I really liked the opening of the Cecchetti/Mohanty/Zampolli PDF:
Debt is a two-edged sword. Used wisely and in moderation, it clearly improves welfare. But, when it is used imprudently and in excess, the result can be disaster.
I liked the "two-edged sword" metaphor all the while I was writing yesterday's post. Soon as I finished, I had another thought.
Perhaps our troubles with debt arise from the ambiguity of the double-edge: Debt is good, and debt is bad. Perhaps if we only thought of debt as bad, we would stay out of trouble. Or if we only thought of debt as good, we'd never think ourselves in trouble.
Nah. It's good and bad, and we just have to deal with our confusion on the matter. Oh, there are explanations, sure. The PDF opens with one. From the Abstract:
At moderate levels, debt improves welfare and enhances growth. But high levels can be damaging.
So: It's not the debt that gives us trouble, but the level of debt. Low levels of debt (or, moderate levels, as the bankmen say) are not problematic; but high levels of debt are a problem. I agree; my key phrase is "excessive debt".
But remember how it was when you were a kid? When you are little, everything is out of reach. When income is little, even "moderate" debt can be insurmountable.
Low and high, big and small: These are relative terms. That's how we get into trouble. We don't see the debt as too high until we're in trouble.
Then it is obvious. But then it is too late.
We need a better way to look at debt. "The double-edged sword" is a useless metaphor that does not keep us out of trouble. To make it right, we need an extra word: credit.
Debt is always bad. Credit is always good. But using credit creates debt!
Before you use it, OPM -- other people's money -- is credit. It is credit until you use it. But the moment you spend a borrowed dollar, all that's left is debt. You don't have the money anymore. After that, you just have the debt.
Debt is the record of credit we have put to use, a record of money borrowed and not yet paid back.
Credit is always good because it is available for use, or because you're using it, adding to aggregate demand, boosting the economy, keeping somebody working. It's all good.
Debt is always bad, because you don't have the money anymore. You don't have the credit anymore. You just have the obligation to pay back money you no longer have.
Let me revise the bit I quoted from the PDF: Debt is not a two-edged sword. Debt is one edge, perhaps the sharper edge. The other edge is credit-money.
The sword is finance. If you have to have a metaphor, the sword is finance.
7 comments:
People usually go into debt in order to maximize income (often by reducing costs).
The problem with debt is the perception of what constitutes maximizing income. If the markets start counting asset appreciation as income then what you really have is giant Ponzi scheme.
Any amount of debt is going to end up looking excessive if it is not balanced against real income.
In 2007 US households thought they did not have excessive debt because home equity exceeded total household liabilities by $1 tn. The rest of household assets were all gravy. Then one morning US households woke up to discover that their total liabilities exceeded their home equity by $8 tn.
http://tinyurl.com/3jtwb9a
The same analysis applies to businesses. If you are counting unrealized asset appreciation as income that is Ponzi finance.
If I could remember my first-ever comment here, it would probably have been something like this:
Debt is a problem if it cannot be serviced, or if the servicing causes too great a burden. Either way, it's unaffordable.
I don't get your credit good, debt bad dichotomy.
"Debt is the record of credit we have put to use, a record of money borrowed and not yet paid back."
Expressed this way, it an accounting identity. You can't had good on one side of the equation, and bad on the other.
Or am I missing something?
Cheers!
JzB
Let us think of the phrase "borrow and spend" as a unit. That is, we borrow in order to spend, and we do not borrow if we do not intend to spend the borrowed money.
An observation: There is a significant qualitative difference between money that we have borrowed-and-spent, and money that we have *not* borrowed-and-spent.
--> Either we have to pay it back, or we don't.
--> Either we have put it into circulation, or we have not.
--> Either it counts as debt, or it does not.
It it does not count as debt, then it is available credit, still waiting to be borrowed.
This is the difference between "credit" and "debt". And it is only the act of putting credit to use that gives a boost to the economy. The debt that remains thereafter is not a boost. It is a drag. It is the offset, the counterbalance, the yang of the yin.
//
Jim, the giant Ponzi scheme you describe is one end of a continuum. At the other end there is only a little innocent borrowing to expand the Mom-n-Pop. In my view there is no significant qualitative difference anywhere along this continuum. I know some people make judgments about good and bad uses of debt -- productive and nonproductive uses of debt. And I agree that is how it looks from our end of the continuum.
The little innocent borrowing that expands Mom-n-Pop also increases financial costs to the productive sector. Certainly other Mom-n-Pops will will compete with the first and borrow as well. Financial costs increase. Financial profits rise as Nonfinancial profits fall. People observe the shift in profits, and learn to prefer financial investment over productive investment. And there you have the Ponzi scheme.
To put my view in your terms, I guess I think we would be okay with Ponzi finance if finance was one-tenth the size it is today. It is the excessiveness of finance that creates problems for the productive sector.
The continuum, then, is 100% productive at the one end, and 100% financial at the other. Oh, and this reminds me of the footnote of Keynes.
Our primary objective must be to find the optimum point on the continuum, the point that provides the best economic performance.
//
Oh, the Blogger editor wants to call it a "Fonzie scheme"
Hi Art,
You say "Financial profits rise as Nonfinancial profits fall." This statement may well be true but you haven't explained how it works.
Scenario A:
Ma and Pa borrow to expand their pizza parlor
with the result being more
pizzas sold or less cost to sell the same amount of pizza such that they can pay off their loan over time and they are left with more disposable income.
Scenario B:
Ma and Pa borrow to expand their pizza parlor
with the result being they have no increase in disposable income from that leverage, but at some point they are able to sell the business to someone else at an increased price which is sufficient to pay off the loan and realize a profit.
Scenario B illustrates how financial profits increase. Let's say the the buyer in scenario B borrows the money. He has slightly higher capital cost than Ma and Pa, but it can work out OK for him also if he can eventually sell the assets for a higher price.
In both cases it seems like the debt is affordable, but scenario B
is unsustainable for same reasons that a Ponzi scheme is unsustainable. The problem is that it can continue for a long time because the borrowing expands the available money.
Hi Jim,
Yeah your scenarios work. I have a different approach. I think that as the financial sector grows relative to the productive sector, financial profits will increase relative to productive sector profits. If I'm right, I don't need a scenario. The growth of finance is evidence enough. That's just the way I think.
You offer only two scenarios. But you say "scenario B is unsustainable"... so you are thinking of scenario B being repeated many times over several decades. Okay, good. It is cumulative effects that are most significant, not individual events. But let's dismiss B and adopt A and let it run for a while.
It is the best of all possible worlds. Ma and Pa have nothing but success. Like any entrepreneur, they are likely to repeat the process. Perhaps they do not wait till the original loan is paid off. Instead, when 20% remains they roll it into a new loan and expand again. By definition (scenario A) they are again successful. They gain confidence. Then too, competitive pressures may drive them to expand again, before the neighbors do. This time, the expansion begins as soon as the previous loan is half paid off.
Over time, Ma and Pa Midas's debt grows as they gain confidence in credit and their creditors gain confidence in them. Meanwhile, the neighbors have seen their success and try to emulate it.
The use of credit and the accumulation of debt proceed apace. Finance grows faster than the productive sector, and with it grow the financial costs the productive sector must bear. But as these costs grow, profits decline.
Financial profits rise as Nonfinancial profits fall.
Hi Art,
My point was only scenario 1 works in the long run because in that scenario debt does not exceed the level of production needed to service the debt. When you have debt growing faster than production (scenario 2) then any individual's chance of success depends on how early in the game one arrives as in any Ponzi scheme.
If people feel motivated to create debt at a rate faster than production (often the motivation is counting asset appreciation as income), it should be expected that finance will grow faster than production. It should be expected that govt will grow faster than production. It should be expected that prices should increase faster than production. The extra purchasing power has to go somewhere.
But eventually there is a reckoning as dercribed by Fisher:
http://fraser.stlouisfed.org/docs/meltzer/fisdeb33.pdf
Jim,
Thanks for that great link.
"...It should be expected that prices should increase faster than production. The extra purchasing power has to go somewhere."
Good point.
Post a Comment