Zero debt would be an economic disaster.

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.

Image: ‘Whalehead‘ Found on flickrcc.net

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 out of nothing when a zero is split into a debt and a credit.  For most individuals’ debts, it is usually created based on the estimated value of future labor.

Buying and selling real estate is a relatively new financial innovation compared to the hundreds of thousands of years humans have roamed the earth. Little by little more and more land has come into the market economy, but 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 lived for millennia and millions still do. Land is simply kept in families by tradition and there is no need to buy or sell it.  Then a bank comes along and offers to lend money to young generations to buy the family properties from the older generations. The end result will be the same thing because the younger generation always gets land when the older generation dies, but this changes the economic power dynamics.

The older generation might like this new way to pass on land because it formalizes the traditional family social compacts that had always helped motivate the young to work the land and care for their elderly. The new financial arrangement, debt, 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 the younger generation paid and retire anywhere and hire 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, but in exchange for the land, the new owners end up doing a lot of work for the previous owners.  All debts based upon durable collateral like gold, silver, or real estate are like this. Another kind of debt is purely 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 by working for me. An hour for an hour.

Economists think that the creation of debt tends to encourage economic production and the destruction of debts tends to discourage it, but that isn’t always true. For example, the idea of bankruptcy is intended to eliminate debt so that there are more incentives to produce again.

Fiat money is a kind of debt created out of nothing too. 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 one 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.

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Posted in Macro
One comment on “Zero debt would be an economic disaster.
  1. […] And reducing debt/money doesn’t necessarily reduce economic energy either.  For example, bankruptcy eliminates debt/money and it should ideally increase work because someone whose debts are too large to possibly repay can get dispirited and give up.  Forgiving those debts can create the freedom to start anew. Bankruptcy debt-forgiveness is similar to an ancient Biblical idea of Jubilee which was thought to be as wonderful as the word sounds (although zero debt would actually be a disaster). […]

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