Why we incur debt matters
Debt is neither good nor bad per se, what we use it for is
Background
In a prior posts I described:
that national debts rise over time because currency issuer deficits are currency user surpluses and currency issuer debt is currency user money.
that banks create almost all the money we use through credit expansion banking.
and how credit expansion banking creates financial instability and is a central aspect of capitalist monetary systems.
Good debt vs bad debt
In this post I’m going to discuss how debt is not a problem per se, but rather what we do with debt can be. There is good debt and there is bad debt.
Within this post, good means to increase the general level of prosperity.
A key concept here is “general level”, because it can happen that an economy can be growing and producing new wealth at a good rate, but the benefits of that growth and wealth creation are highly concentrated within the economy.
Money creation (debt) causes inflation?
It can. Sometimes it does.
It can also cause deflation.
It can also cause housing shortages.
It can also cause asset bubbles, for stock, bonds, real estate, crypto, etc.
A key concept here is we literally make money from debt. So “money creation” is “someone’s taking on debt”.
Sometimes it’s the Treasury. Most people stress this one A LOT.
Sometimes its the private sector (currency users). Most people don’t think about the aggregate effect of this AT ALL, yet it’s almost all the money in circulation.
What do we use debt for?
From a macro economic perspective, we, by which I mean currency issuing governments and all forms of currency users (non currency issuing governments, businesses, non profits, households, etc), borrow, broadly speaking, for:
Production of good and services (direct investment)
Consumption
Speculation (NOT direct investment)
Production
Creating money for production is not inflationary and can be deflationary as it generates an increase in the availability of goods and services along with the increase in the money supply.
Consumption
Creating money for consumption is inflationary as it creates more money without a corresponding increase in available goods and services. This creates the “too much money chasing too few goods” situation.
Financial speculation
Speculation fuels asset bubbles as it creates demand for assets without increasing the supply of those assets. Speculation results in ownership of the assets changing hands without an increase in the quantity of such assets.
Richard Werner explains this well
Richard Werner is a professor of banking.
The video below runs 10 minutes and 45 seconds and Werner explains these concepts well.
For what it’s worth, the insight that what we create create money for matters, and how it matters, is something I learned from him.
While there are numerous videos of him giving lectures and interviews where he discusses this, I chose this video because it’s short.
The panic of 1873 is a great case study
While to me the ideas mentioned above seem intuitive, to illustrate why debt for production increases the general level of prosperity and debt for financial speculation does not, I’m going to talk a little about the financial panic of 18731 (in the USA).
It includes elements of both.
A review of past financial manias, panics, and crashes reveals they generally start for one of two reasons; 1) A new technology is expected to change the world, and/or 2) a new form of money is expected to change the world of finance.
Railroads
Leading up to the 1873 panic, the new technology was railroads2.
While they really did change the world, it took many years for railroad companies to become profitable, so they needed very long term financing.
Building
This was production, plain and simple. We built railways and rail cars creating an enormous amount of economic activity.
Investment
Railroad companies issued bonds3, through banks, on which they were required to pay interest to bond holders. The money raised was used to fund the building of rail lines and cars.
Speculation
However, once bonds were created, they could be and were sometimes sold4, which did not result in the railroad companies receiving more money, but rather merely changed who owned the bond and was therefore due the interest payments and ultimately the repayment of the bond.
Production vs speculation
To recap…
Production (direct investment)
Banks organized bond sales for railroad companies to directly raise money, via debt.
The railroads received capital, in exchange for regular future payments of principal and interest.
The capital was used to build rail lines, rail cars, and whatever else was needed.
Speculation (NOT direct investment)
Once the bonds existed, they themselves became tradeable assets and were bought and sold.
Someone who sold one received a lump sum payment from the buyer, the new owner.
Someone who bought one received future income based on their share of the railroad companies interest payment and was entitled to the bond principal when it was paid.
But no amount of buying and selling bonds in a secondary market would result in anything tangible being built.
Buying and selling bonds after their creation did not generate additional capital for the railroads, but merely changed who received money from the bond payments the railroads made.
And buying bonds with debt (newly created credit money) created leverage, allowing a speculator to buy more bonds than they otherwise could afford.
Railroads generated insufficient revenues
Railroads were deemed to be strategically important to westward expansion5. The US wanted settlers to move west and establish farming communities, but in order to do so, farmers needed to be able to ship their crops to markets in the east.
Railroads served this purpose.
But in the early days, railroads did not generate enough revenue to allow them to service their debt.
Railroad bankruptcies stopped payments of principal and interest
In total, 89 of the countries 364 railroads went bankrupt6.
Banks had to write down loans that were never going to be repaid.
This pushed some banks into insolvency, and they were shut down. Which meant loans they had taken out were no longer being paid back.
Their creditors (other banks) had to write down those loans, which pushed some of them into insolvency, and they were shut down.
This is the usual “doom loop” that occurs during economic contractions.
Surprisingly, I could not find an accurate count of how many banks went bankrupt during this panic.
Back to production vs speculation
Railroad companies and banks were liquidated through bankruptcy and their assets were sold to pay off their creditors.
But whereas the assets of the railroad company had value, the value of the corresponding bonds fell to zero.
Railroad companies left behind tangible assets
Namely rail lines and rail cars in various stages of constructions.
This means that when someone else showed up and bought those assets at auction, the new owner of the assets was not starting to build from scratch.
Because it was a bankruptcy sale, they generally got a sweet deal on the assets and likely bought them for far less than it would have cost them to build them from scratch.
Banks didn’t
But the bonds were not tangible assets. As the payments on the bonds had ceased, the value of the bonds became zero. There was no value to salvage.
Lessons learned?
While there are numerous examples of the difference between creating money for production vs speculation, the build up to the 1873 panic and the panic itself is an excellent example, due to the obvious value railroads created as compared to the trading of the bonds in a secondary market.
Creating money for railroads created railroads.
Creating money for speculation on railroad bonds, created no tangible assets.
In closing
For a nation, debt for direct investment of infrastructure (maritime cargo terminals, canals, railroads, airports, air traffic control, highways, the electrical grid, housing, etc) is good debt. It raises the general level of prosperity.
But debt for other purposes is not. Incurring debt to increase financial speculation fuels asset bubbles, which cause enormous harm when they inevitably burst.