The financial crisis of 2008 started in America, by most accounts, but it had consequences around the globe. Industries collapsed and entire countries defaulted on their debt. On a more micro scale, a huge number of people lost their homes to foreclosure as they defaulted on mortgages that they could no longer afford.
In fact, those mortgages heralded the start of the financial crisis. In relation to huge investment banks, individual mortgages are a minuscule amount of money to lend, but as they became more widespread, even the largest financial players had to take note. Those investment banks, as it turned out, weren’t in a position to bear this kind of instability. Their own heavy debts made it difficult to weather the storm, and as the problem got worse, creditors stopped lending. The recession and bailouts that followed led to a huge increase in government debt around the world, leading to the entire country of Greece declaring a default back in 2012.
In short, debt was what caused the financial crisis, but it was also the outcome of the financial crisis. That’s funny, because most economists often see debt as a relatively good thing. Obviously, our understanding of debt needs a bit more nuance.
Why do economists think of debt as good?
On a personal level, most of us would agree that debt is a burden. It’s an extra bill that you have to pay each month for something you already have.
Economists see debt differently, however. To them, debt is a way to move money from creditors (who have more money than they can use) to borrowers (who need more money than they have). By lending money and creating debt, creditors allow borrowers to participate more meaningfully in the economy as a whole.
However, anyone who has ever gotten into debt can attest to the fact that debt can feel more like a trap than a useful financial mechanism. This terrible financial burden limits our ability to control our finances and live our lives; and, unlike most other financial instruments, it’s inflexible. Once you take out debt, you must pay it back, and on time, or face consequences.
So, how do we assess the impact of debt? Is it a transfer of wealth from the wealthy to the needy with a few strings attached; or, is it a personal financial burden that can often become too much to bear?
If economic models can’t quite capture debt’s reality, then we have to look to the past. What we find is that debt can have wildly different effects on individuals and society, especially depending on who the debtor is.
What types of debt are we talking about here?
Usually when economists study debt as the function of a system, they look at government debt. Corporate and household debt are also worth considering, though, since they often affect our lives much more directly than government debt does.
The chart from The Economist shows debt as a percentage of a country’s GDP (gross domestic product). As we can see, the type of debt that’s most prominent varies quite a bit from country to country.
Lenders and financial firms themselves often hold corporate debt. We think of those institutions primarily as lenders, often forgetting that in order to lend, they often have to borrow quite a bit themselves. In countries with thriving financial sectors, such as Ireland and Luxembourg, the amount of debt that these institutions hold can actually be exponentially higher than their home country’s GDP.
How is that possible? Most financial regulations state that an institution must have assets that hold a comparable value to their debt if they plan to borrow sums of money of that magnitude. It’s for the same reason that banks ask individuals for collateral when they take out loans; they need to know that their loans are backed up by something.
It’s not a perfect system, though. If the assets backing up that debt lose value, they can bring the debtor to bankruptcy almost overnight. It doesn’t matter if that debtor is a homeowner or a global financial institution; if your assets lose value, you could be in a lot of trouble.
That’s, essentially, what happened to many homeowners during the financial crisis in 2008. Inflated home values and loose lending regulations had enabled lenders to provide mortgages that allowed people to buy houses that, in reality, were far beyond their means. The market eventually caught up to them and their houses lost much of their value very quickly. Unable to keep up with the payments on a mortgage that was all of a sudden “underwater,” these homeowners fell into foreclosure in droves, precipitating the global financial crisis that was soon to follow.
So, is debt bad, then?
The lesson there is that the more you owe in debt, the more vulnerable you are financially. You’re leaning heavily on the equity of your assets to provide you with some level of wealth, but if that equity declines, you could be in a world of financial trouble. In short, stability goes down as debt goes up.
In fact, studies show that when household debt exceeds its usual trend in relation to GDP by 10%, the chance of a recession jumps about 40%. You can see similar trends when you look at debt from the perspective of lenders. When lending from banks rises faster than a country’s GDP, it can presage financial trouble. Debt harms both the individual and the economy as a whole.
Before we write off debt as a bad thing, though, we should look at how we use debt and what can happen if we use it incorrectly.
How is debt usually used, and why does it matter?
In general, debt is usable in two different ways.
Debt helps people buy something new, such as a new car or other manufactured goods. Obviously, this purchase involved the exchange of money and the circulation of wealth through the economy, which are good things. Since the purchase is of something new and still in production, it also helps to stimulate demand, which in turn pushes the economy to be more productive (or, if it’s already at full capacity, to increase prices). Again, these are all signs of a healthy economy. Both the new debt and the new purchase factor into calculations of GDP, canceling each other out and keeping the debt-to-GDP ratio steady.
Imagine that debt is in use to purchase something that already exists, though, such as a home (or, in the case of a huge institution, another company). GDP only measures the production of new goods and services; thus, it does not consider this purchase. Debt goes up but GDP stays the same.
This doesn’t really seem like a systemic call for alarm on its own, and it isn’t. However, keep in mind that purchasing an already existing asset (such as a home) also tends to increase the market price of that asset. Over time, home prices rise. If you don’t own a home, you have to borrow more just to buy one. If you do own a home, you see the price of your home rise (ideally), giving you an inflated sense of equity and encouraging you to borrow more against the rising value of your home.
That still doesn’t seem all bad, but eventually, something has to give. Prices will continue to rise until borrowers finally throw in the towel, lacking sufficient income to take on more debt. Without their purchasing power, asset prices (including home prices) start to fall again. It’s a common cycle and one that we’ve come to expect, but it can cause huge problems for people who are already in debt. After all, the equity they have in their assets reduces suddenly, but the size of their debts stays the same. In many cases, they find that they can no longer keep on with their current level of debt and must take drastic measures.
In this case, people and institutions must “deleverage” and reduce the amount of debt that they’re holding onto just to get by. There are three ways to do this, none of which is fun: you default; you sell off your assets; or you buckle down, spend less than you earn, and use the difference to pay down your debts.
“Great! Problem solved.” If people just calm down, show some financial discipline, and pay off their debts, they’ll get out of this predicament eventually.
Not so fast. While it’s true that on an individual level deleveraging can solve debt problems, it can actually harm the economy as a whole when it’s widespread. That reduced spending, among other things, causes income growth to sputter. Even if income doesn’t fall, it won’t rise quite as quickly as expected, which can still lead to dire financial consequences. Meanwhile, the amount of debt that people and institutions hold stubbornly remains the same.
This process can happen slowly, but it can also happen fast and with terrible consequences. During the financial crisis, financial institutions had to deleverage enormous amounts of debt. The sudden deleveraging process caused the prices of the assets and portfolios that institutions were trying to get rid of to fall dramatically, making it harder to get much value back for those institutions. The institutions responded by calling in loans they had already given; at the very least, they refused to give out new loans. Refusing to lend led to a scarcity of credit within the economy as a whole, and while it may have been the right decision for the individual institutions, the reduced ability for individuals to spend on credit made the recession that much worse.
What can we do to avoid the negative effects of debt?
In the wake of the financial crisis, we saw government institutions try to weather the effects of this deleveraging through methods such as taxing less and cutting interest rates to make spending more attractive. Increased government spending was also a tactic meant to pump more money back into the private sector and resuscitate the economy.
As an individual, though, it’s vital to realize that debt can have both positive and negative effects. The examples above are not textbook abstractions about debt; they’re real things that can happen to households as well as institutions and governments.
The short takeaway is that debt in and of itself is an unpredictable thing. Debt always ties to something else, whether it’s your credit score or some form of collateral, such as your home. While the total amount of your debts won’t change, the value of those assets could. Or, you could lose your job, get sick, or have to take on some other sudden expense. If that happens, then, despite your best efforts to plan and be responsible, the debt that you hold could become a burden that’s suddenly too heavy to lift.
Your best bet is to avoid taking on any more debt than you have to. Sure, your car loan and your student loans might be necessary investments in your future that pay for themselves over the long run. That credit card bill you’re running up at the department store or the bar, not so much.
Be careful with debt and it can be an incredibly useful tool to access resources. Use it irresponsibly and it could come back to haunt you.
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