Saturday, May 24, 2014

Debt


NOTE: These 12 essays are being reproduced from my now defunct blog Random Notes, as I intend to cite them in my upcoming essay on the use of words will emotion-heavy connotations and little in the way of actual denotation (such as "need" versus "want", or "exploit" and "fair").

We have heard repeatedly from pundits that our economic problems were caused, or made worse, by people who "carried too much debt" or "lived beyond their means". Strangely, this criticism doesn't usually come form the left (as it might raise some questions about the relation of that debt to the Community Reinvestment Act), but from the nominal right. From Debra Saunders to George Will, many (somewhat) right leaning pundits, who cannot see the inflationary spectre hovering behind all our trouble (for which I forgive them, as even many economist seem to ignore the role of monetary inflation), try to look to our "culture of debt" and "our need for immediate gratification" to explain our problems.

The problem is, it isn't true. At least not in the sense they think.

Let us look at a sound economy. The rate of interest for both loans and as the average return on a blue chip investment is 5%. Under those circumstances borrowing to make a purchase is a matter of indifference. You could buy something for $100 now, or borrow $100 at 5%, put the current $100 in a 5% investment and end up in the same circumstances. Of course, the more debt you carry the more likely you are to have problems should you lose your job or encounter other financial hardship, but from a purely financial point of view, 

Now, let us suppose we are in a situation such as prevailed until recently. The underlying economy is still the same. However, there is layered on top an inflationary expansion of the money supply. Judging from the CPI in the 1990's and early 2000's prices on the CPI rose between 0.4 and 0.6% per month. That works out to an APR of about 6% per year.* Let us simplify and call it a 5% per year increase. Interest rates should rise to 10% in such a situation, but as it is early in the inflation they likely won't adjust fully, and will lag, mainly due to excess money on the market, to 6% or 7%. However, thanks to an artificially low discount rate maintained by the Fed, interest instead stays at 5%. In addition, thanks to government intervention, risky loans, which should carry a rate of 12% or more are instead held down to say 7%, while good credit loans are held down to 4%. 

However, that rate of interest does not match the rate of return on investments. As businesses measure profits in inflated dollars, and also because expenses are underestimated, as is depreciation, by being presented in pre-inflation dollars, they report a large profit, probably close to or exceeding 10%.  In addition to this, the artificially low interest rates on homes serve to boost the market on property, causing a massive escalation in prices, leading to annual returns of 15%, even 20%, in some markets. 

Under such circumstance, taking a loan becomes the more sensible solution.

Let us look at the original purchase. On the most basic level, you could pay $100 or else you could borrow $100 at 5% and then invest the original $100 in an investment returning 10%, or even property returning 15% or 20%, and pocket the difference. In that case there is a very sensible reason to take a loan, at least as long as you expect the artificial boom to continue for the length of your loan.

Nor is that the only consideration. The prevailing rate of inflation means dollars are losing value. So every month you continue to carry a loan, the real principal of the loan declines by the rate of inflation. In other words, the cost of paying it off declines the longer you hold it. Not only that, but employees tend to receive adjustments to their wages yearly, meaning that, while your loan does not keep pace with inflation your income likely will, at least early in the inflation. So not only does the real cost of your loan decline, but your income rises to match inflation, meaning you have a fixed income with a declining principle when measured in real dollars. So continuing a loan as long as possible actually works to your advantage during inflation.

Given this truth, and especially given the creation of financing vehicles such as short-term interest only mortgages,  is it any wonder that artificially lowered home mortgage interest rates created a housing bubble? With housing prices rising even 10%, it makes sense to take a 4% or 5% interest only home mortgage, purchase a house, and simply hold it, making more in appreciation than you pay in loans. And once this practice became more common, leading to escalating home prices, it became self-reinforcing. The rapidly rising home prices made it ever more profitable to enter the market for a quick profit. And thus our housing bubble was born. 

However, though the holding of debt and use of borrowed money did contribute to our problems, that doe snot mean they were unsound practices. From the individual perspective, they still benefited. Not the home speculators, as the housing crash wiped out many. But the individuals "carrying too much debt" are not in the same situation. Their debts have still been reduced by inflation, and they still received inflationary profits from any investments. Granted, they now face an adjustment in those investments, but the erosion of their debts, and any earlier profits they cashed out are still there. And so, as I said initially, carrying debt does make perfect sense given our inflationary policies. If you object, if you think we should save more and spend less, then oppose the government's inflationary policies, not the individuals who react to them.

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* Granted, I should be calculating this by compounding, but as banks figure monthly rates from APR the same simplistic way, it seems a fair comparison.

Originally posted in Random Notes on 2009/02/20.


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