Debt: An Inescapable Concept Part 2: Personal Debt

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.

Debt/credit 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) income.

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 debt.

[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:

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

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

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 Isaiah.

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.

If 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 appreciate.

May15, 2007

Gary 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.

Copyright © 2007