Debt: look at it like this

Following my article yesterday about the Federal government deficit and consumer debt, I had a few queries asking why I was so worried about it, when clearly the government and its economists were not.  That’s a fair question, but it reveals that many people don’t understand what debt does to the debtor – whether government, business or individual.  I figured an explanation was in order.  We’ll deal with it on the order of the individual, because it scales up to the larger entities just fine.

Let’s assume one earns $3,000 per month after taxes and other deductions, or $36,000 per year.  Out of that, one must pay for all the expenses of living – housing, food, clothing, education for the kids and oneself, a vehicle, and so on.  Anything left over can be saved, or spent on non-necessities.

If one needs an expensive item such as a house or car, one usually buys it on credit.  A bank or other institution advances the money to buy it, and the buyer agrees to repay the institution within a certain period at a certain amount every month.  In effect, the borrower is bringing forward his future earnings.  He’s taking what he expects to earn in future months and years, for the duration of the loan, and pre-committing part of it to buy something today.

However, this also has the effect of diminishing the total buying power of his future earnings.  Consider:  he would have expected $3,000 in his paycheck in February next year, just as he does this year.  However, because he’s committed to paying $300 per month on a vehicle loan, his available earnings in February next year are going to be only $2,700, because he’s pre-committed a tenth of them to the loan he’s just taken out.  He’s spent today what he would have earned in the future, and his future earnings will be reduced accordingly – in terms of what he actually has available – to pay for it.

Now, let’s presume that prior to the vehicle loan, he’s been saving $500 per month to cover future needs, emergencies, etc.  Suddenly he can’t afford to do that.  His savings can now be only $200 per month, because he’s taken on an additional $300 every month in debt servicing costs.  That means his “nest-egg” is going to grow more slowly;  and if he needs cash in a hurry, he may not have enough to cover his needs.

What if he has a car crash, and needs expensive medical care to restore him to good health?  He may be left with, say, $8,000 to pay out of his own pocket, but he only has $2,000 in his nest-egg.  That means he has to either enter into a new loan agreement with the hospital, to pay off his debt over time, or borrow the money using a credit card or other loan facility.  That, in turn, adds a new monthly payment to those he’s already making.  Let’s say he has to pay $300 per month towards those costs – but he only has $200 per month in available, not-already-committed income.  To make those payments, he’ll need to go even further into debt, by using a revolving credit facility such as a credit card.

Three years down the road, our debtor is in serious trouble.  He’s maxed out his monthly income by paying off loans he’s taken out.  He’s using a few hundred every month from his credit card to pay for essentials – food, fuel, the kids’ education, and so on.  Every month he’s deeper in debt.  He expects he’ll be able to pay off the credit card as soon as he finishes paying off his vehicle loan and medical bills . . . but what about other expenses in the meantime?  Life doesn’t stop happening just because we’re short of money.  Following his car accident and the repair costs, he might find his vehicle less reliable, and it may need to be replaced sooner than he’d figured.  His spouse may have needs of her own, medical or personal, that require payment (e.g. helping her parents to move house, or taking out a study loan to help her improve her qualifications, or allowing her to take a few months off work to give birth to their latest child – during which she won’t be contributing to household income, making their normal expenses that much more burdensome).

By borrowing money now to fund current needs, our “hero” has effectively mortgaged his future.  He can no longer rely on future income to deal with the needs he may have when he earns it – he’s already committed it to pay for the needs he has today.  He’s “brought forward” future income without having anything to replace it in the future when he actually receives it.  Besides – what happens if he doesn’t receive it?  He might suffer crippling injuries and be laid off work, or lose his job for other reasons.  What will he do without a relatively secure income?  Has he made any provision for that via insurance, or savings, or other means?  (No, playing the lottery is not making provision!)

That’s what debt has done to him. He’s become a slave to what he owes.  If he finds he can’t repay it, for whatever reason, he’s going to lose everything he has, because his creditors aren’t going to listen to excuses.  They want their money back, and they’re going to get it by hook or by crook.

So much for individual debt.  Corporate debt is pretty similar in its effects on businesses.  Governments like to think they’re different, because they can “print money” to pay what they owe.  There’s nothing to stop the US government printing twenty trillion-odd dollars tomorrow morning, to pay off the national debt . . . nothing except what that would do to the value of our currency.  The inflation rate would go out of control in a heartbeat.  Suddenly there’d be twenty trillion more dollars chasing the same amount of goods and services, and the latters’ cost would skyrocket to reflect that.  Hello, hyper-inflation.

By the way, that’s precisely what’s happened to the US dollar – and virtually every other currency in the world – over time.  Because more and more units of currency have to be “printed” – whether as banknotes, or as numbers in a computer – the value of each of those units goes down.  More and more money is chasing a relatively stable number of things you can buy with that money.  Some argue that new and improved items or technologies add to what you can buy, but they’re simply replacing or augmenting other items, so the overall effect isn’t nearly as great as might otherwise be imagined.  (For example, when motor vehicles replaced animal transport, the animals’ costs disappeared from the economy over time, to be replaced by the vehicles’ costs.)

When we say that the dollar today is worth less than it was, say, twenty years ago, that’s what we mean.  Inflation is merely a less finite resource (i.e. money) chasing a more finite one (i.e. goods and services).  If there are a thousand dollars available, and a hundred widgets that can be bought with them, the effective (default) cost of a widget is going to be ten dollars.  It’s simple mathematics.  If, suddenly, there are two thousand dollars available, but still only a hundred widgets, the laws of economics will dictate that sooner or later, a widget’s price will rise to twenty dollars.  The supply balances out with the demand.

That’s why a dollar buys less today.  There are simply more dollars in circulation now than there were earlier – and most of them exist purely and simply because of debt.  When the US Treasury and the Federal Reserve “create” more money, they have nothing of real value to underpin it – just the authority of the US government.  That’s why we call the dollar a “fiat” currency.  It comes from the Latin-origin word “fiat“, meaning “let it be so”.  Because the government says the currency exists, it does exist – but it has no authority or reality apart from the government’s word.

To “create” that currency, the US government – through the Treasury – sells securities, which are bought by investors.  The money they pay for them finances the US government’s expenditure, to a greater or lesser extent.  Those securities are a large part of what supports modern currency.  It’s not like older, asset-backed currency.  That’s long dead. It became too expensive, causing a balance of payments crisis for the USA (whose dollar was considered “as good as gold” for reserve purposes) and too restrictive on world economic growth.  Today, no national currency is backed by physical assets – only by the “full faith and credit” of the issuing government (which may be neither faithful nor credit-worthy).

Securities are, in fact, debt.  They’re guarantees of future payment, issued by the government, in return for investor funds today.  They promise to repay that money out of future government earnings.  If tax income isn’t sufficient to repay what’s owed, new bonds are issued and sold to replace the old ones – what’s known as refinancing or “rolling over” the debt.  Private individuals do something similar when they spend money on a credit card, repay all or part of it at the end of the month, then take out more debt next month on the same credit card.  They’re never really free of that debt;  they’re simply replacing the old debts with new ones on an ongoing basis.

The current US government debt of about twenty trillion dollars is too great to be repaid.  The very concept is laughable.  The sum is so vast that it can’t even be imagined.  It might get wiped out by inflation, but it can’t be repaid in any reasonable period of time, because it’s grown too great for the nation’s taxation income to sustain.  It can only be sustained by taking on more debt.  It’s growing out of control.  The recent budget deal in Congress means, effectively, another trillion or two in debt.  That’s how the increased spending is going to be financed.

If the US government were to pass a law tomorrow, declaring that the national debt was wiped out and that the US no longer owed anyone that twenty trillion dollars, the money would no longer exist in the real world.  Everyone who was owed part of it (i.e. those who bought US government securities to finance it) would lose what they were owed.  The goods and services purchased with that money would still exist;  but eliminating the national debt would, in effect, “steal” them from those who “lent” the money used to pay for them.  It’s the same as if a private debtor – you or I – were to refuse to repay the loan we’d taken out to buy a vehicle, the bank that issued it would lose its money.  Of course, for you and I, there’d be consequences.  The bank would repossess our vehicle, leaving us without transport.  It’s a bit more difficult to do that to national governments!

I hope this has helped to explain why debt – whether individual, corporate, or governmental – is a noose around our necks.  It’s unavoidable to use debt now and again, but it should only be used for major assets or necessities that can’t be financed in any other way, and it should be sustainable – i.e we should be reasonably sure we can afford to repay it.  If we can’t, yet still take it on, we’re effectively mortgaging our own future.  If we can’t repay it, we don’t have a future, economically speaking.  It’s as simple as that.  In part, that’s what the concept of “wage slavery” means.  Wages don’t just pay for current needs, but also for the debts we’ve incurred in the past against our current wages.  Without a wage, many don’t have an economic future – and, in some places for some people, that may mean they have no future at all.  It’s a grim thought.

(BTW, for one opinion on what the US Federal Reserve’s policies – and the debt thus incurred – have done to the USA, see here.  I think he has a point.)

Peter