By John Mattingly
Four-letter words are effective, on occasion.
I don’t fall in with the pageant of people who claim all debt is bad. It would not surprise me if humans invented written language for the purpose of keeping track of debts. Marks on baboon bones (See Ishango baboon bones, Stone Age Africa) from over 20,000 years ago indicate early homo sapiens were keeping track of borrowings. Debt is as old as civilization, so if one has any faith in civilization, one must concede that there is good debt and bad debt.
For purposes of this article, I’m going to define good debt as having two qualities:
1. The calculated gain from borrowed capital is greater than its cost.
Seems obvious enough, but is often ignored. If asked, “Would you borrow money at 10 percent to make a purchase returning 10%?,” few would affirm, yet this is exactly what people do when they borrow to buy a car, a TV, a sofa, a computer. Depreciating goods and assets should always be bought with savings, not loans.
2. Application of the borrowed capital adds value.
Again, this seems elementary, but is easily clouded by greed, the expectation of making easy money, or simple whim. While “value” can be subjective, a decent example is borrowing against one’s home for improvements, versus borrowing against that home to buy a boat.
As a farmer, I have greatly appreciated availability of credit in the spring for seed and fertilizer, which add value both to my farm and to the food web. A healthy credit system has been a big factor in the success of production agriculture. In developing nations where a credit structure is absent, production capacity is limited.
Good debt has both qualities: a positive spread and value added. Debt that makes a positive spread without adding value can be reduced to simple greed, or, as we saw in the Crisis of 2008, complex debt instruments piled on each other. For example, synthetic collateralized debt obligations with no other purpose than a positive spread can cause huge disruptions in the world economy when it is realized that its creation added no value.
When I started farming in the late 1960s, the qualities of good debt were tightly abided. Just 50 years ago, the U.S. was a Wealth Nation. We had a balanced federal budget, a modest trade surplus, a sensible set-aside system for agricultural production, and the U.S. dollar was the world’s base currency, backed by gold. Back then, no one I knew used a credit card.
The 1970s went off like an economic volcano. The U.S. separated from the gold standard, causing all the world’s currencies to be valued by a relative float. In the winter of 1973, oil went from $0.90 a barrel to $12 and then to $40 a barrel by 1979, causing a transfer of wealth from the Western World to the Middle East that was/is unmatched in economic history. Ag policy converted from a sensible, sustainable, set-aside program to reckless fencerow-to-fencerow production. The U.S. ceased to be a Wealth Nation and became a Trading Nation.
Not surprisingly, it was in the 1970s that credit cards moved from being a privilege of the few to being a convenience for many.
The 1980s hit our shores like a tsunami of debt. In October 1979, to rein in the inflation resulting from a non-gold-backed currency, Fed Chairman Volker fixed the money supply, forcing interest rates to float, which led to the initial explosion in the bond markets. Prior to Volker’s edict, bonds were the realm of the ultra conservative, but by the mid-1980s bonds had become a “player’s game” if not the “only game in town” due in good part to changes in federal tax law regarding the treatment of loans held by savings and loans, and subsequent deregulation of same. By 1986, the home mortgage market reached $1.2 trillion, making it bigger than the sum of all other capital markets in the U.S. combined.
Collateralized Mortgage Obligations (CMOs) were created in the early 1980s and accounted for several trillion dollars in invested capital by 1983. Many people think the CMO was a creature of the irrational exuberance of the new millennium, but they were actually created to bring home mortgages into a regularized, predictable, securitized format that could be sliced and diced into myriad financial products, notably interest only/principal only (IOPO loans).
By the 1980s, most people had at least one credit card.
The 1990s were full of debt aftershocks. Statistical arbitrage, debt-for-debt trades, explosion of bond funds that accessed floating rate capital markets to get leverage to amplify yields (aka ARPS: Auction Rate Preferred Shares), synthetic debt instruments created from bits and pieces of other debt instruments, credit default swaps (CDSs) became commonplace.
Credit cards and mortgages were being issued to NINJIs: No Income, No Job Individuals.
The New Millennium economy looked like it had been concocted during a chance meeting at a casino between Fellini and Heisenburg. Debt was being created with very risky metrics of a positive spread and no value was being added whatsoever, from consumer purchases to the actions of the biggest investment banks. Zero percent financing for everything from sofas to exercise equipment, no payments for years, Collateralized Debt and Mortgage Obligations, (synthetic CDOs and CMOs), Gaussian Copulas, Generalized Autoregressive Conditional Hetroscedasticity Models (aka GARCHs), Process Driven Trading (PDT), Momentum Random Walk (MRW), double reverse equity hedges. And literally hundreds of trading strategies run at lightning speed by interlinked computers.
A good bit of the growth we’ve seen in the last forty years has been in the labor force needed to shovel around this mountain of debt and control the erosion caused by its inevitable overflows. In the late 1970s there were literally a handful of investment banks in the world issuing new debt. By the time of the crisis of 2008 there were tens of thousands, all doing the same thing. Take a look around your own town and note how many banks there are now relative to 50 years ago. Every decade has seen the need for more workers in the debt field. If all the world’s debts were suddenly paid off, or written off, we might have 30% unemployment.
Summary. From this brief fly-over of the last fifty years, it’s apparent that much of the economic activity, growth, and production worldwide was enabled by bad debt. Instead of lowering our standard of living a few notches and behaving as true conservatives on a small planet, or as members of a global village (a message that may have caused Jimmy Carter to be voted out of office) we used debt to own-on (ow’n) things rather than own them. Debt was literally used as a substitute for productivity, a form of economic substitution that fails the Red Face Test.
The decade of 2010. Some predict that the bad debt situation will turn into something like the multiplying mop buckets in A Night On Bald Mountain and lead to a collapse and total restructuring of the world economy if, for example, the rest of the world decided to stop lending short term rollover money to the U.S. Treasury at one or two percent interest.
The only basis for optimism is obtained from analogy. Something has always come along to change the picture, something we didn’t know about and thus could not see coming, such as the internet that disabled hierarchies of communication and enabled JIT (Just In Time) and inventory efficiency. My previous article contained reminders of how inaccurate The Club of Rome and Paul Erhlich and every other practitioner of Doomspeak has ultimately proven when a surprise innovation entered the stream of possibility. Something may be on the horizon, or may already be among us, that will change everything, such as an alien visitation with solutions from the universe, a catastrophic reckoning, or humans leaving their bodies. In the meantime, it’s still a good idea to make all of your debts good debts.
John Mattingly cultivates prose, among other things, and was most recently seen near Creede.
