Monday, July 11, 2016

Debt and the economy (again)

The problem of debt rears its ugly head once more.

Eight years ago, unsustainably high debt was the root cause of the worst recession since the Great Depression. Yet world debt overall now is far above 2008 levels. And as with millions of American home buyers back then, many of today's borrowers owe amounts that could become crushing burdens if the global economy should careen into a new recession.

The overstretched include plenty of governments. Total government debt outstanding worldwide was worrisome in 2008. It has since doubled to $59 trillion, according to Economist Intelligence.

But that is just one slice of the global debt pie. Add in household, corporate and bank debt and the grand total was a mind-boggling $199 trillion in mid-2014, up 40% since 2007, according to a study last year by McKinsey Global Institute.

. . .

As debt has mounted, the overall effect has been to choke off growth rather than promote it.

"The problem with high debt levels is that it's very paralyzing," said Kenneth Rogoff, a Harvard University economics professor who has written extensively on the implications of debt.

. . .

The financial system is set up to deal with losses, on a modest scale, via foreclosure and bankruptcy laws.

The question is whether the global economy has reached a point where something more drastic is needed to fire up growth -- such as the Babylonian solution of massive debt forgiveness.

On the face of it, the "debt jubilee" idea seems preposterous. Unilaterally wiping out debt also would mean wiping out the assets of untold numbers of lenders and investors, including pension funds. When loan losses in the Great Recession threatened to destroy the banking system, U.S. and European governments stepped in with taxpayer money to save it -- and vowed "never again."

Yet many experts believe that debt forgiveness for some desperate high-profile borrowers now is a certainty. Greece, which owes $359 billion, tops the list ... Puerto Rico, too, clearly can't repay the $70 billion it owes, Rogoff said.

There's more at the link.

The problem with debt relief, of course, is simply this - who pays?  Ultimately, someone must.  Forgiving a debt means that the money owed to a creditor is not going to be refunded.  That creditor is thereby effectively robbed of his investment in the loan.  If his money is 'stolen' in that way, why should he lend any more to anyone else?  After all, he might be 'robbed' again.  Funds available for loans will therefore dry up - or, at least, they should, in any rational economic system.

Furthermore, debt relief ignores the fact that the guilty parties in the debt crisis extend across the financial spectrum.
  • Governments can apply pressure to banks and other lenders to make loans available to those whose ability to repay them is, at best, questionable.  Consider, for example, laws and regulations forbidding redlining in the USA.  They've had the effect of forcing banks to make home loans to consumers who couldn't afford the repayments when times got tough, which in turn led to the repossession of their homes.  Such loans may have been politically desirable, but they were economically disastrous.
  • Banks and financial institutions need to make a profit, so they'll make loans to those from whom they think they can extract the greatest profit through charging them higher rates of interest.  This, in turn, encourages them to lend to consumers (whether individuals, or corporations, or even nations) whose credit rating is not good.  In order to get credit, they have to compensate lenders for the greater risk by paying them a higher rate of interest.  However, if the borrower defaults, the lender loses his gamble on the loan.
  • There are investors who deliberately seek to buy up 'distressed' debt (bonds, loans, etc.) because they're willing to gamble on their ability to force the borrower to pay up, in whole or in part.  If such an investor (e.g. a so-called 'vulture fund') can buy 'distressed' debt at, say, thirty cents on the dollar, then cajole, persuade or force the borrower to repay it at, say, sixty cents on the dollar, it's made a profit of 100% on its investment (less its legal and other expenses, of course).  Such investors have been the bane of troubled borrowers such as Argentina or Puerto Rico, as they are much less likely to make a deal favorable to the borrower.  They want their money, and they can be downright rude about insisting on getting it.
  • Let's also admit that there are borrowers - individual, corporate and national - who'll gleefully exploit banks' willingness to lend them money.  I once worked with a colleague who owed the equivalent of more than twenty times his annual salary.  He'd bought his house on an interest-only mortgage, leased a luxury sports car, and parlayed as many of his possessions as possible into loans or leases, rather than outright purchases.  He used to boast of manipulating the banks in order to live a far more luxurious lifestyle than the rest of us.  When asked what would happen if he became unemployed for any period of time, he'd simply shrug and say, "That's the bank's problem!"  (Shades of J. Paul Getty!)  It had happened to him before, but he'd learned that there would always be another lender willing to take a chance on him.  He had no savings, no financial provision for retirement, no ready cash to speak of - nothing.  (I often wonder how he fared when the inevitable downturn came.  I wouldn't dare live like that!)

A final consideration is that debt relief would probably only offer a temporary solution.  Forgiving debt sounds like a great idea . . . but if we did, how long would it take for everyone to be awash in debt all over again?  Would we change our spendthrift ways, or go right back to them?  I suspect the answer's obvious.



Bruce said...

The corollary is to look at the number of people that have won the lottery and then look at the number of those that are still solvent one, two, or even three years after. It's a much smaller number, and most of those that are still solvent are because they had a plan and stuck to it.

Humans suck at weighing the unintended consequences of their actions, we're lazy, and most folks lack the will power to stick to a plan, let alone even possessing the ability to properly plan. Because of that, we will be forced to endure whatever solution the magical thinking of the idiots in DC brings forth. And we'll be right back here, in the same spot in no more than 4 years. Again.

BigFire said...

I'm not a 100% follower of Dave Ramsey method of personal finance, but I have no debt and intend on staying that way.

Quentin said...

This is a solved problem: the debtor becomes insolvent and declares bankruptcy. Sure the creditor loses out, but that's the risk the creditor took when lending the money and why the creditor receives interest. After a few lenders go bankrupt the others will tighten their procedures.