Crash Course Chapter 12: Debt

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Now we enter Part Two of the Crash Course. Here you’ll see the very information that led me and my family to make profound changes in our lives – where we live, my line of work, even where we get our food. With the background you’ve received to this point, you are now positioned to understand how the Three “E”s, the Economy, Energy and the Environment, intersect and seemingly converge on a very narrow window of the future: The Twenty-Teens. It’s the data in these next parts that leads me to conclude that the next twenty years are going to be completely unlike the last twenty years. A small warning: This material can be shocking and some or you may find it emotionally challenging.

So we begin Part Two with “Debt.” We’re going to pick up two more Key Concepts in this section, and one of them is utterly essential. It is this: Ever-growing debts implicitly assume that the future is going to be larger than the present. We’ll be examining that statement in detail in this chapter.

Before we go there, a few definitions are in order. A financial debt, then, is a contractual obligation to repay a specified amount of money at some point in the future. The concept of debt is thoroughly characterized within the legal system, so we can say that a debt is a legal contract providing money today in exchange for repayment in the future…with interest, of course.

Debts come in many forms. Auto loans and mortgage debt are known as “secured” debts because there is a recoverable asset attached to the debt. Credit card debt is known as "unsecured" because no specific asset can be directly seized in the event of a default.

For you and I, there are only two ways to settle a debt. Pay it off or default on it. If you have a printing press like the government does, a third option exists: Printing money to pay for the debt. This method is a poorly disguised form of taxation, since it forcefully removes value from all existing money and transfers that value to the debtholders. I view it as a form of default, but one that preferentially punishes savers and those least able to bear the impact of inflation.

The pure debt obligations of the US Government as of April 2008 stand at 9 trillion, 444 billion dollars and change. This is only the debt. Once we add in the liabilities of the US government, chiefly Medicare and Social Security, we get a number five to eight times larger than this. We’ll be discussing these liabilities in the next chapter, so that’s all I’m going to say about them now. Right now we are focused simply on debt, and it’s enough to know that debt is only part of the whole story.

Okay. Next this is a chart of total US debt – that’s federal, state, municipal, corporate, and private debts in the red line, compared against total national income in the yellow line. The total debt in the US now stands at over $48 trillion. That’s 48 stacks of thousand dollar bills, each of which is 67.9 miles high.

If we adjust these debt levels for both population and inflation over time so we’re comparing apples to apples, we find that in 1952 there was the equivalent of $76,000 of total debt per person and that today the number is $183,000. At $183,000 per head, this means that today the average family of four in America is associated with $732,000 of debt. This is a useful way to look at debt because it doesn’t really matter if the debt is owed by a government agency a corporation or an individual, because these are really the debts of our country and all debts get paid through the actions of people. So examining the debts on a per capita, or household basis, gives us a sense of the situation.

Can debts forever grow faster than the incomes that service them? No, they cannot. There is a mathematical limit in there somewhere.

Am I saying that all debt is “bad”? No, not at all. Time for another definition. Debt that can best be described as investment debt provides the opportunity to pay itself back. An example would be a college loan offering the opportunity to earn a higher wage in the future. Another would be a loan to expand the seating at a successful restaurant. In the parlance of bankers, these are examples of “self-liquidating debt.” Meaning that the loans boost future revenues and have a means of paying themselves back. But what about loans that are merely consumptive in nature, such as those taken out for a fancier car, or for vacations, or for more war material? These are called “non-self-liquidating debts” because they do not generate any additional future revenue. So not ALL debts are bad, only too much unproductive borrowing is bad.

In the past five years, American debt has grown by more than $16 trillion, and a very large proportion of that has been of the non-self-liquidating variety. This has profound implications for the future. Because non-self-liquidating loans do not generate future cash flows, it means that ordinary income will have to be used to pay off today’s consumption. And this will mean less cash for discretionary spending in the future.

So what is debt really? Well, debt provides us money to spend today. Perhaps we buy a nicer car and we enjoy that car today. But in the future the loan payments represent money that we do not have then to spend on other items or to save. So we can say that debt represents future consumption taken today. As long as it is my decision to go into debt and the repayment is my responsibility, then everything is cool.

However, once we consider that our current levels of debt will require the effort of future generations to pay them back, we start to trend into the moral aspect of this story. Is it really proper for one generation to consume well beyond its means and expect the following generations to forego their consumption to pay it all back? That is precisely our current situation, and these charts say as much. I often wonder if my children are going to accept this bargain. I have my doubts.

Now, we learned in Section 4 that money can be viewed as a claim on human labor, and we just learned that debt is really just a claim on future money, so we can put these statements together and arrive at Key Concept #6: Debt is a claim on future human labor. Debt is a claim on future labor. When we get to the section on baby boomers and the demographic challenge our country faces, I’ll be recalling this important concept.

When viewed historically, and compared to gross domestic product, the current levels of debt are without precedent, and the chart even suggests that we are living in the mother of all credit bubbles. Current total credit market debt stands at more than 340% of total Gross Domestic Product (GDP). As we can see on this chart, the last time debts got even remotely close to current levels was back in the 1930’s, and that bears a bit of explanation. The easy credit policies of the Fed gave us the “roaring twenties” and then a burst credit bubble, which was followed by eleven years of economic contraction and hardship, which we now refer to the Great Depression. Note that the debt to GDP ratio didn’t start to climb until after 1929. What’s the explanation for this? Were more loans being made? No, the chart climbs here, because while the debts remained, the economy fell away from under them, creating this spike.

In the absence of the Great Depression anomaly, our country always held less than 200% of our GDP in debt. It is only since the mid-1980’s that that relationship was violated, so we can say that our current experiment with these levels of debt is only 23 years old and therefore a historically brief phenomenon. And it is this chart, more than any other, that leads me to conclude that the next twenty years are going to be completely unlike the last twenty years. I just cannot see how we can pull off another twenty just like that area circled in red.

Based on the shape of this chart, our entire financial universe has made a rather substantial and collective assumption about the future. Because a debt is a claim on the future, each incremental expansion of the level of debt is an implicit assumption that the future will be larger than today

Which means there is a very profound assumption baked right into this debt chart. And that is the future will be larger than the present. Here’s what I mean.

A debt is always paid off in the future, and loans are made with the expectation that they’ll be paid back, with interest. If more credits are extended this year than last, then that means there’s an expectation, an assumption, that the ability exists to pay those loans back in the future. Given that our debts are now over 340% of GDP there is an explicit assumption here that the future GDP is going to be larger than today’s. A lot larger. More cars sold, more resources consumed, more money earned, more houses built – all of it – must be larger than today just to offer the chance of paying back the loans we’ve ALREADY taken on. But each quarter we see that new debts are being made at a rate five times to six times faster than growth in the underlying economy. Even with a fairly optimistic assessment of future growth, this trajectory is unsustainable.

Our banks, pension funds, governmental structure and everything else tied to the continued expansion of debt has an enormous stake in its perpetual growth. And so here we come to our seventh Key Concept of the Crash Course.

Our debt markets assume that the future will be (much) larger than the present.

But what happens if that’s not true? What if the means to repay all those claims does not arrive in the future? Well, broadly speaking, if that comes to pass there’s only one result with two different means of making it happen. The result is that the claims – the debts – must be diminished somehow, and that could happen either by a process of debt defaults or by inflation. The defaults are easy to explain, the debts don’t get repaid, and the holders of that debt don’t get their money back. Boom. The claims get diminished. The future isn’t large enough to pay back the claims? Then defaults are simply a way of not paying them.

The inflation route can be confusing, so think of it this way – what if you sold your house to someone and elected to hold a note for $500,000. The terms call for the note to be repaid all at once in ten years as a single payment of $650,000. Well, what if you get paid your $650,000 right on time but that $650,000 will only buy this house? You got paid, all right, but your claim on the future was vastly diminished by inflation. In the default scenario, your money is still worth something, but you don’t get it back. In the inflation scenario you get it back but it hardly buys anything. In both cases your future was diminished, so the impact is very nearly the same but the means of achieving it are wildly different.

So the questions you need to ponder for yourself are: Have too many claims been made on the future? And if so, will we face inflation or defaults as the means of squaring things up? You will arrive at wildly different life decisions depending on whether you answer “YES” or “NO” to the first question and “inflation” or “defaults” for the second question. So they are worth pondering.

All right, here’s what we’ve learned:

  1. Key Concept #6 is Debt is a claim on future human labor.
  2. Per capita debt has never been higher. We are in truly unprecedented territory in this country.
  3. Debt has increased by $16 trillion in the past five years, and most of it consumptive debt. Meaning that future consumption will have to be seriously curtailed, or we’ll enter a period of debt destruction, either by defaults or inflation.
  4. And finally, Key Concept #7: Our debt markets assume that the future will be much larger than the present.

This last insight plays in two critical areas that are coming up in future installments of the Crash Course.

Our entire economic system, and by extension our way of life, is founded on debt, and debt is founded on the assumption that the future will always be bigger than the past. Therefore it is utterly vital that we examine this assumption closely, because if this assumption is false, so are a lot of other things we may be taking for granted.

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