Debt

There appears to be quite a battle going on in the blogosphere between economists who think we should increase aggregate demand through loose fiscal and monetary policy and those who think that, since these were precisely the things that got us into the mess in the first place, we should be focusing on reducing personal debt levels and sovereign deficits.

This raises a few questions that I want to explore; firstly I want to talk about debt.

Lets first set up a few parameters.

Broadly, economic actors can be divided into individuals, corporates, and governments. But governments and individuals are closely tied together. But a government is, in a sense, simply a collection of individuals. Governments raise income from its individual citizens (taxes) and ultimately its liabilities (debts) are borne by its citizens.

Individuals' ultimate aim is to consume. Corporations goal is to make profit for its shareholding owners so that these owners can consume. Governments aim is to look after its citizens and enact their will.

Why do these three types of entity sometimes choose to raise debt, or, to put it another way, why do these entities sometimes choose to save some of their income

Reason 1 is to smooth consumption over time. The most obvious example of this is the student loan, and its opposite, the pension. Obviously, since students earn nothing, and their future selves will earn a lot more, it makes sense to transfer money from one's future self to one's present self. This is an intertemporal budget decision, and you have to pay for the privilege of being able to make this decision, through the interest that the student loan company charges.

Reason 2 is to increase overall lifetime income. For example, somebody might borrow money to buy a BTL property. They are doing this because they believe that this will provide them with investment income. Which it will. But in order to borrow the money to fund this purchase they have to pay interest to the bank. If the investment income is more than the interest, then, simplistically, raising the debt will increase overall income.

For a corporate, reason 2 is the only reason to raise debt. A corporate may raise debt to invest in a factory, that will increase its output, or to buy a competitor, or perhaps to simply fund working capital for a loss making operation in the belief that in the future the company will increase its profitability.

Before I discuss governments, lets go into a bit more detail on the household balance sheet. Let's say that someone is 25, and earns £40,000 after tax per year, and has a debt load of £200,000, on which he pays 5% interest (£10,000 per year). It's been used to fund consumption, in the belief that the person will earn more in the future, which he will use to pay off debt.

Is this "too much debt"? Or, put another way, was it a good idea for this person to go into debt? Basically there are a few things to consider..

a) Is the burden of financing so big, that it's defeating the whole purpose (which was to smooth consumption). I.e. since 25% of the persons post tax income is going on debt financing, then clearly he's consuming less than he could have done. Going to absurdity, if he had a debt of £750k, paying £37,500 per year in interest, then clearly he's screwed up. He can't consume anything, so his consumption smoothing has completely failed.
b) Will the "income/interest" ratio go up over time? I.e. will he really earn more?
c) Is the interest rate fixed or does he bear interest rate risk?

What about someone who has borrowed £200k to buy a BTL flat? Well here the question is clearly very different, and quite simple, namely, is the total return (income and capital appreciation) from the flat higher than the interest burden on the loan?

This is the question that companies face as well (actually it's a bit more complicated than that, since for companies (and really for individuals) you have to take into account whether you could get a better return doing something else...)

For Governments, you can make a similar calculation. Simplistically, if you put in place a fiscal stimulus, funded by debt, this is basically "consumption smoothing", and also "investing" where the investment is essentially in making sure that people are working and therefore adding value. There are therefore 2 questions. Firstly, does the investment produce a return higher than the cost of financing (i.e. is the actual value added by people working rather than being out of work higher than the cost of financing the debt and paying back the debt), and secondly, is the economy in a situation where increasing the debt load and financing burden can be done without defeating the whole purpose of the stimulus, i.e. will consumption drop because of the debt load increase.

a) Is the burden of financing the debt so large that it is self defeating