behavior, thanks to cheap credits. In fact, everything that is produced is directly or indirectly, for our consumption. If we consume this year the same as last year, we are in stagnation. If we consume less, we are in a “recession”. If we consume significantly less, we are in a depression. So a sober mind has to ask? How much can this big kid called the “Commonwealth or State” masticate before it gets too gargantuan and start to spew or regurgitate what it has eschewed?

My argument here is not that all debt is bad. This is certainly not the case. Debt can be a good debt if taken out for investment purposes, assuming that the rate is low and remains so over the period the investment is held. Because the introduction of debt in this case is certainly likely to be expiated by productivity gains.

Now one may ask? How else can we keep the economy afloat if we don’t induce spending behavior through interest rates? Well, the problem is that, when rates are too low, we all borrow and in most cases, we buy depreciating or consumption items. So over time, we are indebted with nothing to show for the debt. One could argue that this is a personal problem and governments aren’t to blame. But this does not discount the fact that there is a problem. So the real question is what else can be done?

Well, there a number of other policy instruments that aren’t politically palatable, but don’t result in the same problem. For example, encouraging people to spend only of their own corpus or savings. This can be achieved through fiscal instruments like the tax system. But who likes to pay more tax? We could also encourage individuals to become net savers as compare to spenders. I will not attempt here to discuss how this can be achieved. The point is, until we get to the point whereby we are largely net savers instead of spenders/borrowers, all the attempts of governments to throw more funds at the economy worldwide, will treat the short term symptomatic pains. But the long term structural issue is debt. This will be a ghost in the main, visiting us whenever the impetus is provided.







[i] See Thompson, Susan “Global stock market losses total $21 trillion”, http://business.timesonline.co.uk/tol/business/markets/article5705t526.ece