Debt: good, bad or ugly?

Prior to this crisis, the world economy had seen massive growth in recent years. We all know there was a hiccup in 2001. But did you know that recession started in March 2001, not after 9/11? The dotcom bubble had burst, but then came the al Qaeda attacks and the War on Terror (no longer called this). An unholy perfect storm setting humanity against herself and the global economy in freefall.

Well not quite. Or, at least, not yet. While the global economy was rocked and broached in this perfect storm, she was not capsized. Central banks lowered interest rates and freed up companies and individuals to borrow heavily; encouraging them to squander money they didn’t own.

As house prices spiralled further and further out of reach, NINJA mortgages became the order of the day allowing the poorest in society to buy overpriced homes by leveraging not their assets, but their aspirations. The credit crunch was entirely predictable. I don’t claim to have been one of the prophets, but I do remember wondering about three phenomena in particular:

  • Self-certified mortgages. Why would an honest borrower need such a thing?
  • Mortgages based on 5 x salary, or even 6. My mortgage (4 x my salary) was already a stretch; what if interest rates soared?
  • 125% mortgages. In an era when average house prices had risen faster than average income for many years, surely a correction was inevitable.  But even price stability would leave these borrowers in negative equity.

There is a link between these factors and the credit crunch (and the ensuing recession), although it’s a bit more complicated. For me, as a buyer in 2002 and a home owner since then, spotting those factors was fairly straightforward. Buyers and owners have a natural interest in mortgages and house values/prices. My failure to spot the link early was based on an obvious old adage: if something looks too good to be true, it usually is. In this case, the factors above suggested the banks were unwise and doom was to be expected. I assumed the banks knew what they were doing, but that made an ass out of both of us.

This was debt at its worst, and a fairly extreme example. A tool for profit or investment (good), abused by greedy executives wanting superannuated profits at excessive risk to their companies (bad). The result of this for banks, shareholders, peak buyers, jobless borrowers, threatened workers, taxpayers, and this generation’s grandchildren (who will service our burdgeoning national debt) is just plain ugly.

All mine!

It's all mine!

One day we will emerge from this recession (I hope). That day may be some way off. In the meantime, it’s time to think about how we should conduct our economics in future. This question is nothing new and the G20 leaders have made some attempt to address it.

My interest (ignore the pun) is in the role of debt. In my opinion, mortgage debt, like beer and curry, taken in moderation is not a bad thing. Nor, perhaps, is well-priced debt to finance a sensible new car (as opposed to the Aston Martin you can’t afford).

But what about other extra-mortgage debt (spent on holidays, sofas or plasma TVs, for example)? There is a mainstream school of economic thought which suggests this kind of debt is good for the economy, even if it might not be ideal for the families and individuals so burdened. The thinking goes that consumer spending encourages growth and that consumer debt enables more spending. Therefore, consumer debt encourages growth. Since growth is good, consumer debt is also good.

I’m not convinced, and I’m not the only one.  I don’t doubt that debt-fuelled consumerism will influence growth, but I believe its effect must be time-limited. Of course a borrower has more to spend, but only for as long as his loan lasts. And as soon as his repayments begin, he must pay interest in addition to the capital. The opportunity cost of money spent on interest is the other consumer goods he could have spent his money on.

The rich rule over the poor; the borrower is servant to the lender.
(Proverbs 22:7)

If ‘Bob’ decides to buy a new 3-piece suite every eight years or so during his working life, that may amount to five refurnishings. Let’s say each suite cost him around £2,000 (A DFS bargain no doubt, but ignoring inflation) and was financed by a five year repayment loan. The interest rate is (a typical) 9.9%. By my reckoning, Bob’s repayments work out at £42.40 per month, which might seem reasonable. But across the term he pays £544 in interest. That’s a lot of money to throw away.

If, instead of financing his second suite with a loan, Bob had started saving £42.40pm after his first loan was paid off, he would be in a position to buy his second suite four years later (ignoring savings interest). That, of course, requires discipline and means delaying his gratification by a single year. He could afford his second suite after nine years (five to pay off the first loan and four to save up for the second). Instead of paying £2,720 in interest for five suites, he will pay just £544 in interest for the first suite. He saves £2,176. Plenty enough to cover the cost of one suite and a night out at Gordon Ramsey’s.

That’s why borrowing is bad for Bob. But is Bob’s borrowing good for the economy? I don’t think so. He can still buy just as many suites if he saves for them. In fact he can buy another one with the money he saves in interest. So by saving first, his consumer spending could be even higher than borrowing would allow him. The idea that consumer borrowing should boost spending (in anything but the short term), would seem to me a fiction.

Bad for the economy?

Bad for the economy?

There is another macro-economic reason I would discourage widespread consumer borrowing. I imagine the price of borrowing, like the price of anything else, to be governed by supply and demand. If there are more borrowers (demand), the price (interest rate) rises. The Bank of England sets the base rate, but this adjustment is simply intended to manage demand by the same mechanism.

So if the economy is saturated with borrowers frittering away money they haven’t earned, demand for money is high and therefore the price is too. As a bank, why should I lend £10,000 to a small business for new machinery for 7%, when there are consumers queuing up in my branch to borrow at 10, 12 or 15% for new suites, bathrooms, holidays or yachts? Of course, there may still be sound reasons to lend to the business, but my core point stands. A culture of borrowing will have an impact on the cost of borrowing.

Every £2,000 loaned to Bob for his suite is money that cannot be loaned to a business for investment. Every business, or potential home-owner, wishing to borrow to invest is competing against other borrowers. In a culture of consumer borrowing, this competition forces up the cost of borrowing. Good for banks, yes. But bad for business, bad for home-owners, bad for the economy and, as we’ve seen, bad for Bob.

In general? Just a bit ugly too.

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8 thoughts on “Debt: good, bad or ugly?

  1. Maybe debt should be fully market controlled like other commodities? Instead of buyers and sellers, match creditors (savings) with debtors (debt). This may be true for corporate bonds, but they are an institutional tool, and not enough of the money supply really makes its way down this path. It takes out the central planning element of monetery policy.

    As bad as uncontrolled debt can be, no debt isn’t great either. With no market for savings, what would the retun (read incentive) be to save?

  2. Pingback: Crunchy Crunchy « To Get At The Answer You Need The Question

  3. I’m still scrating my head at today’s budget – the government is aiming to borrow >£220bn on gilts (it’s having to do this using banks as proxies since it’s worried about its credit rating and its ability for people to agree to buy). Iceland went to the IMF, and had to raise interest rates to 15% as part of the deal, to be able to pay back the IMF quickly.

    But, to take David’s example of the sofa, if Bob uses a loan, the money doesn’t magically disappear – it goes into the finance company who gave him the loan, who can then distribute it how they see fit. The problem comes when people see loans as assets, which is how the whole system can inflate. Surely credit is OK for macro-economics provided it is properly accounted?

    One good thing in the budget – the ISA allowance has gone up to %5200/yr for cash and shares each.

  4. Thanks for your comments, especially the ‘crunchy crunchy’ blog. I’m not an economist, so some of my views may not entirely stack up, but I do feel the assumption that growth fuelled by consumer debt is unsustainable and that a healthier economy is possible without such a pronounced culture of lending. The crunchy crunchy blog makes the point that short term (5 years) considerations tend to drive policy, due to the electoral cycle. Yes, that’s true, but it would appear to be far from sustainable. I also believe, as articulated in my post, that so long as Bob has borrowed money from the bank, that money cannot be loaned to others who may be using it to invest. Extra-mortgage consumer loans therefore investment loans to businesses. Perhaps that’s junk economics; it’s only my blog as I see it!

    • You’re entirely right about it not being sustainable. Nothing about our culture is sustainable. Nothing about an economy which necessitates growth is sustainable. That it grows indicates that it cannot be sustained. We will eventually, like bacteria in a petri dish or yeast in the fermentation process, meet the edge of our environment, the limit it can take. I’ve written about my opinion on whether we are smarter than yeast before, it’s on my blog if you want to take a look. 😉

  5. You have pinpointed something very important in the whole debt issue – delaying gratification. This is something that psychologically is getting more challenging for people. Our society doesn’t do “waiting” very well. Aside from that, many of us are looking to have basic human needs like significance, security and self worth met in buying and owning possessions.

  6. Thats an excellent article !! and sooo easy to read 🙂 … thanks a lot …. ive just read some similar views on the history of debt crisis on

    http://half-bridge.blogspot.com/2012/03/history-and-causes-of-credit-crunch.html

    definitely worth a read !! —- (Yours and the one above)

    I like it when writers make a connection of economics with psychology/philosophy.
    Maybe economics is also a study of human behaviour —- at some level

    🙂 — thanks

    • Hi Sarah, thanks for your comment, I appreciate it.
      I do think you’re right. Economics is the study of human behaviour. But early economic theory suggested we are all rational. That certainly isn’t true, even for professional traders. What is probably more true is that we make decisions in what we perceive to be our self-interest, and we may not always be right!

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