Debt 101 – Debt in Perspective

By Tim In Consumer Debt

12

Jul
2019

Lending or borrowing money is (in normal times at least) a fundamental feature of the modern economy. Households, companies and governments all participate both in lending (e.g. through savings and investments) and in borrowing (e.g. through loans, credit accounts and mortgages). Financial debts (sometimes called liabilities) are the accumulated money owed at any one point in time by person, a firm a government or indeed the nation as a whole.

A fundamental principal of capitalism is that these accumulated liabilities attract interest charges over time. Debt rises in two ways: firstly, by borrowing more money (e.g. for increased public spending) and secondly through interest accumulated on the debt. For any given interest rate, a higher level of debt places a greater demand on people’s income to pay off the interest and stop debt accumulating.

Some of this requirement could be met from revenues generated by peoples own financial “assets” or savings. By participating in the economy both as savers and as borrowers, people can try and balance their financial liabilities (money borrowed) against their financial assets (money lent) The extent to which it “matters” how much debt we hold depends (in part) on this balance between assets and liabilities. And as the past crisis shown, on the financial reliability of the assets.

Three aspects of debt have attracted media and policy attention over the last decades: Consumer (or personal) debt, the national debt and the gross external debt. Though all are concerned with money owed, these debts are quite different and have different policy implications. the following paragraphs set out the key elements of each of their relevance for economic sustainability.

CONSUMER DEBT

Consumer (or personal) debt is the amount of money owed by private citizens. It includes home loans, credit card debt and other forms of consumer borrowing. Personal debt in the UK and USA for example is currently dominated by home loans, which at the end of 2018 comprised at over 80% of the total. For as long as the value of homes continued to rise, people’s financial liabilities (home loans) are offset by the value of their physical assets (homes). Problems arise when house values collapse. Liabilities are no longer balanced by assets. when this is compounded (as in a recession) by falling incomes, debt – and the financial viability of households – becomes highly unstable. Like much of the growth economy, financial stability turns out to be dependent in an unsustainable way on growth – in this case growth in the housing market.

NATIONAL DEBT

The national (or public sector) debt is the money that government owes to the private sector. When a government continually runs a deficit (spends more than it receives in revenues) the national debt rises. Just as for households, reducing the debt is only possible when the public sector runs a surplus (it spends less than it receives). Increased debt is a common feature of public finances during recession. But, servicing this debt – without compromising public services – depends heavily on future government revenues increasing. This can happen in only three ways. First, by achieving the desired aim of growth. Second, by increasing the tax rate. And third, by using the debt to invest in productive assets with positive returns to the public purse. A continually rising public debt in a shrinking economy is a recipe for disaster.

EXTERNAL DEBT

The total debt held outside the country by government, business and households is called the external debt. the sustainability of this debt depends on complex mix of factors including the extent to which it is balanced by external assets, the form of both assets and liabilities (including the currency in which they are held) and the relative strength of domestic currency on the international market. Particular pressure is placed on an economy when its economy is shrinking and its currency is losing value. In extreme circumstances, a country may find itself unable to attract investors willing to support its spending and unable to liquidate its assets to compensate for this. At this point the level of external debt relative to the GDP becomes critical. Calling in debts worth almost five times the national income, for instance would be catastrophic.

DEBT AND THE MONEY SUPPLY

The amount of debt held by government, business and households is closely linked to the supply of money in the economy. Most of the “new” money in national economies is now created by commercial banks in the form of loans to customers. Governments through their central banks attempt to control how much money is created in the form of debt through two related instruments. One is the base rate – the rate at which the central bank loans money to commercial banks. The other is the reserve requirement – the percentage of deposits that banks are required to hold in reserve and which cannot therefore be used to make loans. The higher the reserve requirement the fewer loans are made. the lower the base rate, the more likely commercial banks are to make loans. Over the last two decades, the US Federal Reserve (and many other central banks) used an expansionary monetary policy to boost consumer spending. This worked to protect growth for a while but ultimately led to unsustainable levels of debt and destabilized the money markets. This is one of the reasons for calls to increase the reserve requirement. 

At Birchwood Stanhope, it’s important to us you have a fundamental understanding of what you are investing your time in. Our Charged Off Consumer Debt portfolios in USA offers an easy to understand investment with growth potential driven by significant economic situation which is forecasted to continue for years to come.

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