Economics of Debt

Henry C.K. Liu hliu at
Fri Feb 2 21:48:57 MST 2001

One of the shortcomings of economics is that inadequate attention has
been paid to economics as a behavioral science.  The problem can be
traced to the concept of the economic man who is supposed to act
rationally in his own interest which is generally defined rather
simplistically as financial gain.  Modern economics of course deal with
the problem of human behavior with more sophistication, albeit always
through the back door, and always equating self interest with pricing. A
market economy is coordinated
through the price system based on the principle of declining marginal
utility. Economists construct indifference curves to show a consumer's
preferences. A good whose consumption goes down instead of up when its
price goes down is called a Giffen good.  An inferior good is a good
that you buy less of when your income goes up. A Giffen good must be an
inferior good, but most inferior goods are not Giffen goods. The effect
on consumption of a pure change in price is shown in an
income-compensated demand curve (also known as a Hicksian demand curve
after economist John Hicks). A Marshallian demand curve is based on
marginal utility. Utility is observed only in choices. The problem of
consumption is simply the problem of choosing the bundle of goods that
maximizes your utility, subject to the income constraint--the
requirement that the bundle you choose costs no more than your income.
The so-called Presidential
Elecion Cycle Theory of stock prices held by some investment analysts
suggests that major stock market moves can be predicted based on the
four-year presidential election cycle. The pattern is as follows: stocks
decline soon after a president is elected, as the new leader, incumbent
or not, takes harsh mearsures and unpolular steps necessary to bring
inflation, government spending and deficits under control.  During the
following two years or so after an election, taxes may be raised and the
economy may slip into a recession. At about the mid way of the four year
term, stocks should start to rise in anticipastion of the economic
recevery that the incubent president wants to be roaring at full steam
election day.  The cycles is supposed to repeat itself every four years.

The above is a select sample of theories hat makes sense generally only
if they fit specific defining conditions.

The purpose of this post is to suggest that human behavior is complex
beyond the measurment of price and that price alone is not sufficient to
influence market behavior.  Marx dealt with the concept of fetish as a
factor in demand.  Education is another factor.  Economics literature
has never dealt saitisfactoerily with eduction, being unable to clearly
define it as consumption or investment or both. Similarly with health
care and environmeantal preservation.  If it is both, there should be a
limitless supply/demand relationship.  One could not possibly have an
over-educated society or an over clean environment.

With debt, it is quite obvious that debt changes human behavior.  A
little debt reinforces responsibility. The American value system is
built on the notion that home owners with a life long mortgage are
better citizens than renters.  People tend to take better care of their
"homes" if they "own" it, even though 90% of the purchase value is in
debt. On the other hand, it is clear that excessive debt encourages
irresponsibility.  The borrower may develop an irresistable incentive to
walk away from his debt if he perceives that debt to be beyond his
ability to repay, or the cost of the debt exceed its benefits.  The
American bankruptcy regime is designed to give such debtor a fresh start
from debt.  Unlike European predecents, no one in the US can be put in
jail for failing to pay his debt, unless fraud is involved.  In fact,
there is the legal concept of lender liability, based on which a
distressed debtor can sue the lender for damages for lending money
irresponsibly that leads the debtor into financial trouble.  Debt
bascially is unearned money with a promise to repay it with
optimistically estimated earned money in the future, that for example,
the borrower will not become unemployed through no fault of his own.

On the corporate level, debt also alters management behavior. Leverage
increases profit margin on successful business plans.  But debt also
exaggerate losses when business plans fail. And in the US system,
bankruptcy is always a legal if not painless way to refute debt.  The
comfort to the lenders is that equity investors are wiped out first
becuase the lenders' variously collaterized positions.  Banks used to be

the sole intermediaries of debt.  For this reason, a Central Bank is
formed to supervise and provide liquidity tio the banking system.  Thus
central banks came into existence on the asumption that the existence
and health of the banking system is in the national interest.  And to
protect that interest the cnetral bank is allowed to act a lender of
last resort to the nation's banking system with public money, or more
accuracy through the government authority to create fiat money.  Thus
regulation on banks
is a fair quid pro quo social contract.  Bank deregulation without
corresponding raising of the standard for central bank bailout is a
direct breach of this soical contract.  If banks cannot be allowed to
fail, they
should also not be allowwed to deregulate.  More ominous,  the US credit
system has broken through the banking system, the bulk of debts now is
intermediated through the unregulated credit markets through
securitization of debts.  Over this market the government is generally
only an interested bystander, so far quite unwilling to regulate even
derivative trading by banks.
There is ample evident to suggest that the level of interest rate does
not influence the level of debt in an economy.  When interest rate is
high, it often merely reflects the credit unworthiness of the borrower
or the high risk for the lender.  High interest rates in fact creates
more incentive to take higher risk by offering more compensation to the
lender. As the Willaim Zechendorf, the bankrupt real estate tycoon once
said: "I 's rather be alive al 30% interest than be dead at 3%." It is
not clear that debt, unlike equity capital, actually puts money to work
for the highest and best use, or where it is most needed and where it
does the most good.  Debt tends to be most productive at the highest
risk level which destabilizes the economy.  Debt securitization actually
lowers the credit quality systemically by socializing the risk across
the whole system rather than concentrating on the singular defaulter.
Debt also discourages ecnomic democracy, since the poor generally find
it much harder to obtain credit.  There is much truth is the saying that
it is not how much you own, it is how much you owe that measures how
rich you
are. Debt also encourages carelessness with money, since the lender
implies faith in the borrowers ability to repay in the future.  People
tend to be more careful with money hey earned in the past in the form of
savings because they remember how hard they had to work for it.  In
comparison, debt is based on future earnings, which is deemed easier
money by the exisence of the debt itself. The problem with debt is that
it needs to be serviced regularly (except zero coupons which cost more),
and a debt-propelled economy will reach a point where its ability to
service the growing debt is exceeded, unless inflation is ahead of
interest charges. Thus runaway systemic debt always leads to
hyperinflation.  Bankruptcy only relieves the debtor, but not the
economy.  If, as Minsky claims, money is created when credit is
extended, then the erasure of debt destroys money and shrinks the

But the most fundamental aspect of a debt economy is that it cannot
sustain a slow down, even a soft landing.  If Greenspan were better
versed in debt economics, he would have inderstood that a debt bubble,
unlike the conventional business cycle, cannot survive the slightest
deflation.  His attempt to engineer a soft landing by raising interest
rates only accelerated the debt bubble's burst. His only option was to
prevent the debt bubble from forming by tightening credit quality years
ago, but he chose to rely on the "market" to exercise its discipline.
Instaed of discipline, the market gave him an insatiable apetite for
destructive debt.  Once the bubble is on its way, Greenspan is on top of
the debt tiger that he cannot get off without being devoured by the
beast.  It was not the New economy, it was not the new productivity that
gave the US its decade long boom.  It was debt.  Withoput debt, there
would have been no New Economy, no dot com industry, no structured
finance, no budget surplus and no current account deficit or its flip
side capital account surplus.
The 1990s was the debt decade. Much of the technology was invented prior
to the beginning of the decade and became widely applied through debt in
the form of vendor finance.  The communication revolution was built on
debt that had been accumulated in the last decade.  The greatest
of the 90s was more and more sophisticated debt instruments.

Henry C.K. Liu

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