Debt? What Debt?

After the Presidential debates one would have wondered if national debt is in the vocabulary of our two candidates. Surely Donald Trump’s business deals in the 1970s and Hillary’s personal appearance are more important than the national debt. At least those two issues were discussed. But nary a word was uttered about the national debt. 

Each try to outdo each other with policies that would increase the debt but none seemed worried that a larger debt might be a problem. Surely making college free is more important that a nation’s debt. Surely giving families more time off from work is more important than a nation being able to pay off its debts.

So here I go again about debt. Debt is both easy and complicated. It is both beneficial and dangerous. It is seductive like a night with a hooker and debilitating like the rash that follows. And like the drug addict, he or she is the last one to ever admit that he or she is hooked. What a topic!

Debt is easy to understand. Consider three stories.

Story 1. You get to the end of the month and you spent all your cash. Luckily you have a plastic card that lets you buy a few more essentials. Or maybe you buy a few more Miller Lites or a lottery ticket. Next month you conserve a bit and are able to buy all you need and payoff your credit card. In that case, the debt lasts only a month. That story is both simple and nice. Debt was an instrument to accomplish an objective.

Story 2. You want to buy a house or a horse. Or a hose. These items all start with H and all three of them are durable goods. If you take care of them they last a while. It makes sense to pay for them over a time period that is similar to the life of the durable good. So you use credit to buy a durable good and you pay it off over time. That is another simple and acceptable role for debt. If you are a humble employee in the workforce you don’t buy a $4 million dollar house. It is too expensive. It would create too much debt to pay back. Instead you buy a house whose payments are comfortable for your monthly income.

Story 3. You buy that $4 million dollar house. Or maybe you really like JD but you decide to instead buy a new $400 bottle of Pappy. You like the Pappy so much that you buy a bottle a day and a few extra bottles for your friends. Clearly you cannot afford $12,000 per month for bourbon. But it REALLY tastes good. Your mortgage lender or your credit card company likes you to take on more debt. At least until the day comes when you quit paying them.

Story 3 is a silly story, right? But we know that people and countries do this kind of behavior. People go into debt for all sorts of reasons – houses, cars, education, jewelry, gambling, drugs, and more.  Countries get hooked on defense spending, pension programs, healthcare, and more. When I say hooked I am not implying anything negative about spending on any of these items. The problem comes when you spend more than you can afford and you find it difficult to stop.

But what can you afford? That’s an interesting part of all this. Except for the dishonest and corrupt, most of us think we can afford our debt. Like me, many of you bought your first house, looked at the size of the mortgage, and started to shiver and shake. Can I really pay back that amount? I was young then and did not know what would happen to me. But a good financial system has criteria and rules and they are willing to bet on people who have track records and/or whose current situations warrant trust.

This brings to mind two challenges. First, we make mistakes and accidentally take on debt that is too high. Second, unexpected things unfold that change the equations. Worst among these is that you lose your job and/or your future income turns out to be much lower than you expected. Also terrible is that unexpected expenses crop up and eat up your income – healthcare, a family member needs help, your kid gets accepted to Harvard, and so on. Whatever the case, stuff happens and then you can no longer pay the debt.

When you can no longer pay the debt is when things get tough. There is no easy way out. You are between the proverbial rock and hard place. Even if you find a way to not fully repay your creditors, you are back to square one. You have lost the durable good that you can no longer afford. And now, you will find it much more difficult to get new credit – so you will have to live on what you earn. The choices at that point are very unattractive.

Notice that all of this would have been avoided if you had not taken on the debt. Or that you had taken on the debt in a more sustainable way. That leads to unpleasant but rational realities like borrowing much less than the bank will allow. That might mean buying a cheaper house or car or going to IU instead of Harvard but it also means that contingencies are easier to deal with. Another option is to wait. While you wait you save money and later make a good down payment on the durable good. No alternative is foolproof in an uncertain world. But some options reduce the probability of a catastrophe.

Debt is inevitable. Debt can have unforeseen negative and debilitating consequences. So it is good to handle it carefully.

All the above applies to countries too but it gets more complicated. For one thing, having its own currency means that most countries can print money to pay debts. At least for a while. Excessive currency creation we know might work for a while but then it causes inflation and other instabilities that transmit a message to creditors – this ship is taking on water and may sink.  

Think about what happens when a country gets a debt problem. Below I am summarizing some of the things we have learned from debt crises over the years in many different places. The first signs come when the debt gets big enough for people to notice. At that point investors shy away from the debt and that reduces bond prices and raises interest rates in that country. If the debt is not attended to debt rating agencies downgrade the debt causing rates to rise even more. A reduction in purchases of debt by foreigners may cause the currency to depreciate. A rapidly depreciating currency is worrisome and will sometimes cause a country to try to stabilize the downswing. It does this by buying its own currency using foreign reserves – and then the level of those reserves fall. That sends another worrisome signal to the world.

Then the world waits to see if the government gets the point. Everyone knows they have gone into too much debt and need to do something about it. The more the country hesitates to reduce its debt in conventional ways – the more confidence falls, the more interest rates rise, money flows out, the currency depreciates, and foreign reserves plummet.

I am getting depressed. Where is that JD?

What about the US today? Where are we? Actually we are okay. Yes the debt went from roughly 30% of national income to more than twice that in the past decade – and is scheduled to rise even more based on current laws. Some estimates have US debt closing in on about 100% of GDP soon. But that is BEFORE we factor in any of the current proposals by the candidates for more spending and/or less taxes. So maybe we are talking well over 100% by the time the new President gets rolling.

But that’s not the whole story. What happens if we have a crisis? We are due for a recession in the next few years. Given alarming trends in China, Russia, Iran, and Syria might we decide to spend a lot more on defense and security?  Will we need to bail out business and/or student debt? Such scenarios could send our national debt soaring to well above 100% of GDP. Then what will happen? Nothing good! Now is the time to worry about that. Not after the fit hits the shan.