Debt

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A debt is anything that is owed, and being in debt is the state of owing something to another. There are moral debts, such as debts of honour and debts of gratitude, but the most obvious form of debt in most people's minds is economic or financial debt, when one party owes goods, services or money, to another. In that context it is a means of transferring resources from those who own them, but do not wish to use them, to those who wish to use them, but do not own them.

The terminology of debt

A voluntary loan agreement may be presumed to give benefits to both borrower and lender, and to have no direct effect on other parties. A loan benefits the borrower at the expense of the lender, in return for which the borrower may be expected to compensate the lender by the payment of sum of money in addition to the eventual repayment of the loan, that is termed "interest". The amount of interest payable annually is termed the interest or discount rate. The loan agreement may also be expected to take account of the possibility that the borrower may fail to repay the loan ("default" upon its terms) by failing to fulfill its obligations concerning the payment of interest or the return of the original payment (termed the "principal"). The agreement may include the provision of "collateral", which will give the lender title to (ownership of) an asset belonging to the lender, if the borrower defaults (the term "mortgage" may be used if the asset is property). Alternatively, or in addition to the provision of collateral, the agreed interest rate may embody a "risk premium" in addition to the appropriate "risk-free interest rate". Toxic debt is debt whose repayment with due interest is deemed unlikely. The date on which a debt is due to be repaid is termed its "maturity" date. The term "roll-over" refers to the replacement of a matured debt by another of similar value, and a "revolving debt" is one which is automatically rolled-over whenever it matures. The term leverage is used to refer to a proportional measure of indebtedness. Leveraging is the process of increasing indebtedness, and deleveraging is the process of reducing indebtedness.

Categories of debt

Household debt

  • The term "consumer credit" usually refers to short-term unsecured loans, usually related to specific purchases. It includes deferred payment arrangements made by sellers and by credit card companies, as well as "hire-purchase" agreements and short-term bank overdrafts.
  • A mortgage is a loan secured on property - usually real estate - that is used to finance the purchase of the property, or to obtain money for other purposes. An "adjustable rate mortgage" is a mortgage whose interest rate is related to a published index, and a "hybrid mortgage" is one in which the interest rate is fixed for a stated period,after which it may be varied.
  • A householder's equity in his property is the market value of that property less the amount of the outstanding amount of the mortgage upon it. Negative equity arises when the amount due exceeds the market value, a circumstance under which it pays the householder to default on repayment and surrender the property to the supplier of the mortgage.

Corporate debt

Corporations make loan agreements by the issue and sale of securities that are termed bonds if their term to maturity exceeds one year, and commercial paper if that term is shorter. A secured debt entitles the creditor to receive a specified items of corporation property if the corporation defaults on the terms of its debt. The terms of a corporate bond may include a call option enabling its holder to require its repayment before it matures (in which case it is termed a callable bond), or the right to exchange it for an equivalent amount of the corporation's equity under specified conditions (in which case it is termed a convertible bond). Bonds represent a claim upon a corporation's assets in the event that the corporation ceases trading in an order of priority determined by the terms of the bond and the legal regime under which they are issued. There are national differences of practice and terminology in that respect.

Public debt

The term public debt (often referred to domestically as "the national debt") is used to refer to the borrowings of governments in general.

International debt

Access to the bond and money markets is in principle available to governments and established corporations throughout the world, but in practical terms direct access is available only to those with acceptable credit ratings. Other sources of finance that are available to developing countries include:

  • Multilateral Development Banks[1]. that provide governments, communities and private sector businesses with market-rate loans funded by borrowing on the international capital markets, and low-interest loans funded from government donations; and,
  • Microfinance Service providers[2], a wide range of formal and informal organisations that provide various types of (usually unsecured) small loans at above-market rates to small groups who tend to make collective efforts to avoid default.

The market for debt

Legal aspects

Borrowers' rights

Most legal systems impose limits on the ability of a creditor to seize the property of a debtor who is unable to repay a debt. Some exempt a minimum amount of real estate and some also exempt some categories of movable property such as tools of trade. There are often usury laws that limit the amount of interest that may be charged[3].

Creditors' rights

The legal protection of creditors against default by borrowers varies from country to country and among states within countries, but its main features are the provision for:

  • foreclosure, or repossession, in which the creditor assumes the ownership of colateral property;
  • liquidation, in which the borrowing company sells all of its assets and uses the proceeds to pay its creditors;
  • administrative receivership, in which the creditor appoints an expert to manage the company with the objective of paying back as much as possible of the outstanding debt (the preferred option when the default arises, not from a lack of assets, but from a lack of liquidity)

For the protection of prospective creditors, loan agreements usually have to be placed upon a register to make public any prior claims upon the borrower's assets, and it is illegal for a company to continue trading if its directors know it to be insolvent.

Sovereign debt

The law offers no protection to the creditors of foreign governments, and it is legally open to any government to repudiate its debts. Since countries cannot cease trading, however, the concept of bankruptcy is inapplicable to countries; and while a country may be unable to pay its debts on time, it necessarily retains the capacity to make eventual or partial payment. To avoid some of the costs of sovereign default, creditor and debtor countries may agree to restructure the debt (for example by reducing the level and extending the period of interest payments). The "Paris Club[4]" is an informal organisation of creditor countries that negotiates such agreements.

The concept of "odious debt[5]" has sometimes been used to argue that debts incurred by a government were illegal because they had not been undertaken in the interests of its country, but an international discussion[6] in 2008 did not reach agreement about the implications of the concept.

Attitudes to debt

The historical tradition

A debt that is freely undertaken may be presumed to confer benefits upon both parties and to no harm no-one, in which case it is not obvious that it should be an object of disapproval. There is similarly no obvious reason for objecting to agreed interest payments, since they may be presumed to be in accordance with the time preferences of both parties. Interest-bearing debt has nevertheless been widely condemned at several stages in the course of history. The divine instructions received by Moses, as recorded in the Bible, include:

And if thy brother be waxen poor, and fallen in decay with thee; then thou shalt relieve him: yea, though he be a stranger, or a sojourner; that he may live with thee. Take thou no usury of him, or increase: but fear thy God; that thy brother may live with thee. Thou shalt not give him thy money upon usury, nor lend him thy victuals for increase.[7]

- which have, from time to time, been interpreted by western religious authorities[8][9] as forbidding all charging of interest. There has been much debate concerning the interpretation of the term "usury", and as late as the 1920s, the then popular Catholic author, Hillaire Belloc, wrote that:

It means any interest, however low, demanded for an unproductive loan. It is not only immoral [on which account it has been condemned by every moral code - Pagan, Mohommedan, Catholic] but it is ultimately destructive of society. [10]

Secular objections to debt have been expressed by Shakespeare in Polonius's advice to his son:

Neither a borrower nor a lender be, For loan oft loses both itself and friend, And borrowing dulls the edge of husbandry.[11];

- and by Danté', whose Divine Comedy places usurers below murderers, in the third round of violence in the seventh circle of hell where:

The Blasphemers lie supine; the Sodomites are in continued motion; the Usurers sit hunched up[12];

- and by Benjamin Franklin:

But, ah, think what you do when you run into debt; you give to another power over your liberty. If you cannot pay at the time, you will be ashamed to see your creditor; you will be in fear when you speak to him, you will make poor pitiful sneaking excuses, and by degrees come to lose your veracity, and sink into base downright lying; for, as Poor Richard says, the second vice is lying, the first is running into debt.[13].

Attitudes to public debt have also been generally hostile, for example Thomas Jefferson believed that :

the principle of spending money to be paid by posterity, under the name of funding, is but swindling futurity on a large scale.[14]

However, the utilitarian philosopher, Jeremy Bentham, took the contrary view about personal debt, arguing that:

no man of ripe years and of sound mind, acting freely, and with his eyes open, ought to be hindered ... from making such bargain ... upon any terms he thinks proper. [15]

Behavioural influences

Many examples have been recorded of behaviour that is contrary to the presumption that interest-paying loans will be accepted if they offer net benefits to borrowers. The phenomenon of debt aversion has, for example, been observed among students, many of whom have been found to be unwilling to accept loans from which they would expect to benefit[16]. It has also been concluded that most people undertake routine debt without due regard to its relative costs and benefits[17].

Other forms of logically inconsistent behaviour have also been observed. The term Time inconsistency has been applied to observed patterns in the treatment of loan agreements in which different time preference rates have been applied to different stages in their execution[18]. The term "hyperbolic discounting" (as distinct from conventional "exponential discounting") denotes the use of a higher annual rate of time preference against short delays than against longer delays. It has been pointed out that, although hyperbolic discounting is time inconsistent when applied in terms of relative time, it is not time inconsistent when applied in terms of absolute time (such as the application of a lower rate to a later period in the subject's life)[19].

Current attitudes

Household debt in the United States, Britain and Japan amounts, on average, to more than a year's disposable income, and to about 30 per cent of that level in Germany and Italy[20]. It consists mainly of long-term house mortgages (which householders may not consider to be debt) but includes a substantial amount of revolving (ie regularly renewable) debt in the form of delayed payments for credit card purchases[21]. Debt continues to be a matter of concern on the part of its holders and nearly half of credit card holders in the United States are reported to suffer feelings of guilt about their use[22]. There is also evidence of debt aversion among United States businessmen, and a substantial number of large public non-financial US firms follow a zero-debt policy [23] Historically high levels of public debt are also a matter of general concern, and an opinion poll in February 2009, reported that it was one of the top two matters of concern to United States voters [24]. According to Robert Schiller, Professor of Economics at Yale University, investors tend to over-react to statistics relating public debt to gdp, and to persuade governments to make premature reductions in public expenditure in the aftermath of recessions [25].


The economics of debt

The appraisal of proposals involving delayed consequences is dealt with in the articles on discount rate and cost-benefit analysis.

As a means of transferring resources from those who own them. but do not wish to use them, to those who wish to use them, but do not own them; debt may be expected to promote economic growth by facilitating investment. As a means of "consumption smoothing", that enables a household to forego consumption when its income is relatively high, in order to enjoy an acceptable standard of living when the wage earner retires or is unemployed; it may be expected to promote personal and collective welfare. The most effective development of debt for those purposes tends to occur in stable communities with adequate financial intermediaries and means of the enforcing loan agreements[26]. The accumulation of debt can, however, be a cause of damaging instability. According to Hyman Minsky's financial instability hypothesis[27], borrowers accumulate debt in prosperous times, and allow it rise to a point at which it cannot be repaid out of current income. Debt reduction (or "deleveraging" nearly always follows a financial crisis[28], and inevitably creates reductions of consumption and thus of economic activity [29] [30].

International debt has assumed economic importance in recent years, as massive international capital flows[31] have affected domestic economies. Until the 1990s the major direction of flow arose from borrowing by the developing countries from the industrialised countries, but the direction of flow has subsequently reversed after the governments of developing countries began to use domestic savings to buy the bond issues of the industrialised countries [32]. Factors that have influenced high levels of saving by the developing countries[33] have included the lack of consumption smoothing institutions such as insurance, income support and pension funds. The main factor that has influenced the large proportion of those savings that has been lent abroad has been the lack of domestic investment opportunities. Those are changing influences, and changes in the volumes of such flows of capital are a potential source of economic instability[34].

If the annual interest payable on a government's debt rises faster than the national income, the point will eventually be reached at which it would exceed the revenue that could be raised by taxation. The debt trap identity establishes that the budget surplus (or reduced deficit) needed to avoid an increase in the ratio of debt to GDP depends upon the level of that ratio and the difference between the interest rate payable on the debt and the growth rate of nominal GDP. An increase in the risk premium that the bond market applies to a government's borrowing may increase the cost of its borrowing to an extent that increases the market's perception of its riskiness, in response to which the bond market may apply a further increase in its risk premium. (An expectation of a reduction in economic growth could also trigger such a response). Repetition of that sequence could eventually force the government to default by placing the cost of a roll-over of maturing debt beyond its capacity to raise the necessary funds. The market's awareness of that possibilty may add to the destabilising effect of its actions.

References

  1. Multilateral Development Banks, World Bank, 2010
  2. Typology of Microfinance Service Providers Version 1.31, World Bank[1]
  3. The Right to Borrow, Policy Note No 44, World Bank, April 1995
  4. Welcome to the Paris Club Website
  5. Vikram Nehru and Mark Thomas: The Concept of Odious Debt: Some Considerations, World Bank, May 2008
  6. Round Table on Conceptual and Operational Issues of Lender Responsibility for Sovereign Debt, World Bank, April 2008
  7. Leviticus 23 verses 35-37[2]
  8. Aquinas on Usury
  9. Interest (Usury or Riba) in Islam, Hilal Plaza.com
  10. Belloc, Hillaire: "On Usury" in Essays of a Catholic, T A N Books & Publishers, 1923 [3]
  11. Hamlet Act 1, scene 3, 75–77
  12. Danté Alighieri The Inferno, [4] (Google books extract)
  13. Benjamin Franklin (in a preface to his Poor Richard's Almanac, 1758
  14. Thomas Jefferson: "Letter to John Taylor" 1816
  15. Jeremy Bentham: In defence of Usury, Payne and Foss, 1818
  16. Erica Field: Educational Debt Burden and Career Choice: Evidence from a Financial Aid Experiment at NYU Law School, NBER Working Paper No. 12282, National Bureau of Economic Research, June 2006
  17. Gregory Elliehausen: Implications of Behavioral Research for the Use and Regulation of Consumer Credit Products, Federal Reserve Board, March 31, 2010
  18. Reuben Ernesto , Paola Sapienza, and Luigi Zingales: Time discounting for primary and monetary rewards, Munich Personal RePEc Archive, July 2008
  19. Eric Rasmusen: Some Common Confusions about Hyperbolic Discounting, Working Paper 2008-11, Kelley School of Business, Indiana University, 25 March 2008
  20. R de Bonis: Household Aggregate Financial Wealth OECD, 2010[5]
  21. Consumer Debt Hoover Institution, Stanford University, February 2009
  22. Walecia Konrad: What Americans say about credit cards, Bankrate.com, 2010
  23. Ilya A. Strebulaev and Baozhong Yang: The Mystery of Zero-Leverage Firms, Social Science Research Network, August 2006
  24. Voters’ Attitudes about America’s Growing Budget Deficit and National Debt, Findings from a Nationwide Survey Among Registered Voters, Conducted by Hart Research Associates and Public Opinion Strategies [6]
  25. Robert J. Shiller: Debt and Delusion, Project Syndicate, 21 July 2011
  26. Wasseem Michel Mina: Contract Enforcement, Institutional Stability, and the Level and Maturity of International Debt, Georgia State University, August 2002 [7]
  27. Hyman Minsky: Stabilizing an Unstable Economy, McGraw Hill 1986
  28. Susan Land and Charles Roxburgh:Debt and Deleveraging, World Economics, April-June 2010 [8]
  29. Will Devlin and Huw McKay: The macroeconomic implications of financial deleveraging, Economic Roundup No 4, Government of Australia Treasury, 2008[9]
  30. Mark Thoma U.S. Household Deleveraging and Future Consumption Growth, Roubini Global Economics, May 19, 2009
  31. Randall S. Kroszner: International Capital Flows and the Emerging-Market Economies, Federal Reserve Board, May 15, 2007[10]
  32. Ben Bernanke: The Global Saving Glut and the U.S. Current Account Deficit , Federal Reserve Board, 2005
  33. Norman Loayza, Klaus Schmidt-Hebbel, and Luis Servén: Saving in Developing Countries: An Overview, World Bank]
  34. Martin Wolf: Fixing Global Finance, Yale University Press, 2009]