D is for debt

March 21st, 2014 at 4:30 pm by David Farrar

This week’s letter from the NZ Initiative:

In Shakespeare’s Hamlet, Polonius’s sage advice to his son about friendship was:

“Neither a borrower nor a lender be
For loan oft loses both itself and friend.

In contrast, borrowing and lending between complete strangers makes the world a better place. 

People can deposit savings with institutions that on-lend the funds to people who need to borrow to buy a house or expand their business. Globally, banks and other such intermediaries shift savings from countries that have a surplus of savings over investment opportunities, such as China in recent decades, to deficit countries. 

People with surpluses are better off than if their opportunities to invest were narrower and people with deficits are better off than if their opportunities to borrow were fewer.

These transfers of savings may take the form of debt or equity. This article is about debt. 

Unlike equity, debt involves no ownership control of the borrower’s enterprise. Instead the borrower typically agrees to pay the lender interest and principal according to a pre-determined schedule, as for term deposits or payments on government bonds.

The lender is risking that the borrower will default, and needs to take care as a result. Higher interest rates can compensate for greater risk, but not if the borrower defaults.

Conversely, borrowers who borrow too much can inflict severe future distress on themselves and their associates.

Borrowers have less incentive to be prudent when they are merely the agent of the person who is really liable. For example, when large companies or governments are borrowing, they are putting their shareholders and taxpayers at risk respectively, rather than the managers, politicians or officials who are signing the borrowing contracts.

Unless such agents are well-controlled, they may borrow imprudently.

Similarly, lenders have less incentive to be prudent when they are merely someone’s agent, or when they can assume that someone else, such as the government, is assuming the risk. Government-backed lenders, Fannie Mae and Freddie Mac, were major underwriters of the last US housing bubble.

Misplaced confidence in financial soundness is a dangerous thing, particularly for taxpayers. Unsurprisingly, research has found evidence that government guarantees for bank deposits increase the risk of bank failure.

Peace-time debt crises of national significance commonly reflect government mismanagement of fiscal, exchange rate, monetary, industry and/or prudential policies. But they can also have climatic and international causes. The costs in unemployment and lost output can be very serious.

Not sure what next week’s E is!

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13 Responses to “D is for debt”

  1. Reid (16,700 comments) says:

    Too bad they didn’t cover this part of debt. Like the Bank of England did the other day…

    http://www.youtube.com/watch?v=iFDe5kUUyT0

    http://www.bankofengland.co.uk/publications/Documents/quarterlybulletin/2014/qb14q102.pdf

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  2. gravedodger (1,575 comments) says:

    Might just be E for Economy?

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  3. mjw (401 comments) says:

    “Peace-time debt crises of national significance commonly reflect government mismanagement of fiscal, exchange rate, monetary, industry and/or prudential policies. But they can also have climatic and international causes”

    Ahem. Methinks this view is a little bit out of date.

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  4. Reid (16,700 comments) says:

    Might just be E for Economy?

    E for Equity.

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  5. lolitasbrother (774 comments) says:

    bad story from the Milford bush Farrar,
    John key has pushed our National debt from or 10 billion to 50 billion,
    don’t give us contrived debt eyesight Farrar ,
    its not a bird in the bush, with a slipshot camera

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  6. Alan (1,087 comments) says:

    “People can deposit savings with institutions that on-lend the funds to people who need to borrow to buy a house or expand their business.”

    Seriously, does anyone think that’s how banking works ?

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  7. jcuk (756 comments) says:

    Alan beat me to it … I do not dispute the rest of the item but that part is pure hogswash ….

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  8. EAD (1,450 comments) says:

    DPF – why oh why do topics like Central Banking and debt get posted late on Friday afternoon!!

    This article is gibberish at it assumes that huge levels of household debt doesn’t hurt the economy because more debt among households just means that savers have loaned them money … i.e. that it is a net wash to the economy.

    To make this assumption, it relies on the myth that banks can only loan as much money out as they have in deposits. In other words, they assume that if bank customer John Smith has $100 in the bank, then the bank can loan that $100 to someone else.

    But as Alan, jcuk and Reid above me note – banks actually loan out money whether or not they have enough in deposits … and then borrow the shortfall from the central bank.

    And to add further to that, when a bank creates “money” out of thin air, it only creates the principle, but not the “money” to pay the interest due on the principle. Therefore someone else somewhere in the system must take on debt to create “the money” to pay the interest due on the principle. That is the kicker – if you understand the laws of mathematics, this is an exponential function that requires an exponential expansion of debt to pay the exponentially expanding interest. Lowering interest rates can slow the exponential increase but it cannot stop it. The system is therefore finite and will end – High levels of private debt caused by our monetary system are the CAUSE of economic crises.

    Debt grows exponentially, while economies only grow in an S-curve. A crisis is baked into the system. 2008 was the precursor, something bigger is on the horizon.

    Read either of these this for an understanding:
    http://www.zerohedge.com/news/2013-09-17/what-time-would-you-leave-party
    http://www.debtdeflation.com/blogs/2012/01/28/economics-in-the-age-of-deleveraging/

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  9. Ben Dover (526 comments) says:

    Chinese Premier Li Keqiang on Wednesday announced a 12.2 percent increase to China’s military budget for 2014 to 808.2 billion yuan ($132 billion).

    Observers said that the growth is spurred by increasing global tensions and is consistent with China’s growing economy.

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  10. EAD (1,450 comments) says:

    NB: I wonder what people struggling with massive mortgages would think about going to work for 45 years to pay back money owed on a mortgage that a bank conjured up out of thin air?

    On that thought, Goodnight :)

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  11. Ben Dover (526 comments) says:

    Chinese President Xi Jinping on Tuesday urged the country’s armed forces to courageously assume their responsibility in safeguarding national sovereignty and interests.

    “We expect peace, but we shall never give up efforts to maintain our legitimate rights, nor shall we compromise our core interests, no matter when or in what circumstances,” Xi said while joining a plenary meeting of the People’s Liberation Army delegation at the ongoing legislative session.

    Xi, also chairman of the Central Military Commission, called on the armed forces personnel to be firm in faith and loyal in mission.

    To build a strong army, China should capitalize on strategic opportunities to deepen national defense and military reforms to resolve the institutional, structural and policy restrains, Xi said.

    “We should break our fixed mindset to foster a mode of thinking that is in line with our goal of building a strong army,” Xi stressed, calling for the creation of a cozy environment for pressing ahead with reforms.

    Emphasizing the state’s leading role in the process, Xi also called for the function of the market to jointly create a highly effective development pattern that features army-civilian integration.

    At the meeting, Xi urged Party committees and governments at all levels to lend support to the military building and reforms, and assist the army in accomplishing diversified missions to secure the building of a strong military.

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  12. Ben Dover (526 comments) says:

    PLA orders discussion of combat readiness

    The People’s Liberation Army (PLA) General Political Department has ordered the army and armed police across the nation to discuss combat readiness and effectiveness, the PLA Daily reported on Tuesday.

    The PLA Daily said the across-the-board discussion aims at instilling the concept of combat readiness, adding that the discussion will be the army’s prime political task this year.

    The PLA General Political Department has required military officers to learn modern military technologies and IT knowledge and to analyze what it takes to win a modern war.

    The discussion will entail weeding out military practices that run counter to the “combat-readiness standard” and learning the Communist Party of China (CPC) Central Military Commission (CMC) chairman Xi Jinping’s remarks on national defense and army building, according to the PLA Daily.

    Xi, who leads the country’s reform on national defense and the armed forces, stressed that military reform should be guided by the objective of building a strong army at a key military reform meeting on Saturday.

    With “being able to combat and win battles” as the focus, Xi said at the meeting the reform should target key problems in strengthening combat preparedness and weak links in honing combat effectiveness.

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  13. ROJ (125 comments) says:

    Why the h*** do we have banks and other financial institutions focusing on the availability and cost of the debt? It was only about the time I paid off my first place that the change happened. That was with the advantage of inflation. Now I am a saver I FEAR it.

    No problems about a bank being an intermediary for money. The problem is what is the driver.

    If you sell money, where does it come from? Dreams I suggest.

    If money is saved instead, then when it is in sufficient quantity then it may be put to work. The mindset that implies is to ensure that the purpose to which it is put is robust and cautious, rather than frenetic

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