Wednesday, July 2, 2014

The problem of debt

Some readers have taken issue with my frequent advice to get out of debt, as far as possible, and not to use credit unless absolutely necessary.  They point out that many of us can't cope with our monthly living expenses without the assistance of at least some credit.  Furthermore, if inflation takes off, fixed-interest debt is actually easier to pay off with inflated dollars - so why not carry at least some such overhead?

Trouble is, not many people understand the overall impact of debt - not just on ourselves as individuals, but upon companies, regions, nations, and the entire world economy.  Here are a few useful articles to explain it.  Let's begin with the inimitable Charles Hugh Smith.

One of the Grand Narratives of our era is the substitution of debt for income: as earned income and disposable income have stagnated for 40 years, the gap between the rising cost of living and stagnant household income has been filled by borrowed money.

Money has been borrowed to replace income everywhere: consumers have borrowed money to buy things they otherwise couldn't afford, students have borrowed over $1 trillion to attend college, governments have borrowed money to fund wars and social spending, corporations have borrowed money to buy back their own shares, pushing stock prices higher.

There's one little problem with debt: interest must be paid on debt. Let's focus for a second on the difference between cash income and borrowing money. Cash doesn't cost money to maintain; debt does. In a functioning economy (as opposed to the dysfunctional mess we have now), cash would earn income from interest paid by borrowers.

If cash income is saved, the cash can buy stuff without debt or interest payments. That is a powerful advantage over debt.

How powerful is the advantage of cash over debt? It's literally life-changing. Take a look at your credit card statements, which now include an estimate of interest you will pay and how long it will take to pay off the balance at a given monthly payment.

Those making minimal payments will end up paying 100% or more of the balance due in interest.

The phenomenally high accrued costs of interest is true of mortgages, student loans, auto loans, corporate debt and government debt: eventually, current spending is crimped as more and more net income is devoted to paying interest.

There are two words for what happens when real income declines and interest payments rise: impoverishment and insolvency. This dynamic is scale-invariant, meaning it works the same for individuals, households, enterprises and governments.

. . .

The more debt that is taken on by marginal borrowers--where marginal is defined as unable to weather any shock or decline to their financial position or income--the more risk piles up in the system.

The analogy is a forest where the deadwood is never allowed to burn: The Yellowstone Analogy and The Crisis of Neoliberal Capitalism (May 18, 2009). The net result of rising systemic risk is a massive conflagration that burns off off the accumulated risk and bad debt.

Such a fire sweeping through the mountains of risky debt piled up in the American financial system would bring down the entire Status Quo.

There's more at the link.  Highly recommended reading.

The Telegraph agrees that on a national economic level, we have to move away from debt as the engine of economic growth.

What growth there is remains highly dependent on extraordinary monetary stimulus. Despite lacklustre prospects for investment and demand, debt continues to rise almost everywhere.

These debt pressures ... last well beyond the normal parameters of the business cycle. These cycles tend to last seven to eight years and are, to a large extent, creatures of the political cycle. It is the politicians who dictate the time frame for most macroeconomic policy, feeding impatience at the slow pace of economic recovery, and the demand for artificial remedies to correct it.

Such remedies generally involve piling on a load more debt, making the underlying financial cycle - which tends to be much longer – very much worse ...

. . .

In any case ... there has been no serious attempt to get to grips with the financial cycle, which requires moving away from debt as the engine of growth, and substituting effective measures to improve the economy’s long term supply.

To the contrary, since 2007, the ratio of non-financial sector debt to GDP across the G20 as a whole has risen by more than a fifth. This has helped prop up demand, but it has led to new financial booms which mask fundamental weaknesses and loss of productive potential in many advanced economies.

Again, more at the link.

Michael Snyder has some very telling statistics about the world's debt burden.

  • $17,555,165,805,212.27 - This is the size of the U.S. national debt.  It has grown by more than 10 trillion dollars over the past ten years.
  • $59,398,590,000,000 - This is the total amount of debt (government, corporate, consumer, etc.) in the U.S. financial system.  40 years ago, this number was just a little bit above 2 trillion dollars.
  • $71,830,000,000,000 - This is the approximate size of the GDP of the entire world.
  • $100,000,000,000,000 - This is the total amount of government debt in the entire world.  This amount has grown by $30 trillion just since mid-2007.
  • $223,300,000,000,000 - This is the approximate size of the total amount of debt in the entire world.
. . .

Most people tend to assume that the "authorities" have fixed whatever caused the financial world to almost end back in 2008, but that is not the case at all.

In fact, the total amount of government debt around the globe has grown by about 40 percent since then, and the "too big to fail banks" have collectively gotten 37 percent larger since then.

Our "authorities" didn't fix anything.  All they did was reinflate the bubble and kick the can down the road for a little while.

I don't know how anyone can take an honest look at the numbers and not come to the conclusion that this is completely and totally unsustainable.

How much debt can the global financial system take before it utterly collapses?

How recklessly can the big banks behave before the house of cards that they have constructed implodes underneath them?

For the moment, everything seems fine.  Stock markets around the world have been setting record highs and credit is flowing like wine.

But at some point a day of reckoning is coming, and when it arrives it is going to be the most painful financial crisis the world has ever seen.

More at the link.

Finally, here's Rick Santelli of CNBC talking about the immediate impact of debt on the US economy.

I can't argue with him . . .

All those facts and figures tend to concentrate on the 'big picture':  but people forget that we're a microcosm of that big picture, just as the big picture is a macrocosm of all of us and our financial situation.  As a collection of individuals, we, on average, are in debt up to our ears and beyond.  The few who aren't are a drop in the bucket compared to the many who are.  People have forgotten the ancient and time-honored truth that one should only go into debt long-term in order to buy long-term assets (such as a house or land).  For most of us, this isn't the case.

  • Are you buying a car on a note that will take more than three years to pay off?
  • Are you carrying credit card balances that you have to 'roll over' from one month to the next, rather than pay them in full at the end of each month?
  • Are you using store credit to buy clothing and other items?
  • Are you paying off a student loan balance?
  • Are you paying off a mortgage on a home?

If you answered 'yes' to any of those questions, you're part of the great majority of US consumers.  If you answered 'yes' to three or more of them, the odds are very high that you're probably carrying too much debt.

By reducing or eliminating debt, you achieve many things:

  • You can save the money you're no longer paying towards interest charges and account balances each month, allowing you to accumulate a cash reserve;
  • You can reduce your monthly expenditure to what you can truly afford, rather than have to rely on revolving or rollover credit facilities to finance some of it;
  • You can buy something and actually own it, instead of it being owned by a bank or finance company.

That last point is important.  Take just one example, car leases.  I know many people who protest that the only way they can afford a new or nearly-new car today is to lease it.  They're probably right . . . but they'll never own a car.  They're forever tied to the apron-strings of a leasing company.  They fork out two, or three, or four hundred dollars a month for a two- to three-year lease, then hand the car back and take out another lease for the next one.  Because vehicle prices will have risen in the interim, they'll have to pay more for a similar car (i.e. higher monthly payments), or settle for a less desirable model if they want to keep their payments at their previous level.  For their entire working career, they'll be paying hundreds of dollars every month to drive a car.  On the other hand, if they saved up a few thousand dollars, bought an older used vehicle, and learned to do basic maintenance on it themselves, they could save their monthly lease payments to build up their reserves, then pay cash for a better car in due course.

(That's what Miss D. and I did last year after successfully reducing our debt load over the previous few years.  When the time came that she needed a new vehicle, we had enough saved to pay cash for a several-years-old vehicle that she's happily driving at the moment.  We aren't carrying any debt to pay for it, and we've already replenished the savings we used to buy it.  What's not to like?)

Debt's a trap.  It prevents you accumulating a 'cushion' to tide you over hard times, and deprives you of disposable income you may need to buy essentials in a tight spot, because all of your ready cash is committed to paying off creditors.  That's no way to live - and in hard times it can be devastating.  If you fail to keep up your payments, your house, car, furniture, etc. can (and probably will) be repossessed.  How are you going to live then?  Far better to own the basic necessities of life free and clear, unencumbered by debt.  That way no-one can take them from you.

Some argue that high-cost items like one's home can't be afforded except through debt financing.  I agree;  but most of us buy far more expensive homes than we need.  I'd say fewer than one in ten consumers actually sits down before shopping for a house, decides what they can reasonably afford in accordance with generally accepted standards of fiscal prudence, and sticks to that budget when buying a home.  Most people want more, and over-extend themselves financially in order to get it.  That's just storing up problems when hard times arrive, because those over-extended payments don't get any smaller, even if you're out of work . . .  On the other hand, I know several families who've survived extended hard times by moving into an old mobile home, or even a travel trailer.  It's been far from ideal, but it's served as a low-cost roof over their heads, freeing their limited income to buy food, gas, etc.  They've lived that way for up to a couple of years before finding their financial feet once more.  There's no shame in it, and a whole lot of good sense.  I'll have no hesitation in doing likewise if the need arises.


EDITED TO ADD:  For an excellent example of someone who found himself with serious debt problems, and took drastic, radical steps to deal with them, see this article.  It's well worth your time.  He's also published a book about his experiences, which is fun and informative reading.

EDITED A SECOND TIME TO ADD:  Francis Porretto has a personal perspective on the chains that debt puts upon us, and vows never to wear them again.  Recommended reading.


Anonymous said...

Debt is a trap. Remember that if you miss a few payments, items can be taken back and you lose what you already payed into it.

I have a coworker who rarely carries cash of ANY kind - purely works with debit cards for daily needs, credit cards for longer term. What is he going to do when we have a long term grid crash ?

STxRynn said...

in 1999, I really took this to heart. I cashed in a whole life policy to pay off the $14,000 of credit card debt I had. Most of that was interest that had accrued due to paying the minimum for a few years. I had enough left over to buy a 10 year old Suburban for the family. A few years ago, we sold our home, used the equity to buy a small house. I have no debt now. I live in a small home, make 2 payments a year for taxes and insurance.

This freed up money to begin developing my skill set for the inevitable crash of the bubble economy. I am able to help folks out around town, as well as my kids.

I cannot adequately describe the sense of FREEDOM that I live with knowing I am saving money, able to help out anyone that needs it, and still support my wife and I. And I'm not even very good at finances. I struggle with long term planning.

YOU CAN DO THIS! Failing to plan is planning to fail.

Anonymous said...

The idea of paying off debt with inflation devalued dollars sounds seductive.
The problem is twofold. Or maybe more, I am not an economist.
1. You may not have a job, or your wages may not increase enough to pay your debt because everything ELSE you buy goes up. Liquidity counts. There is a term for this "stagflation".
2. They may change the rules on you midstream- who do you think makes the rules in this country, anyway? Unilateral re-figuring of loan terms could happen.

Debt reduces flexibility to maneuver and respond to events. It makes what should be minor inconveniences into major problems.

Tirno said...

I'm wondering something...

$223 trillion dollars in worldwide debt.

Now, to a simple person like myself, you borrow something from someone who has it. So, who (probably many who-s) ultimately owns the original capital that provided the supply side of that debt?

I think we'll find that quite a lot of that debt is someone that borrowed $Y capital at (X)% interest and lent it right back out at (X+1)% interest. That probably happens Z times until the we get down to the 'retail' end of lending. The worldwide debt then shows as $(ZxY) on an original capital of Y.

We could probably stand to have the layers of lending compressed down so we have a real idea of actual worldwide debt. Perhaps a worldwide account rationalization holiday. It'd be worthwhile to square up the books so that rather than Alice lending to Bob lending to Charlie lending to David, the accounts could be squared up so David owes Alice with Bob and Charlie getting agent's fees.

Unfortunately, that'd probably also show that the Federal Reserve has been lending backed by no capital.

Rev. Paul said...

My wife & I have been on a cash economy for 15 years. Yes, it's occasionally an inconvenience (like trying to rent a car without a credit card), but if we can't afford something, we just don't get it until we've saved enough to pay cash. Remembering the 21+% interest rates in the '70s make me doubly cautious of 27% rates on credit cards.

No thanks.

Jim22 said...

"They point out that many of us can't cope with our monthly living expenses without the assistance of at least some credit."

I'd like to point out to them that they are paying a mountain of debt service. That's interest to the lender for carpenters like me. That's what keeps the lenders in business.

If you didn't have that debt service to pay every month you would have a whole lot more disposable income. Hundreds of dollars more in most cases.

Becoming debt free is not an overnight thing. It requires a long-term plan and the discipline to follow it. It can be done. It is done regularly by people just like you.

A good start is the home mortgage. In order to pay your home off in half the time you need to make double principal payments. That does not mean double mortgage payments. In the early years of your mortgage you pay very little toward principal. If your payment is $1,000 a month less than $50 is applied to principal. The rest is interest to your lender.

Now you see the size of the debt problem. If, instead of paying your normal $1,000 each month you pay $1,050 you are making double payments toward principal.

How do you think they got those nice, expensive bank buildings?

Old NFO said...

Good points, and getting out of debt SHOULD be a priority...

Tom Bridgeland said...

Plus, being debt free is just so relaxing. I remember clearly my last student loan payment. I have had no long-term debt since. We do have and use credit cards, but always pay back every month. No temptation to overspend. I wrote my story here:
If you don't mind me plugging an article I wrote.

Peter said...

@Tom Bridgeland: I don't mind at all. I must try your book - it looks interesting.

Quentin said...

Just a nitpick on an excellent article but

Let's focus for a second on the difference between cash income and borrowing money. Cash doesn't cost money to maintain; debt does.

isn't quite correct because inflation eats into cash savings. If you have cash savings of $100,000 and inflation is 2%, then your cash is only worth ~$98,000 after a year. So having cash has cost you ~$2000. Of course, most people would try to put their money to use by investing, but the point remains.