Musings on Debt

Here’s what I think about debt. It’s awesome but there’s a catch.  When debt is used in the proper context it is a powerful tool allowing for suppliers to meet market demands and ensure smooth delivery of goods and services. When debt is used improperly it creates boom and bust cycles as well as shortages and scarcity due to malinvestment. 

So what is the proper context? Debt treated as a rescheduling of payment where you receive money before taking some action to be able to repay. In this context there is an implication that the debt will either be used to generate the means money or you have a means to generate consistent revenue consistent or in excess of the borrowed money. 

What is the wrong context? Borrowing money to use without a consistent means to generate excess returns that can used to repay or for non-productive means. Going into debt to go on vacation or gambling when you don’t have a steady job or other means to repay you are misusing debt and are contributing to malinvestment. When there is too much malinvestment then resources dwindle and investment stops.

At the point investment stops to produce any good or service you need to have all of the resources necessary to produce before you get started. In practical terms take the example of toys for Christmas. Toy makers need to buy materials, employ workers to manufacture and truckers to distribute Christmas presents starting in July or even earlier. The money is borrowed and companies repay as they sell their goods, the term Black Friday refers to the date when companies sell enough product to pay off the debt and make a profit. If investment stops and you companies can’t borrow then companies who need to have all the money to make toys in July and if profits weren’t high enough toys the next year might not be produced. The logical conclusion in this scenario would be to make the most basic of toys that would guaranteed to sell. New entrants to the toy market would be few as only companies that already had money could produce and the risk would be very high. 

So if there are legitimate uses for debt how did we get into this mess?  Simply put moral hazard. When the negative effects of failure are so benign, government bailouts, opaque debt securitization, loan forgiveness or endless refinancing, then the appropriate context for lending (credit risk management) is no longer considered. When banks can sell loans to the government so the banks don’t have any loss if the loan fails then you are guaranteed to have greedy banks make as many loans as possible without context consideration. The borrowers in this situation also ignore context and inappropriately defer to the judgement of the bank as to whether or not the loan is appropriate. When the borrow doesn’t understand the bank is selling the loan to the government the trust in banks lending standards is misplaced. 

From a personal standpoint one must always use your own judgment and consider your own context when taking on debt. 

References

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80% of Americans in debt