Part I, Private Debt
This blog is intended to describe how private debt might look in a world that uses productive capital as its money, and is intended to answer questions we have received from several readers of the book.
When thinking about macroeconomics, abstracting to the simplest case is almost always profitable in aiding understanding. Consider the example of debt in an economy that is devoid of fiat currency. That is, contemplate debt in a world where we think of consumption and saving in terms of real goods and services, thereby not letting ourselves get confused by various illusions created by fiat money.
Suppose we start with an island consisting of perhaps 200 individuals. They work singly or as groups (businesses) to produce different types of output and they trade freely with one another to obtain what they need or want.
At any particular time, some of these individuals accumulate more wealth or output than they wish to currently consume. This excess of production over consumption represents their savings, and they must decide the most profitable way to place it. In making this decision they must consider risk and potential return. Of course, their goal is always maximizing their lifetime consumption at an appropriate level of risk.
Let’s start with the case where the only thing they can do with their excess of production over consumption is to invest it. By “invest” we specifically mean they can create productive tools or knowledge enhancing their own future production, or the future production of other individuals or businesses upon the island. In making this investment they therefore increase the island’s stock of productive capital available for future output production. Clearly this is an important function for the future growth and prosperity of the island economy. As a reward for accumulating capital the savers reap, on average, the marginal product of capital as the reward. The marginal product of capital is the rate of return that a saver would expect to earn. By saving, say, 100 bushels of seed corn, the saver might reasonably expect to have 103 bushels of corn the next period—a return of 3 percent.
Starting from that idyllic position, now let us suppose that individuals who enjoy an excess of output over their desired current consumption might do something else with their savings, which is to extend a loan to other individuals (or businesses) on the island. The potential borrowers are those who would wish to currently consume more than is obtainable with their current production or income.
If borrowing is introduced into our island economy, then those who need more output than they currently produce can offer a price (an interest rate) to entice those with an excess of output to lend it to them. How can they promise to pay an interest rate with any confidence? The borrowers must have an expectation or guarantee that their future output or income is going to grow sufficiently over the future to enable the repayment of the interest and principal on their loan or debt. Or, perhaps the consumption item desired is lumpy, large relative to current income, and infrequently purchased (for example, a house). In any case, the terms and assurances of the loan is part of the negotiations between borrower and lender. Moreover, to obtain their loan in a rational world, borrowers must be able to offer an attractive return and risk to the lender. That is, a borrower must promise to pay the lender a higher risk-adjusted return than the lender might earn himself through his own direct investment in new productive capital.
Will a potential lender be willing to extend someone else a loan if the lender has an ability to use his savings in his own or another’s investment project? That is, if a saver can direct his savings toward accumulating capital (a fishing net, tractor, etc.) for himself, for example, why make a loan to someone else? He will only offer his savings to a borrower if he can earn a risk-adjusted return which exceeds the expected return to capital. In an economy that uses capital as the bedrock of value and exchange the return to capital will be viewed as the benchmark return—attainable by the default position of simply accumulating additional units of capital.
A default on a loan occurs when a borrower cannot or will not meet the demands for payment of principal and interest on a loan that was made to him. Of course, loan defaults will sometimes occur. Not all loans made will be wise or prudent on the part of the lender or the borrower. In addition, things will happen—disasters, wars, accidents, and disease are always an unexpected part of human existence.
Where does the introduction of private debt leave us in our overall island economy? On a macro-level, all loans either allow borrowers to invest or consume. If all loans were made for purposes of investment, then the economy’s stock of productive capital will be larger than occurs if loans are made for purposes of financing consumption.
We are able to conclude that borrowing amongst individuals is not necessarily helpful in an economy that needs more productive capital. When an island needs investment, extending loans to individuals for purposes of consumption simply keeps the economy undercapitalized. Put simply, enabling lending in an economy that starts from a position of putting all of its available savings into investment of new capital cannot possibly result in a larger capital stock. At most it will be equal and, in fact, probably less. In any economy, even one that uses capital as money, no one say how much lending will occur in the aggregate or how much is “good.” If individuals enjoy lending back and forth to one another, the total volume of loans might become huge. If they primarily invest their excess of production over consumption, the total volume of private debt may be very small. If loans are predominantly made to businesses which then invest them in new capital creation then the net effect of borrowing upon the creation of new capital may be almost the same as direct investment—although the ownership of the new capital is changed. The important thing to realize is that, whatever its volume, the stock of private debt does not change our island’s aggregate economic wealth. Each loan created between a borrower and a lender creates an asset to the lender and imposes an exactly off-setting liability upon the borrower.
Once loan contracts are made, then the ownership of the resultant notes or bonds may be secondarily traded in the marketplace. One could even visualize private island “raters” who offer valuable and expert opinions as to the likely risk or quality of individual loans or pieces of island debt. Thus, an islander who now finds themselves with an excess of production of desired current consumption can now invest it, make a new loan with it, or buy an existing loan or bond in the marketplace.
Suppose, for some reason a “lending frenzy” takes place upon our island which produces an enormous stock of aggregate private debt. Is such an activity to be welcomed or abhorred? Well, as we have discussed it has no necessary net implications upon the aggregate economy and its net level of consumption or investment. Thus, we could say in the absence of loan defaults, all loans will be faithfully paid off and size of the total stock of private debt that occurs is irrelevant.
However, in the real world of uncertainty, the more loans that are made the higher is the probability of loan defaults—even if the loans are carefully underwritten. Of course, the situation is worse if imprudent or poorly underwritten loans flourish. The reason is that once loans start to default a “death spiral” of debt or bonds can proceed. As loans default, the price willingly paid for them not surprisingly falls in the market place. This in turn raises the interest rate required on new loans or the interest payments on loans already made but subject to adjustable interest charges. In the limiting case a debt crisis or “implosion” can occur with new lending driven to zero.
However, we can place some confidence in the limiting mechanisms of a transparent, simple free loan market. Although a debt explosion is theoretically possible, it could be argued that, in a rational private lending market, prudent, strong underwriting would be the norm and loan defaults would the exception rather than the rule. When defaults did happen, they would be isolated and quickly addressed. Moreover, loan defaults would naturally be immunized or quarantined with consequences largely limited to the individual lenders and borrowers who incurred them. Secondly, the always present benchmark return to capital would make the occurrence of such a lending “frenzy” difficult to imagine. To say the least, an always available, unimpaired return to capital would provide a strong, healthy natural brake on the scale of private lending activity.
So far debt seems pretty clear and simple. What could go wrong with lending in our simple island economy? The answer lies in governments, public debt, fiat money, taxation or mandates, and a government-regulated private banking system. We will explore that next.
A few nights ago I watched a John Stossel special on FOX news focused on government’s war against small business. The special started with Stossel surrounded by mountains of papers representing the federal rules and regulations imposed on businesses. To economists, the theme was a familiar one: Guised as much-needed regulation, government’s myriad of rules and red tape often has the affect of suffocating small companies. Discouraging entrepreneurs from pursuing new ideas ultimately benefits those larger companies having more lawyers, political ties and strong lobbies. 
