This chapter considers only private debt - debt taken on by individuals and businesses. Public (government) debt is discussed in chapter 88.
The history of debt is intimately tied up with the history of the human race. Debts are listed in the earliest of recorded documents; in fact the purpose of many such documents was to record debts (Graeber 2011 p21). Hence it is likely that debt was around long before there were written records. Debt probably originated soon after agriculture was developed, when humanity first enjoyed surplus wealth, as a means of sharing out the excess in a manner that ensured it would be returned in equal or greater measure later. The history of debt is a fascinating subject in its own right, and I can heartily recommend Graeber's book (Graeber 2011) as a very readable and informative account.
Debt has always been deeply ambiguous, debtors feeling badly treated by their creditors and creditors throughout history regarded as greedy and uncaring. At the same time 'paying one's debts' has always been regarded as a cornerstone of morality, defaulting on debt repayment being highly dishonourable and ruining reputations.
What debt does is to allow the trading of wealth to be spread across time. I can obtain something today that I don't yet have the wealth to trade for it, on the basis that I shall have sufficient wealth in the future both to pay back the value of what I obtained and to compensate the provider for being deprived of it until paid back. Trade would be very difficult and much more restricted without debt.
Let's consider an economy without debt. The only way in which I can increase my income is to work harder or longer or find a quicker way of making whatever it is that I make and sell. In other words I have to increase my productivity. To get more income I have to trade more wealth. Such an economy is both very stable and very sluggish. Once people are working as hard as they can the only way they can have more is to become more efficient - to develop better techniques so that the work they do results in more wealth being produced. If they want more wealth then they must produce and sell more wealth. Now let's introduce debts. With a debt I can increase my income beyond that which I get from working, which means that I can spend more. There are four ways in which I can spend the extra money and the difference couldn't be more important, both for me and for the economy:
i. I can buy a wealth-creating investment - buy myself a tractor so that I can work more land than I can without one; buy an electric saw so that I can produce more doors and window frames; buy a van to carry my gardening tools further afield and speed up travelling between gardens; and so on;
ii. I can buy an existing asset in the hope that it increases in value in the future;
iii. I can buy a new television or pay for a holiday or find some other way to spend it on enjoyment; or
iv. I can buy day-to-day consumables such as food and clothing.
In summary these are wealth-creating investment; existing-asset investment; luxury consumption (satisfaction of wants); and basic consumption (satisfaction of needs). Wealth-creating and existing-asset investment were discussed earlier when considering what people spend their money on in chapter 20. The thing that is important is the provision made for repaying the debt, because debts must be repaid with interest, and if the lender and borrower are not to be harmed (by defaulting on repayment) then sufficient additional wealth must be available to trade in order to repay it by the time that repayment becomes due. If it is then all is well. If the debt was for wealth creation then the debt has allowed earlier economic growth than there would otherwise have been, and, importantly, it is the debtor who enjoys the growth and has additional wealth available to trade for money to repay the debt. Debts for existing assets don't promote economic growth because they merely represent wealth and money changing hands, there is no net effect on the economy. If the debtor is lucky then the assets bought will rise in value and enable the debt to be repaid, but this represents a gamble, it might work and it might not. Debts for any form of consumption can promote economic growth if demand is high enough, but that growth (if there is any) is at the level of the economy as a whole, it isn't enjoyed by the debtor. Therefore wealth that is traded to repay consumption debts, and debts for existing assets that don't rise in value, must be taken from wealth that the debtor would otherwise trade for spending. Debts for luxury consumption are commonplace and are taken up to permit enjoyment sooner than would be possible by saving up. The interest is the price paid for bringing the enjoyment forward and hopefully the person taking the debt knows that he or she will have the wherewithal to repay it when due. Debts for basic consumption are bad news both for the debtor and the creditor. If there is insufficient income to pay for basic consumables today then it is unlikely that there will be sufficient to pay for both consumables and interest in the future.
If the creditor spends the money received from debt repayment then aggregate spending doesn't drop and the economy isn't harmed. But such people in the main are investors, who don't tend to spend their excess money on wealth creation - see chapter 20.
Debts are therefore very much a mixed blessing for the economy. They are good when used to buy wealth-creating investments - provided that the economy has the capacity to accommodate those investments (it's no good buying a tractor if there isn't any more land available to cultivate), and when used for consumption they allow the economy to expand while they are being taken out in larger quantities than they are being paid back. Economic expansion arises because debts create a much bigger market for wealth than there would otherwise be - it includes those who don't yet have money as well as those who do, so productivity increases to meet this additional demand – as long as there is spare capacity.
However debts aren't always good for the parties involved. A debt that isn't repaid isn't in itself bad for the economy because it still allowed wealth to be created, traded and consumed, but it is bad for both the debtor, who invariably suffers a penalty for the default, and for the creditor, who has given away money and gets nothing in return. There will always be some debts that aren't repaid, that is the risk that the creditor takes in making the loan, so a prudent potential creditor assesses carefully the creditworthiness of a potential debtor. This assessment usually rules out those who want debts for basic consumption because they are least likely to be able to repay. The interest charged normally includes an allowance for default in addition to the charge for being deprived of wealth or money for the duration, unless of course the lender is a bank which still gets the full interest but isn't deprived of anything - see chapter 48.
Debts are also incurred when wealth itself is lent rather than money. For example rents paid on land and property represent interest on borrowed wealth.
Debts transfer money (or wealth) from creditors to debtors immediately, and then transfer money back from debtors to creditors over a period of time. Creditors tend to spend much less of their money on new wealth than debtors do, because creditors have money in excess of their needs and wants whereas debtors have needs and wants in excess of their money. Therefore transferring money from creditors to debtors increases spending in the economy, which has a stimulating effect provided that there is sufficient spare capacity to absorb it, otherwise it merely fuels inflation. The same applies for bank-created money. Although it didn't exist before the loan was taken out it adds to spending when spent by the debtor.
New debts stimulate and expand the economy provided that sufficient spare capacity exists to absorb the new spending. However this stimulus only lasts until payments from debtors to creditors begin to approach the level of new debt issued from creditors to debtors. When this situation arises the impact on economic stability depends on the overall level of private debt in the economy. If private debt spending is small in comparison with total spending then it will only have a minor effect, but if it is a significant fraction of total spending then it will have a major effect.
As the total level of private debt increases the economy becomes increasingly unstable, even before repayment equals or exceeds new debt issue. To see why this is so we should recognise that debtors for whom interest payments absorb a high proportion of total income have little excess for all other purposes and are therefore very vulnerable to any decrease in income. Also large amounts of debt create a web of interconnecting links between all the players in the economy. Businesses depend on spending by a steady stream of customers taking on new debts, and debtors, whether individuals or businesses, depend on continuing streams of business revenue to keep themselves in work and businesses afloat. Banks, money markets and other lenders depend on debtors repaying their debts so that they can pay their creditors - savers, depositors, other banks, the BoE, money markets, private investors, pension funds, insurance companies and others, and everyone depends on savings, banking, pensions and insurance. Any slight economic downturn, such as might be triggered by an increase in the price of essential imports or a slowdown in the housing market, hits debtors hard – the heavier the debt the harder the hit. What happens is that such people are forced to spend less, especially on non-essentials, so producers are forced to cut back on production by cutting the hours of work for employees or by laying them off, reducing their incomes and causing increasing numbers of rescheduled and defaulted debts in a knock-on manner, reducing further the interest and repayment income stream to creditors.
Additionally many debts, especially mortgages, carry variable interest rates, so any increase in interest payable also increases the number of rescheduled and defaulted debts. Debtors in these circumstances cut back heavily on all expenditure, and people who were considering taking on new debts now feel much less secure in their income, so they delay or abandon such thoughts. These effects cause even more loss of productivity in a self-reinforcing downward spiral. The extent of the decline depends on the total amount of private debt, and more specifically on the proportion of total spending that came from newly issued debt.
The loss of income to creditors is directly related to total private debt in the economy, and when it is high the tight linkages between separate players makes the instability even worse. Companies that engage in lending - banks and others - have accepted debts in the form of loan agreements, which are assets to the lenders, but they have also borrowed funds from depositors, savers, other banks and so on, which are liabilities. They normally have healthy balances - their assets exceed their liabilities - but they generally sail so close to the wind that a sustained series of defaults soon tips them over into unhealthy balances. They are like mountaineers walking on treacherous slopes. They all own backpacks containing large quantities of money, but those backpacks are carried by other climbers who have borrowed them at interest. Their rate of climb is fuelled by debt interest payments, where the income of each depends on all the others maintaining their payments, so these tight linkages rope them all together, but without any fall arresting equipment. All is well provided that they all keep repaying and climbing, but as soon as one can't pay she starts to fall and all the others are dragged down too. This is the debt domino effect, where even though each participant's net debt is small (i.e. almost the same amount is owed by others as that which she owes to others) she can still go down when a debtor defaults. The banking and financial network is so complex that each participant has multiple debt and credit connections to many others.
These are economically destructive debts - not individually, but collectively.
Debts are destructive when spending from newly issued private debt becomes a significant fraction of all spending in an economy, and the higher the fraction the more destructive the debts.
Debts arise not because people want what they don't have, people have always had such wants, but because other people have sufficient money over and above their own needs and wants to lend it out. Banks are even smarter; they found a way to lend money they don't even have. The reason that debts increase is that the debtor pays back more to the creditor than the creditor paid to them, even allowing for inflation and default risk, which provides the creditor with even more in real terms to lend next time.
However in normal circumstances this spiral is self-limiting after a number of circuits have run their course, the limit being reached when all the good quality debtors have all the debts that they want or can manage. A major concern for potential creditors is the creditworthiness of potential debtors. Once money is lent the creditor is normally tied to the debtor and his or her ability to repay until the debt is discharged, so great caution is called for.
The necessity for creditors to exercise caution in lending acts as a major safeguard in limiting economic instability, but creditors themselves see it as a severe hindrance because it limits their ability to make profits, which are directly related to the amount of money they lend.
Happily for creditors, but unhappily for the economy, a very clever way round this hindrance was found and exploited to the full prior to the 2008 crash. The massive build-up of debt before the crash kept the boom going for longer, but all it did was make the crash all the bigger when it happened. The way it played out is examined in the next chapter.
The above discussion has focused on the impact of private debts on the economy, but debts can have very damaging effects on individuals, so measures should be in place to mitigate those effects. At the moment people in debt are offered advice as to how to manage their money, and in extreme cases they can declare themselves bankrupt, but in all cases debt is regarded as the debtor's problem. The following is offered as a suggestion for how better control might be applied.
In the case of loans taken out for wealth creation purposes the interests of the creditor should be aligned more closely with the fortunes of the debtor. At present the person who can't pay her debts is the one at fault, no blame attaches to the original lender or later buyer of the debt, even though they should have been more careful in offering the loan or in buying the debt.
· For every debtor who shouldn't have borrowed there is a creditor who shouldn't have lent.
· Creditors should be duty bound to help debtors in trouble because they share the blame for repayment difficulties. Also the default interest that debtors pay provides insurance for creditors against default (i.e. total interest from all debtors covers all defaults), and is sufficient to allow for any and all circumstances provided that it has been assessed correctly, and assessment is the responsibility of creditors. The additional opportunity-cost interest that debtors also pay provides creditors with a profit, so creditors are adequately rewarded even allowing for defaults. What should be avoided is bankrupting debtors or forcing the sale of collateral. Many creditors do agree to deals when debtors are in trouble, but only because it is in their interests to do so, they are under no obligation to accept any lesser terms than were agreed at the outset. A promising approach to the current mismatch might be to have the initial interest rate and repayment period agreed in the normal way, but in the case of difficulties the debtor can request an interest reduction or deferment, an extension of the repayment period, or even debt reduction or cancellation. The debtor will make a proposal with reasons and accounts to back it up; the creditor will consider it and accept or negotiate with the debtor. If agreement can't be reached the two sides will each make their proposals to an adjudication panel, on the basis that the panel can only agree to one or other proposal in its entirety, whichever they believe to be the more reasonable in the circumstances. This ensures that both sides will be as reasonable as they can - the more outlandish the proposal the more likely its rejection. Adjudication fees will be split equally between the two parties, regardless of outcome, again to encourage resolution without the need for adjudication. In the same way if the debtor does particularly well (recall that the loans we are considering are for wealth-creating purposes) the creditor can request an interest rate increase, a shorter repayment period, or whatever else they feel is appropriate, and have it negotiated and adjudicated if necessary in the same way.
Similar procedures can apply for loans for purposes other than wealth creation, but without the creditor being able to claim any betterment of the terms. This will make the lender much more cautious in offering loans in the first place, especially where collateral is involved. Measures such as these aim to achieve for domestic lending what Keynes attempted to achieve for international lending. He was unsuccessful, not because his proposals didn't have merit, but because the Americans vetoed them for no better reason than that they thought it was in their interests to do so at the time, though in the longer term it wasn't. These matters are discussed in detail in chapter 67 section 67.2.
Other much wider recommendations for reform of the economy are set out in chapter 100.