Simplifying Debt

 

Part I, Private Debt

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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.

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3 comments
  1. Peter Christman said:

    So, in your island economy you don’t create new capital (or money) when one individual makes a loan to another. You say, “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.” But the borrower also has the asset he bought with the loan. To me it sounds like the island increased its capital stock by 100% of the loan value.

    To test this lets ask what happens if the borrower buys a service (in this case a college education) from the lender. Now the lender has his original “money” back as tuition (+100) plus the college loan (+100). So if the student pays off the loan the capital stock of the professor and the island has doubled – nobody thinks that a diploma can be exchanged for anything valuable, right? But if the student defaults, the loan is worth zero and the college professor is back to square one. So lending increased the capital stock and default destroyed capital formation – just like in the real world. Sounds a lot like fractional reserve banking without the reserve requirement.

  2. Dwayne said:

    Peter:

    Thank you for the interesting comment. I enjoyed reading it, although I am not sure I entirely understand your criticism. Particularly, I don’t agree that a world with capital as money is similar to a system of fractional reserve banking. To the best of my ability I will attempt to address your comment in the context of the simple example you provided. Pardon me for delving into some accounting issues, but I think it is unavoidable. Also, I apologize if my discussion indicates I did not fully comprehend your comment.

    I believe the heart of our disagreement pertains to usage of the word “capital.” As economists, we use “capital” somewhat differently than finance folks. The word “capital” as used by economists refers to the tools of production. (In our book, we do propose that the tools of production become the medium of exchange, thus the title Capital as Money.)

    Suppose the sum total of our island’s capital consists of two fishing nets (two units of capital, which also is two units of money). Let’s start from the simple position where the island’s “lender” is the owner of the two nets—he owns all the “capital.” Now, the lender loans one of the nets to the borrower to be paid back in, say, four years. As the island’s accountant, I would make the following accounting entry on the books of the lender:

    DEBIT AN ASSET ACCOUNT: LOAN DUE IN 4 YEARS (1 Fishing Net)

    CREDIT AN ASSET ACCOUNT: 1 FISHING NET

    On the borrower’s books the following entry occurs:

    DEBIT AN ASSET ACCOUNT: 1 FISHING NET

    CREDIT A LIABILITY ACCOUNT: LIABILITY PAYABLE IN 4 YEARS (1 Fishing Net)

    Of course, this has not created any new fishing nets—there is no new productive “capital.” The lender now owns a net, and the borrower owns a net. The contract between the borrower and lender has simply transferred ownership of the capital from the lender to the borrower for the duration of the loan.

    In reading your comment, you say “the borrower also has the asset he bought with the loan. To me it sounds like the island increased its capital stock by 100% of the loan value.” But the capital stock has obviously not increased—not unless we include the loan on the lender’s books as being capital.

    If the borrower now purchases services from the lender by paying with a fishing net, the following accounting entry occurs on the lender’s books:

    DEBIT AN ASSET ACCOUNT: 1 FISHING NET

    CREDIT A REVENUE ACCOUNT: REVENUE (In the amount of 1 Fishing Net)

    Again, no fishing nets have been created; the lender once again owns both nets, and the borrower owns zero.

    Let’s move forward in time four years, to where the borrower has graduated and now must repay the loan. What if he can’t do it, and so he defaults? You assert that “if the student defaults, the loan is worth zero and the college professor [lender] is back to square one. So,…..default destroyed capital formation.” The default may have destroyed capital formation, but it certainly did not destroy any capital. The lender still has both units of capital.

    Now, we may agree on one thing: If the student does pay back the loan, he is going to have to pay it back with something. He may have to work and produce a net to pay back the loan. If he does produce a net so as to pay back the loan, the economy’s capital stock grows. Capital does grow over time, and likewise the money supply will grow with it in a capital-as-money economy.

    My take is that at any given point in time, an economy has only so much output available for consumption or the creation of new productive capital. Lending among ourselves doesn’t magically somehow increase this. If the lending results in new productive capital being built or created, then next period growth in output produced may occur. In general, we hope this happens because if it doesn’t it will be hard to pay the principal and positive interest payments on all our notes.

    Of course, the real world does not use capital as money. It uses fiat money and a system of fractional reserve banking. Fractional reserve banking does not create new productive capital when loans are made, nor is capital destroyed when defaults occur. What fractional reserve banking does do is create new fiat money when loans are made. Worse yet, it creates an illusion of additional productive capital. The illusion is created when demand deposits are used to make long-term loans. The owner of a demand deposit rightfully believes he is the owner of something of value in the vault of a bank that is available “on demand.” The recipient of a loan may in fact use a loan’s proceeds to purchase an asset, and he also now owns something of value. But the depositor cannot really lay claim to something that has been lent; he is the victim of a fraud.

    Returning to the world of capital as money described above, imagine if the lender of the fishing net extended the loan with the understanding that the net could be retrieved on demand, but suppose the borrower believes the loan does not have to be paid back for four years. Now we would have a problem similar to the one that occurs under fractional reserve banking. There are only two nets on the island, but the perception exists that three nets can be had on a moment’s notice: the borrower believes he owns a net, the lender believes he owns a net AND he also believes he can fetch another net “on demand.” This is akin to the fraud that exists with fractional reserve banking.

  3. Eamonn said:

    In the current fractional-reserve banking system banks do not merely abrogate the property rights of depositors when they make loans; they also create new spending power in the process. Thus at any time, current demand, by a simple accounting identity, is equal to current income plus the increase in debt. Therefore it is critical in understanding economic dynamics to include banks, debt, and money in any models. Contemporary Australian economist Steve Keen has explored these concepts and has started building dynamic models that include the above. His work builds on those of economists Minsky, Schumpeter and Fisher.

    What “Capital as Money,” or any full-reserve banking plan regardless of the form of the money, would accomplish would be to restrict the role of banks to their popular image as merely middlemen between savers and producers (time deposits) or guardians of cash (demand deposits). Their ability to create new spending power, and reap most of the rewards, would be gone. And as was mentioned in the article, while booms and busts would no doubt still occur to some extent, the degree of such crises would likely be less due the elimination of the agency problem involved in fractional banking.

    Note to Brian and Dwayne: Use recent events in Cyprus (the Troika (EU, ECB, IMF) hijacking depositors’ money for bailouts) as fuel for a new article. It establishes a somewhat eerie precedent.

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