11 – CREDIT AND DEBT
Credit makes the world go ’round. It is far more important than money. The sheer volume of loans for businesses, credit cards, mortgages, bonds and other securities, dwarf the money supply. If money is poorly understood by the public, then credit might as well be in outer space. Books have been written on monetary theory but there aren’t any good credit theories. This is strange, since economists have been around since the 18th century. Even then overseas trade was financed with credit – bills of exchange passed between banks and brokers just like money. Except that they weren’t money, they were loans. Their values fluctuated and could disappear into thin air. If only they would behave like money!
Credit seems to be simple. Paraphrasing Wikipedia:
Credit is any form of deferred payment. Credit is the granting of resources (money, financial or material) by one party to another where the second party does not reimburse the first party immediately, thereby generating a debt, and instead arranges either to repay or return resources of equal or greater value at a later date.
Simple enough! Lenders evaluate a borrower’s ability and willingness to repay the debt. Lenders thus assume a risk in giving credit and borrowers pay interest to compensate for it. A written or other recorded form of credit agreement is called a credit instrument and is held by the lender as an asset, while the borrower’s debt is a liability. The asset’s value, however, would fall to nothing if the original borrower were to default. Because the lender’s credit instrument is an asset, it can be used as collateral against further borrowing and the creation of more credit instruments which can generate yet more lending.
But it gets complicated. What kinds of credit are there? How are they classified? Do they obey something like Gresham’s Law where the bad drives out the good? One early economist, Henry Thornton, grappled with the nature of credit. [1] In 1802, he concluded that credit in the economy expands or contracts naturally as there is general optimism or pessimism. He believed that the credit system should be managed by a central bank with its operations determined by judgment, not reduced to a rule. His contributions are accepted today but were forgotten later in the 1800s because Ricardo and his successors dominated economics with the idea of static equilibrium. Their methods ignored the distinctions between money and credit.
A. Mitchell Innes, an early 20th century English economist, took up the trail again. In papers published in 1913-1914, [2] he stated the case that money is actually a form of credit:
“. . . some would go so far as to suggest that the true nature of money is best described as a representation of the credit-debt relationships that exist in society.”
James Earley, a more modern economist, also noted that economists have treated credit quite inadequately. He coined the term ‘creditist,’ as opposed to ‘monetarist,’ and defined it as follows: [3]
“A creditist is someone who views the behavior of credit – the volume of borrowing and lending – as the fundamental variable in determining the behavior of the economy.”
He told of how Joseph Schumpeter worked for years on a book trying to formulate a complete theory of money and credit, but found it too difficult and never finished it. Earley quotes Schumpeter:
“Credit operations of whatever shape or kind do affect the working of the capitalist engine – so much so as to become an essential part of it without which the rest cannot be understood at all.”
Schumpeter tried, but Earley believed he failed because he assumed that credit and debt circulate through the economy as money does. The task is hard because credit does things that money cannot, and there are bewildering multitudes of forms of credit. Earley went on to say that credit, not money, should be the more fundamental concept. He believed that money is but a stepchild, a derivative, of credit. As Keynes later remarked, money alone as a medium of exchange is only one step removed from barter.
It amazes me that such important concepts as credit and debt have gone unresolved by economists for so many years, or rather, centuries. I think their bias toward near-barter static equilibrium has prevented them from analyzing the time-dependent interactions between loans, investments, inventories, durable goods, etc. They know about these things in great detail, but can’t really describe their relations through time. Each of them changes continually and affects the others. A big reason that economists have neglected credit is because it’s not possible to include it in any equilibrium analysis. Credit and debt are never steady and stable. They are always rising or falling; it’s their nature. But economists have contrived to omit them from their basic equations by noting that their net amount is always zero so, presumably, they can both be ignored. Which, of course, is ridiculous.
The credit system allows our economy to work far better than one with only money. Credit speeds up economic activity. People can buy immediately rather than save up for the purpose. Investment is quickened and the economy grows faster. This should be win-win except that credit deals, unlike money transactions, take time to play out. Credit-money loaned at one time is paid back later. The burden of a debt declines with time and so does the value of a loan. When a debt is finally paid they both disappear. But while they’re alive circumstances can change. There’s many a slip ’twixt the cup and the lip. Events and human motivations enter in surprising ways. Expectations of others’ actions and of future events are hugely important. People act upon what they expect, and can change their plans. Expectation and confidence are powerful motivators. With high confidence, optimism rises. Businesses begin new ventures even in the face of uncertainty. Keynes called this urge to action “animal spirits.” Things proceed easily and everyone prospers. But with lack of confidence, caution is the watchword. Spending is cut back and debt paid down. Animal spirits are replaced by precaution. Sales drop, costs are cut, hours reduced, and employees are laid off. Investments are postponed. Demand falls and unemployment rises. What is sensible behavior for every businessman damages everyone.
It seemed obvious to me that debt could not be assumed away in economics. Ignoring it would be like ignoring money in politics or sex in advertising. It couldn’t be done. Debt is absolutely necessary in a working economy. It is always present and has always been so. The earliest financial transactions we know of were debts marked on clay tablets in Mesopotamia, recording who owed what to whom. When the debts were settled the tablets were broken. This system was working centuries before coins were invented. Today a mainspring of the economy is missing from beginning economics textbooks. There is an empty chair at the table. Chapter 1 of any Econ 101 textbook should introduce Supply, Demand, and Debt.
It is puzzling that economic equilibrium sells so briskly while debt lies on the shelf. I believe it’s because they don’t mix; they are mathematically incompatible. One can’t have economic equilibrium if some of the money circulating in the economy vanishes as debts are repaid. The imaginary economic man, homo economicus, can function only if all of his transactions are final, finished and done, once they are made. How can he rationally consider unknown future interest rates or the likelihood of defaults? If we assume economic equilibrium and rationality however, then economic equations can be solved, calculations made, and results published. The choice is obvious: take those postulates and run with them.
Debts and their matching assets do indeed cancel out. But there’s something wrong with that argument. It assumes, implicitly, that it doesn’t matter who owes the money to whom. If that were true debt wouldn’t be a problem at all. After all, debt is money we owe to ourselves, so the overall level of debt makes no difference to aggregate net worth – one person’s liability is another person’s asset.
The level of debt matters only because the distribution of that debt matters, because highly indebted players have different problems than players with low debt. And this means that all debt is not created equal. Credit instruments slosh back and forth. There is turmoil if heaps of assets pile up here and huge debts over there. Colossal volumes of credit are created to finance payroll, inventory, construction, trade, investment, speculation and more. Equally huge amounts of debt disappear as salaries are paid, sales are made, inventories reduced, bonds redeemed, stocks and real estate sold, and so forth. This immense churning of credit and debt, growing here and dying there on every time scale, is what mainly drives our economy.
Credit instruments, being assets, themselves serve as a medium of exchange and are actively traded in markets. They are not, however, units of account or stores of value like money because their values fluctuate with market conditions and interest rates. A credit instrument and its matching debt have the same nominal value when they’re created but not thereafter. The debt liability is a fixed, known monetary amount. But when its offsetting credit asset is later bought or sold in a bond or mortgage market, for example, it may have a different value because people have differing opinions about the future.
Loans can be created using existing credit instruments as collateral. This layer of new loans may be used yet again as collateral for further loans. Pyramids of credit can be built upon shifting foundations of underlying debt. Recently a mountain of debt obligations, and derivatives thereupon, was erected upon a base of millions of humble home mortgages. But it wasn’t like the movie It’s a Wonderful Life with Jimmy Stewart. When a borrower took out a mortgage from Jimmy’s bank it was supposed that the funds came from the savers’ deposits. Jimmy convinced the townspeople it actually worked that way. He prevented a run on his bank and saved the day. But nowadays it’s different. Banks get loanable funds from the Federal Reserve, not customer’s deposits. A local banker sells his mortgages to big-city banks who bundle them into interest-paying securities which are sold to wealthy investors. When a homeowner pays off his little mortgage, the big security holder loses a tiny fraction of his principal and must accept a slightly lower interest rate from that time onward. If all the loans in his security were paid off it would lose all value because the assets behind it have disappeared – but that’s a chance he takes. That’s how it works today. When good records are kept, the location and status of every mortgage is known and vigilant bankers follow up on any changes. The laws of ownership and legal title presume that this process is always followed so that disputes can be resolved.
Nowadays, as the saying goes, “this time it’s different.” The bond market has become extremely large and complicated. Mortgage-backed securities are sold and re-sold to dealers, funds, overseas banks, and tax-sheltered accounts in Switzerland and the Cayman Islands. It’s become impossible to keep up with the paperwork even when it’s computerized, much less to track it into every corner of the world’s financial system. No one cares if a jumbo bond loses a thousandth of a percent when a single loan is paid, refinanced, or defaulted on. How many of these are there, really, in a given ten-million dollar mortgage-backed security? It has lost some principal, but how much? No one knows and no one really cares if a few are missed. Big trouble arrives, however, if large numbers of home mortgages go bad all at once. Almost all of them are current and up to date but no one can quickly find out which ones. Those mortgage-backed securities must be worth something but no one knows exactly how much, so they may become unmarketable. Some of the world’s biggest assets can become effectively worthless while all the good mortgages behind them are still intact. It is no longer true that “one person’s debt is someone else’s asset.” Strange things do happen.
In a recession, new loans can become very hard to get while old debts stay the same. When old loans need to be rolled over, new ones may not be available. Businesses lay off employees and sell empty office space. Home foreclosures go up. Jobless people move in with friends. Things might be different if the original mortgages were held only between bankers and borrowers. There could be some hope of renegotiating terms and sharing the pain. It’s not possible now, though, because bankers no longer have the loans. They’ve been sold onward, perhaps many times, and could be in the hands of someone in Singapore. Instead, a local banker has to repossess a house he doesn’t want, a borrower loses his home and his credit rating.
In 1960s Japan it was the same but different. Their big banks made too many commercial loans during Tokyo’s real estate boom. When the collapse came, office buildings lost their tenants and businesses defaulted but the Japanese banks did not recognize the losses. They held on to the loans because foreclosing would mean writing them off. Bad loans outweighed good ones and the banks were effectively broke. So they kept the worthless loans on their books even though no payments were being made. It was “extend and pretend.” The loans’ book values were better than nothing. The papers representing them went into the bank’s vaults and didn’t come out. The borrower’s debts were destroyed but the lenders still held the offsetting assets. Again, one person’s debt didn’t equal someone else’s asset.
Finally, society can suffer greatly from a mal-distribution of private credit and debt even if though they remain balanced and net to zero. If many households get overextended on consumer credit – credit cards and second mortgages – and their monthly payments are hard to meet, they will cut back on expenses like new cars, travel and dinners out, thus depressing business. Layoffs begin if consumer demand falls far enough, worsening the situation. It could lead to a downward spiral into a debt-deflation recession.
All of these end-game scenarios are within the purview of economics even though it has no way to predict them. Economists readily admit that they are examples of so-called market failures, when economic variables go off the charts and the machinery runs up against the stops, as it were. But there’s no shame in that. Market theory isn’t perfect. Even the physical scientists are still searching for their Theory of Everything. Yet there is a bigger reason why debt cannot be taken into economics, why it’s treated like an ignored stepchild. Debt is also moral and cultural. It is a bigger thing than money and commerce. It encompasses human relationships like power and forgiveness. Debt has always been a way for some men to rule over others. It is much older than money. Debt has the larger meaning of obligation which establishes relationships between people. Most obligations are small and unrecorded. Small gifts help people get along. Little favors matter. Tribal potlatches are big public rituals that hold communities together. Whether they are large or small, personal or public, practical or symbolic, all debts and obligations are meaningful and tie people to one another.
Debts payable in money have a harder edge because they are enforceable. The operative term is “force.” Some of the earliest writings we have about debt as money describe the evils of debt peonage. A farmer with a bad crop may pledge part of his land for a loan at a high interest rate which he can’t repay. Another bad year may force him to become a tenant farmer on what was once his own land with the debt forever growing, trapping him in debt peonage. This practice was so destructive to society that governments had to control it. Every major civilization had debt forgiveness policies, ‘jubilee years,’ in order to prevent peasant uprisings. Expensive funerals or dowries could also ruin a poor man. Even worse, some families sold their sons or daughters into servitude in order to erase debts. Why and how could they have come to this? En-force-ment is at the basis of monetary debt. Today, job losses, huge medical bills or predatory lending can force families out of their homes.
The idea of debt is woven into our culture in strange ways. Our everyday sayings show how finance, custom, and religion are mixed into it: you’re living on borrowed time; forgive us our debts as we forgive our debtors; a debt paid back is redeemed; we owe each other respect; it’s not worth my time; such a gift can never be repaid; you scoundrel, you’ll pay for that! Folk tales and scuttlebutt are full of it: what goes around comes around; you have to pay the piper; you get what’s coming to you, what you deserve, your comeuppance. This applies to borrowed money, borrowed status, borrowed oxygen or energy from the biosphere, borrowed time you’re living on – all of them. In many religions sin has been equated with debt (owed to the devil) and is redeemed by acts of repentance, contrition, forgiveness by priests or by God. The coupled concepts of debt and fairness must be wired deeply into people.
What can economists say about this? Nothing, really. This entire domain of meaning is totally out of their reach. They meander on about people’s “utility” and “revealed preferences.” Such concepts are useful only when expressed as numbers, usually money. Contradictions spring up when economists try to squeeze the notion of debt into a free market. Exchanging goods for goods, or buying and selling goods with money, always presumes a negotiation between equals. But a debt is something else entirely. When a note is signed, the equality of the parties vanishes and there is an imbalance of power between them. The creditor has the upper hand; an asset. The debtor holds an obligation. The asset might be worth more or less than its face value but the obligation is always in full force. Assets piled on top of each other can grow to the sky. Piled-up debts can lead to bankruptcy or to owing one’s Soul to the Company Store. Today’s concept of a loan, mortgage or credit card as a legal obligation is very far from a free market. To make a credit system work there must be a State with enforcement powers. If some conservatives got their wish and the government truly ‘got out of the way’ our arms-length, it’s-not-personal, credit system would stop functioning. A man’s bond would only be as good as his word. But, that’s how most people have lived most of the time in the world’s villages and towns. Personal credit systems have been the rule among both the poor and the rich. People who know and trust one another – insiders, clan members, friends – don’t try to make money off each other with usury or petty cheating. A good reputation lost is hard to recover.
There are even bigger, awesome, kinds of debts: allegiances to King and Country; obligations to our ancestors, to the gods. These overwhelming, unpayable debts are beyond human capabilities and understanding. What is a person to do or think? Fear and trembling, abasement and sacrifice. An economist may laugh saying, “put them aside – what have these to do with commerce?” The answer is, of course, a lot. Such big ideas built cathedrals in Europe. Today our culture holds that though man was created in sin, he is an autonomous individual. Individualism is the basis of today’s commerce. But yet, while buying and selling, people are thought to be guided by an Invisible Hand. Mr. Lloyd Blankfein, one-time CEO of Goldman Sachs, believed he was doing God’s work.
Though economists try to put the big ideas aside, they are stuck with a technical problem: how do debt-burdened, out-of equilibrium systems develop through time? Loans and liabilities spring into existence and slowly fade away. New money circulates in the economy but is removed at a later time. Some loans collateralize further loans and liabilities which themselves begin to slowly diminish. All the interconnected flows of money are continually changing with time. Where does the money flow? How does it rise and fall, here, and there? What happens here, or there, if there is bankruptcy or default over there, or here? Equilibrium cannot happen unless no loans are created and all existing loans are paid off.
Engineers handle this with something called Network Theory. It describes the time-motion of electric charges (billions of tiny electrons) moving through complicated networks of circuits that can store, delay, or resist their flow. Simple networks have simple behavior. Complex networks behave in weird ways. Currents can flow forward, then backward, build up and die away. They may show oscillations. Economists might create their own network theory to find the time-motion of money (billions of tiny dollars) flowing through complex economic networks. Such networks would store money, resist its flow, and delay it. But there is yet no such economic network theory. Concern with the time development of economic variables is very recent among economists. Those having mathematical skills don’t seem to think it’s important.