I often see articles that claim that rising debt is an inherently bad thing. For example, Erik at data-driven thoughts appears alarmed:
The average debt that an American holds has increased by 200x since 1943, from ~50 dollars to ~10,300 dollars. However the population includes all individuals, even those who probably don’t hold debt (children and possibly elderly). The chart below accounts for debt holders by visually showing debt per American, debt per adult*, and debt per working adult**. Average working Americans have about $17,500 in debt.
This is misleading because it doesn’t adjust for the growth of the economy. Furthermore, debt is not inherently bad for the economy. The absence of debt would be the absence of finance because all financial instruments are forms of debt and all debts are contracts. Nobody knows what the ideal quantity of debt is, but zero debt would be an economic disaster.
One person’s debt is always another person’s savings, so if debt is bad, then savings is bad. Most people think of their checking account as an asset, but it is also a debt that a bank owes to you. A bond is a debt that an organization owes to the bond owner who considers it savings. Some financial assets include physical collateral which is not a financial instrument, but a claim of ownership. For example, a mortgage is a debt that a home buyer owes to a bank with the house as collateral. Some people see a mortgage as a form of home ownership, but the payment contract is clearly a debt. A share of corporate stock is usually seen as ownership of a piece of a company, but it is closer to a form of debt than a form of ownership. It is a collateralized perpetual bond with a variable repayment rate that is tied to the profitability of the company. Unless you own a big enough fraction of a company’s stock to have a real say in how it is run, the company’s CEO and board of directors have much more ownership power than you and you are more like a lender.
Ownership is a property right and a property right is the power to exclude others from something. CEOs and corporate boards have this power. Banks often have more ownership control over companies than most shareholders do. For example, German corporations often have representatives from banks that lend to them on their board of directors. So there is often some overlap between debt and ownership that blurs the line between these categories.
Although most people want to think of their cash as their ownership of a solid asset, cash is really the most liquid form of pure debt. My $100 bill is like a debt that the rest of the world owes me $100 worth of goods and services. I can take it almost anywhere to get repaid. Of course, when I exchange it for groceries, the $100 debt hasn’t disappeared. It is just transferred benefits to the grocer and now the world owes the grocer $100 worth of goods and services. Even commodity money under the gold standard was mostly pure debt because almost nobody used pieces of actual gold as money. They used paper money and bank checks just like today. In fact, for decades under the gold standard, it was illegal for private citizens to have gold coins and bars because the banks needed to keep as much of it as possible for running the back-room operations of the banking system. The banks only had enough gold to represent a small fraction of the value of all the money was circulated which they kept as a kind of collateral, but it was never very good collateral because there was never enough for everyone to collect on it anyhow.
Where did debt originate? Debt is created in two ways. It can be created out of nothing, or it is created by a contract for a future payment of labor. For example, buying and selling real estate is a relatively new financial innovation compared with the broad scope of human history. Today there is still much land in developing nations that isn’t clearly owned by its residents and cannot be formally sold. That realization was Hernando de Soto’s most famous contribution to economics. Consider a village with traditional rights to family property, but without markets for buying and selling real estate. This is how all of humanity once lived and many still do. Then a bank comes along and offers to lend money to young generations to buy the family properties from the older generations. The older generation might like this as a way to formalize the traditional family social compacts that had maintained the elderly because it gives the older generation more flexibility. They no longer have to live with their kids on their property to get cared for in retirement. Now they could take the money and retire anywhere and get help from anyone they can buy it from.
This process would create a massive amount of debt out of nothing. Suppose that the debts are all eventually repaid. Then everyone owns their own real estate again, and the debt disappears into nothing again. The real estate that it was based upon never changes. All debts that are purely based upon durable collateral like gold, silver, or real estate are like this. The other kind of debt is based upon contracts for labor. For example, we could create a debt if I work for you for an hour and you offer to pay me back in kind. That debt is created by labor and it will only disappear when additional labor is created.
Fiat money is the first kind of debt. It is debt created out of nothing. The second kind of debt is constantly being created through business deals. This dichotomy between debts created out of nothing (like money and mortgages) and debts created out of labor is a bit of an oversimplification because debts are always a mix of labor and physical objects to some degree, but in some contracts, the labor required is trivial and in other cases, the labor is almost everything. Many economists think that the creation of debt tends to encourage economic production and the destruction of debts tends to discourage it, but labor debt is a contrary example. The creation of labor debts can only happen by producing labor and the destruction of labor debt is always expected to involve more labor, but sometimes the debt is forgiven instead.
Whereas money is a kind of debt that pays zero interest, most debt contracts do involve interest. Interest adds a labor component to debt because it implies that there is a flow of production involved in the loan and all production requires some amount of labor. A house provides valuable services to its residents that enables them to work in a particular location which allows them to pay back a mortgage loan with interest. In this case, more economic activity is created by the destruction of the debt than by the creation of the debt because the interest encourages production.
This helps explain the empirical regularity that credit usually expands when GDP is rising and falls when GDP is falling (a recession). Because all interest-bearing loans require some labor to repay, the reduction in credit means less repayment and less motivation to work. And why would credit fall in the first place? I’m not sure, but I think the big problem is a rise in default rates. When loans default and people give up on repayment, then debt can disappear without any labor. And if loans default, lenders will have less to lend out which means less future repayment and less motivation to work.