Debt: An Inescapable Concept Part 2: Personal Debt

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Debt is an
inescapable concept. It is never a question of debt or no debt.
It is always a question of which kind of debt, owed to whom, when.

In my previous
chapter, I covered the issue of social debt. I showed why it is
inescapable. Personal debt is as inescapable as social debt.

Let’s say that
you are hired for a new job. Normally, you must work until the next
scheduled payday before you are paid. You therefore must extend
credit to your employer for the monetary value of your work. The
more you earn per hour, the more credit you must extend. The longer
you must wait until payday, the more credit you must extend.

Here is the
irony: You, who are not rich, must extend credit to a company you
believe is economically successful. In such arrangements, which
are universal in the job market, the relatively poor person is required
to become a creditor to the relatively rich organization.

On the other
hand, what if the employer pays you immediately, as soon as you
begin work? The paycheck is for your salary after taxes until the
next payday. The employer extends credit to a new, untried worker.
You probably have never heard of such an arrangement. If I were
an employer, it is the one I would use.

Maybe the employer
abides by the Mosaic law governing employment. "Thou shalt
not defraud thy neighbour, neither rob him: the wages of him that
is hired shall not abide with thee all night until the morning"
(Leviticus 19:13). Still, you must extend credit to your new employer
for at least one work day.

is inescapable. There must be some degree of trust operating for
an exchange of labor for money to take place.

There are critics
of personal debt who issue universal condemnations of the debt/credit
relationship. They have not thought through the logic of their position.
If there were a universal cessation of debt, civilization would
collapse within days. The division of labor would cease.


For the person
who sells his labor, there is a risk that he will not be paid at
the end of the payment period. This risk is low, because employers
who want to stay in business must pay their workers. A bad reputation
here will dry up the supply of future laborers. But there must be
an extension of trust by the employee.

For a company
hiring a new employee, there is always a risk that he will not show
up on time, or he may perform poorly, or he may steal things. There
must be an extension of trust by the employer.

Both parties
must deal with risk. Both parties must extend trust. This risk may
be low, and this trust may be low, but both are mandatory in a society
that has a division of labor.

When an exchange
of labor for money takes place, there is an almost inescapable element
of time involved. Where there is time involved, there are both risk
and trust.

In Elia Kazan’s
little-known 1963 movie, "America, America," there is
a scene where a young Greek, who has been defrauded repeatedly,
buys a ticket from Greece to America, sometime around 1920. He is
using money he obtained through fraud. He tells the ticket salesman
to hold out the ticket. He in turn holds out a wad of money. He
extends the money to the ticket seller, while he reaches out to
take hold of the ticket. Only when he has the ticket in his hand
does he let go of the money. The salesman also lets go of the ticket.
There is no time element and therefore no extension of trust.

We cannot run
an economy based on simultaneous transactions like this one. They
take too much time to arrange and execute. A ticket salesman will
do it one time for a peculiar, fearful, distrustful buyer, but not
all day long.

The debt/credit
relationship is therefore an aspect of the time/trust relationship.
The latter cannot exist without the former. Civilization cannot
exist without both.


When you sell
your labor until the next paycheck, you are selling present goods
(labor right now) for future goods (money later on).

Would you deposit
money in your employer’s bank account in order to receive the same
amount of money in a month? You might if you had currency, and there
had been a wave of robberies recently. Your employer is providing
a service to you: safe storage. But without some external risk that
you regard as a great threat to your money, you will not voluntarily
surrender money today for the same amount of money tomorrow or next
month or next year.

This is because
you discount the value of future money in relation to the value
of today’s money. This principle applies to every scarce resource,
not just money. You are responsible in the present. You have assets
in the present. You have alternative uses for these assets in the
present. So, the present is more valuable to you than the future
is. It is close at hand; the future isn’t. The present is real;
your future is problematic. The value of a good owned in the present
is greater than the value of the same good owned in the future.

This is a matter
of comparative risk: safety now vs. safety later. It is also a matter
of time preference: the benefits of now vs. the benefits of later.

To persuade
people to surrender their lawful control over some good, a borrower
must offer an increased quantity of goods in the future. We call
this the rate of interest. It is the result of the discount that
people place on future goods vs. present goods. The borrower must
overcome this discount by offering more in the future for a good
borrowed now and not returned until a future date.

The critics
of the debt/credit relationship acknowledge neither the risk factor
nor the time-preference factor in every transaction involving the
surrender of control over an economic resource. They treat transactions
involving surrender and return over time as if time and trust were
free goods. But there are no free lunches and no free time.

Whenever a
valuable scarce resource is treated as if it were a free good, there
will be an analytical error in the discussion of economic cause
and effect.

When any critic
of the free market calls for the intervention of the state to prohibit
transactions that charge for inescapable costs of human action,
he is calling for one or both parties to the transaction to extend
a free good to the other. Perhaps this call is self-conscious. If
it is, then the critic owes it to his listeners or readers to spell
out in detail the effects of this call for a mandatory transfer
of wealth to others.

Usually, the
critic is unaware of the implications of his call for a ban on full
payment for a transaction. He is unaware of his conceptual error:
his treatment of something valuable as if it were a free good. He
therefore fails to assess the outcome of political intervention
into the market. He blames economic effects that he does not like
on something other than his erroneous assessment of economic cause
and effect.


There is an
economic law that states: "When the price of something falls,
more of the item is demanded." This law is an extension of
the concept of scarcity: "At zero price, there will be greater
demand than supply." So, the closer to zero the price is, the
greater the quantity demanded.

There has been
a great increase in consumer debt in the United States over the
past quarter century. There is a reason for this, one which is rarely
mentioned: falling interest rates. The price of loans has been declining
since the credit squeeze of 1980—81. Therefore, the quantity of
loans demanded has risen.

Borrowers estimate
how much debt they can afford to buy (carry). They look at their
after-tax disposable income. Then they look at the price of debt:
the interest rate. They borrow to finance their lifestyles.

The significant
figure for both creditors and debtors is the household debt service
ratio (DSR). This is the ratio of debt payments to disposable (after-tax)

In early 1980,
the DSR for house renters was 24.5. In late 2006, it was 25.5. In
other words, there has been no significant change. Renters know
how much debt they can handle.

In early 1980,
the DSR
total for home owners was 15.9. In late 2006, it was 19.4. This
was an increase of 22%. This increase came after 1984, after the
Reagan recession (1981—82) was clearly over. Borrowers carefully
estimated what level of debt they could handle and slowly and cautiously
increased it.

This is not
an example of what is sometimes called irrational exuberance. This
was a careful long-term response to new economic conditions. The
recessions of the 1970’s (1970—71; 1975) were behind them. Home-owning
borrowers responded accordingly. They concluded that they could
handle more debt. They were correct.

So, the household
debt level increased among homeowners, but the debt service ratio
did not significantly increase. Among renters, it did not increase
at all.


The significant
change came in the reasons for this indebtedness. The Federal Reserve
Bank of St. Louis publishes a
chart showing the level of personal savings
, 1947 to 2006. From
1947 to 1960, the increase was slow. It climbed in the 1970’s, but
no faster than the dollar declined in purchasing power. It peaked
in 1986 at about $340 billion a year, fell to $240 billion in 1987,
rose until 1993 to almost $323 billion. Then it began to fall. It
was under $170 billion in 2000, just before the recession of 2001.
During the recession, it fell to $131 billion. It went back up to
about $175 billion in 2004.

Then, in 2005,
it fell sharply in the first quarter. By the second quarter of 2005,
it went negative. For the year, it was negative $35 billion. Rarely
does any economic chart show a decline this steep. Americans are
today net borrowers in the $100 billion a year range. Individual
Americans have not only ceased to save, they have fallen into considerable

[Note: To obtain
any year’s figure, use the View Data table. Add the four quarterly
figures and divide by four.]

Rising home
values have allowed this: assets to borrow against. So have falling
interest rates. But why in 2005?

I offer this
explanation. The Chinese central bank’s policy of monetary inflation
and buying dollars to lend to Americans finally produced an unprecedented
effect. A fundamental change in Americans’ attitude toward the future
took place. Americans’ attitudes toward time shifted from a mild
future-orientation to historically unprecedented present-orientation.

There may be
a better explanation. I am willing to consider it. When we see a
shift this widespread and this rapid, no explanation makes much
sense. To use the term of a recent best-selling book, 2005 was a
tipping point.

The practical
question now is: What might tip it back? If nothing does, Americans
will not recover the attitude toward the future that marked them
from the beginning of the English-speaking nation in 1607 at Jamestown.

We have moved
from future orientation to present orientation. Edward Banfield,
a Harvard political scientist, four decades ago re-defined class
position in terms of time orientation. Present-oriented people are
lower class.

Using his definition,
in 2005 Americans visibly moved from middle class to lower class.
I regard this as significant for the nation’s economic future.


As far as consumers
are concerned, it doesn’t matter who owns the capital inside the
nation or the region where they spend their money. The free market
sets the rate of return on capital. The process pays no attention
to specific ownership within the private capital markets.

As far as consumers
are concerned, it also doesn’t matter who loaned them the money
they used to purchase goods and services. The free market sets prices,
including interest rates.

It matters
greatly — or should — to consumers what their future status as consumers
will be. If they refuse to purchase assets that are likely to produce
a positive rate of return over time, they are deciding to do one
or more the following:

  1. Remain
    in the work force much longer than their parents did;

  2. Become
    much more dependent on their children than their parents did;

  3. Accept
    a standard of living much lower as a percentage of their income
    as labor force members than their parents did.

As present
net borrowers rather than present net savers, Americans are purchasing
the future which they value most highly. They have recently elevated
their estimation of the value of present consumption far above the
present discounted value of future consumption. They are not only
consuming their seed corn, they are borrowing more corn to consume.
This is a voluntary decision. The free market allows them to make
this decision.

This is the
significance of the balance of payments deficit of about $800 billion
a year. It points to an American mindset that discounts the future
at a high rate.

Asian exporters,
financed by Asian central bank inflation which keeps their currencies
at price below what an unregulated free market would produce, are
selling more consumer goods to Americans than Americans are buying
from Asians. The Asians are lending Americans the difference — or
in some cases, buying the capital assets that employ American workers.

Asians are
buying legal title to future streams of income generated by American
employees and taxpayers. American employees will not own any share
of future income that is owned by Asian investors.

What is significant
here is the time and trust aspect of this arrangement. Americans
imagine that they will get something for nothing when they grow
old. They believe they will receive future income streams despite
the fact that they are selling capital or refusing to buy it today.
They no longer believe that there is a relationship between the
ownership of capital and future income.

In 2005, Americans
finally bought the party line of the U.S. government: There will
be something for nothing. "Social Security and Medicare will
deliver the goods, irrespective of who owns capital that employs
American labor and produces goods purchased by Americans."

From 1935,
with the passage of the Social Security Act, until 1965, with the
passage of Medicare, the American public mentally bought the government’s
official line: something for nothing. In 2005, the American public
finally bought it emotionally.


There is no
tooth fairy. There is no retirement fairy. There will be no streams
of income for the vast majority of old Americans. There will probably
be monthly checks. They will not buy much.

The rational
basis of high expectations of future income can be only two things:
(1) ownership of capital or (2) theft from people who own capital.
Voters accepted theft as a legitimate source of retirement income
in 1935 and 1965. As their faith in the productivity of theft increased,
their faith in capital investment as the source of retirement wealth
waned. In 2005, the tipping point occurred. Americans finally accepted
emotionally the worldview of the drunkards in the days of the prophet

Come ye,
say they, I will fetch wine, and we will fill ourselves with strong
drink; and to morrow shall be as this day, and much more abundant
(Isaiah 56:12).

Americans will
wake up with a gigantic hangover in their golden years.


Once you understand
that debt is basic to civilization, you should ask yourself: "What
is good debt? What is bad debt? How can I avoid bad debt?"

There are financial
counsellors who recommend that people tear up their credit cards.
Some people should do this. They are addicted to debt. They need
to go cold turkey.

This advice
is specific, not universal. Credit cards are a bad idea generally.
Their rates are too high. People are easily sucked in to years of
high-interest debt. But this is not an argument against debt. It
is an argument against subprime, high-interest debt.

If you pay
off your credit card bill every month, the card is not a liability.
It can be an emergency tool, such as on the road when your car breaks
down. The point is, the card becomes a liability only if you have
a problem with debt. You’re the liability, not the card. Don’t confuse
cause with effect.


Debt and trust
go together. President Reagan said of nuclear disarmament, "Trust,
but verify." This is good advice. Limit your extension of trust.
Limit also your extension of credit.

Don’t ask for
too much trust. Limit what you expect. Limit also your debt.

you can get a 30-year fixed-rate mortgage at a low interest rate,
and you really want the home, take the mortgage if you have an expected
stream of income to pay it off, such as Social Security. Paying
off the mortgage is a good use of a stream of income denominated
in dollars. They will depreciate.

The home will

15, 2007

North [send him mail] is the
author of Mises
on Money
. Visit
He is also the author of a free 19-volume series, An
Economic Commentary on the Bible

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