Thursday, November 17, 2011

Curse of Debt (1)

The age of debt is over reaching a climax. It began following the collapse of the IT bubble, when Alan Greenspan reduced interest rates to the keep the tech wreck from affecting the rest of the economy. The period of sustained low interest rates led to a massive debt binge all around the world. Everyone got in on the game.

Businesses moved from equity funding to debt funding to expand their activities. The advantage to business of debt financing was that they could control more assets with a smaller investment of equity.

Households went crazy buying houses. The real income of most households has been declining for the last few decades. They were able to compensate for this loss by leveraging their houses to fund a consumption splurge. This debt expansion also created housing bubbles all over the world.

Politicians need to spend to buy votes, so they love debt. They can buy more votes without raising taxes. Sovereign debt (the fancy name for government debt) grew rapidly all over the world, as politicians spent like there was no tomorrow.

Debt has a place, if it is used to buy assets that will produce sufficient return to cover the interest.

Most business debt was used to buy assets, so although business debt increased significantly, most businesses held assets that could be sold to pay off the debt if necessary.

Households and government used their debt to fund consumption. (Some households thought they were buying real estate assets, but when house prices collapsed, they realise that they had been buying increased consumption after all).

Borrowing to fund consumption seems wonderful at the time, because you can consume more than you can afford. However, when the consumption is finished, everything that you bought is gone, but the debt remains. It has to be repaid at some time in the future, and until that day comes, you have to pay interest over and over again. Debt is always a blight on the future.

Now interest rates are rising, the pain of debt is biting all over the world.

Households are trying to reduce their debt, but the only way they can do so is by reducing their consumption in the present. That is painful.

Governments are trying to reduce their debt, but the only way they can do this is by taxing more or spending less. Politicians hate both options, and their citizens feel the pain either way.

This all creates problems for the productive sector. When governments and households both cut back, there is no one left to buy their output. Some businesses that borrowed to buy productive assets are finding their assets are not producing the return they expected when they agreed to pay the interest on their loans. So businesses are putting off staff and unemployment is increasing. This makes it harder for struggling households to repay their debt. Government collect less tax, so their debt reduction becomes more difficult too. Glorious debt has become a vicious circle.

A decade ago, they whole world thought that debt was the way to go. Now the fun is over, but the debt still has to be repaid. This curse of debt will be an overhang on the world economy for most of the next decade.


Eli said...

This is a concept/reality I have struggled with especially in regards home ownership.
Do we continue to rent and try to save as much as possible. Or get into housing market with the debt and interest that brings with it.
Seems everyone tells me its a no brainer but I'm not so sure.

Ron McK said...

The people who say it is no-brainer gained their wealth during a period of high inflation and low interest rates. People relying savings were decimated during the same period. It was a government-policy-induced transfer of wealth from one group to another.

Eli said...

so do you think interest rates will get much higher or that its too high now?

Ron McK said...

that is a hard question to answer. Interest rates represent the price of the future. When people have confidence in the future interest rates fall. When people lose hope, interest rates rise. As we are going into a season where people have lost hope, interest rates would be expected to rise. However, in the modern economy government control interest rates, so this natural movement does not take place. Government's will keep interest rates as low as they can as they can for as long as they can, because they are big borrowers, and they want people to keep borrowing. If they ever lose control, we could expect interest rates to rise much higher as people lose hope. I am not sure when that will happen.

More at Interest.