All debt is not created equal; some is productive and some is not. The subtle difference between the two types of debt eludes many economists.
But why is this important? Why do economic theorists and those who make decisions need to pay attention? Because the quality of the debt determines whether or not it can be re-paid. And if we cannot repay our debts in a productive way, we all suffer.
Productive Debt
Productive debt creates wealth. When we borrow to start a business, expand an existing factory, or purchase needed supplies at advantageous prices we create productive debt for a valid reason. The borrower is utilizing capital to generate returns in excess of the cost of capital. Further, prudent borrowing holds out the possibility of “sustainability”: meaning that the created wealth can be replicated. Borrowing to expand a semi-conductor factory spurs further production, creating jobs, orders for suppliers and tax payments. The lender has the security of a productive asset and a stream of income to ensure re-payment of the loan.
Non-Productive Debt
During the credit expansion of the last decade non-productive debt proliferated. Borrowing took place to buy automobiles, plasma televisions, appliances, single family homes and snowmobiles among other consumer items. Each of these “assets” depreciates rapidly and has attendant upkeep costs. The debt-laden purchase of any of the above items never led to increased wealth, it merely added another consumer trapped in a debt-ridden life. In the case of debt-laden purchases of single family homes consumers saddled themselves with mortgage, taxes, insurance and other upkeep costs. Lenders exacerbated non-productive debt through lax lending standards (lending to sub-prime borrowers) and innovative financial products (adjustable rate mortgages, 125% loan to value, second mortgages). Lenders believed that they would be bailed out of bad loans through ever-rising house prices. Unfortunately, we learned that this was a faulty assumption.
A second area of non-productive debt is equally pernicious. Ultra low interest rates have encouraged speculation in stocks and commodities. Leveraged investments de-stabilize the economic system through inflating asset values, spurring commodity inflation and ultimately creating bubbles and inevitable crashes.
The Shangri-La of Non-Productive Debt
Doug Noland characterizes the United States as the worst offending country in the making of nonproductive debt. In his analysis, he is critical of the loose policies of the Federal Reserve, which encourage unsound lending and have contributed to our bogus boom and inevitable bust:
First of all, booms create a fragile mountain of debt not supported by underlying wealth-creating capacity. Second, Credit Bubbles inflate various price levels throughout the economy, creating systemic dependencies requiring ongoing debt and speculative excess. And, third, the boom in non-productive debt will tend to foster consumption and malinvestment at the expense of sound investment in productive capacity. When the boom eventually falters, market revulsion to unsound debt, the economy’s addiction to uninterrupted Credit expansion, and the lack of capacity for real wealth creation within the (“Bubble”) real economy ensure a very severe crisis and prolonged adjustment period. These dynamics become critically important as soon as a government (finally) loses its capacity to perpetuate the Bubble (i.e. Greece, Portugal, Ireland, etc.)
As a crisis unfolds, the markets eventually must come to grips with a very harsh reality: There will be denial and it will take some time to really sink in – but the markets will come to recognize that too little of the existing debt is backed by real wealth. Non-productive Credit booms are, after all, essentially “Ponzi Finance” schemes. See The King of Non-Productive Debt
At this point, the Federal Reserve is faced with severe choices. It can risk economic implosion, or it can continue to mainline “the debt addict” with greater and greater infusions of new debt. As we are now witnessing, this money is going into speculation in the commodity and stock markets rather than into productive investment in the “real economy.” Real economic activity is suffering at all levels as income is diverted to debt re-payment and prices of key commodities soar.
Built on Sand?
A visual metaphor can help us understand how dangerous, unstable and fragile an economy becomes with a mountain of non-productive debt:
What makes sand piles so interesting is the usually seamless transition from stability to collapse. One can add grains to a sand pile for quite some time without disturbing its stability – it simply grows bigger and bigger. Alas, eventually the point is reached when one grain too many is added or is put in the wrong place, and an avalanche and collapse of the sand pile will ensue.
These sand pile dynamics appear to have a lot in common with the modern-day financial system – they serve at the very least as a good metaphor. Of course a crucial difference is that grains of sand do not exhibit purposive behavior, whereas the financial system is populated by thinking and acting human beings. Nevertheless, there are some interesting parallels. Just as a grain of sand near the bottom of the pile has no direct connection to one lying at the top, the various cogs in the financial machinery are likewise not necessarily connected directly with each other, but what happens in one area of the system nonetheless tends to reverberate through the whole system. See The Edifice of Debt
Collapsing Castles
There are two simple principles to consider in evaluating the ongoing financial crisis. First, does individual income, or tax collection generally, support our current level of outstanding debt? Second, is Michael Shedlock’s admonition true: “what cannot be paid back, won’t be paid back“? Fantasies of resolving our debt in creative ways, like selling national assets such as road systems or national parks, are just that – fantasies. Selling physical vestiges of our national heritage is not only soul-destroying and stupid, it just won’t work.
And yet we continue to accumulate non-productive debt at an alarming rate. Was the collapse of the sub-prime market the “grain of sand” that caused near systemic collapse? What will be the next grain of sand? What will be the consequences?
loading...
Related posts:
- The Organic Economy
- Is the US Economy an Impaired Asset? Part II
- Bring Back the Robber Barons
- Unemployment and the Fall of Labor
- Consistently Inconsistent
Tags: Doug Noland, Michael Shedlock, non-productive debt, productive debt
