Saturday, February 21, 2009

Whither debt?

Having thought a bit about why debt exists in the first place, both from the individual perspectives of the creditor and debtor, I've found myself wondering about the further systemic implications of a debt economy. 

It seems clear to me now that the problem debt creates is inherent in the reason for its existence; capital with a maturity is simultaneously the only way to guarantee that you can get your money back when you want to spend it, and the only way you can get a cycle of forced liquidation of productive assets.  So it's no accident that a debt economy will repeatedly have credit crunch liquidity crises like the one we see now.   If the music stops playing and everyone wants to sit down at once, the massive liquidation is a problem because many of the assets being liquidated cannot themselves be consumed, and are only worth something as ongoing productive concerns.  You can't eat a factory today, something I learned from this Brad DeLong presentation.

But this just explains the bust side of the instability.  It shows you how the system can go from a sort of dynamic equilibrium where debt is continuously rolling over to a static equilibrium where everything is liquidated and there are no more capital assets.  You would think that the guys who invented debt realized that this was a problem from the outset and used it sparingly, but of course, for each creditor individually, it makes sense to plan out all of your expenses in advance and meet those exactly with the timing of the maturity of your debt.  The problem is one of systemic coordination of course, and leads directly to the logic of the modern central bank as a creditor of last resort that prevents the bust by temporarily printing enough money to redeem the claims of creditors without resorting to mass liquidation.

But our little toy credit economy also lets you see how the boom is produced as well.  Because some economic value is being left on the table when a creditor is satisfied with just getting a little bit of interest along with his principal back.  Someone is walking off with the excess gains that the debt holder is trading for the certainty of timing of his cash flows.  The leveraged entrepreneur is asymmetrically incented to shoot for the moon, and he is more incented the more leveraged he becomes (the less equity of his own that he puts up), and short of the threat of bankruptcy, he certainly never has any incentive to reduce his leverage and lose some of the extra economic value the debt holder is giving up.  The only thing regulating this level of leverage will be the willingness of the creditor to extend more credit, which is of course vastly increased by the comforting presence of an entity whose express purpose is to make good on these claims in times of crisis. 

Wake up and smell the inevitability of moral hazard. 

So the logic of debt, which at an individual level serves to dampen volatility, serves to create the possibility of both boom and bust at a systemic level.  And insofar as there is a creditor of last resort, you can see how this whole process is a sort of ratchet mechanism that lets creditors recover all of what they give up in the boom by taking back ownership during the bust.  One group goes for broke, and then another forces them to go broke for its profit.  Click-click, economic value has been ratcheted out of the hands of equity and into the hands of debt.  So much for progress. 

Now tell me, as a debt-holder, that your fundamental priority in a system like this will not be taking control of and assuring the continued functioning of the creditor of last resort.  Controlling the government is the key to making this whole ratchet system go in just one direction.  This is yet another reason to smash the state; the common conception that the state redistributes income is accurate.  The error lies in believing that the net redistribution is from rich to poor -- in point of fact, it goes in the other direction.

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