The Perils of Debt
Money-lending is a staple of the modern economy. For a price, credit allows consumers and firms to bring spending forward in time by borrowing from their future income. Theoretically this practice enables greater economic efficiency. If I wish (and can afford) to save a chunk of my money for later, I might as well loan it to someone who wants to use it for productive ends right now. For the privilege of borrowing my money, the debtor will pay me interest.
Sometimes people get ahead of their skis and debt spirals out of control. In 2007, a confluence of moral hazards, greed, and financial illiteracy conspired to pop a bubble in the US housing market. The ensuing recession was the most severe since the Great Depression eighty years earlier. As I’ve written elsewhere, major crises and ordinary economic contractions are usually caused by the business cycle of taking on and repaying debt.
Financial regulators, central bankers, and politicians do their best to temper the cycle’s peaks and valleys by manipulating interest rates, spending strategically, and cutting taxes. But there’s no replacement for public education. Although low-income households often rely on debt to meet their needs — an unfair reality that could be remedied by implementing a basic income — there are people in every socioeconomic stratum who get carried away with the debt they acquire.
The American Dream is the main culprit. The prospect of owning a tangible asset, rather than just renting one, is too tempting for many to ignore, especially if a lender dangles before them a tantalizingly plausible payment schedule. What many borrowers don’t understand is that a payment schedule they can deal with today could become unaffordable tomorrow due to factors beyond their control. To illustrate more vividly the concept of debt within the broader economy, consider a parable.
A cautionary tale
Imagine a deep, raging river. On one bank of the river there’s a village.
On the other side, a cave full of treasure.
The village people farm and run businesses to earn money for themselves, but the treasure across the river is too enticing to ignore. There’s a rope bridge spanning the river, hanging about a metre above the water.
Or, if you prefer…
Rain raises the water level sometimes, but usually the bridge remains unscathed. Village folk regularly make the trip to and from the cave to collect treasure for themselves and their family. After all, visiting the cave is a lot less work than plowing the fields, and it pays more.
Normally the bridge offers safe passage, but the voyage is not without risk. The river’s current is far too strong to swim across. Every decade or so the rains come heavier than normal, raising the water by more than a metre and partially swamping the bridge up to knee-height. Fortunately, being farmers, the villagers are mostly a sturdy lot who can claw their way back. Still, anyone too weak to wade their way home is swept away. After respects are paid to the victims, the village council allocates some funds to mend the bridge.
Once every half-century or more, calamity strikes: the torrential rains bring a flash flood that submerges the bridge completely. This time, amongst those unlucky villagers caught in the middle, only the very mightiest survive. The shock of such loss grips the village for years after as the people grieve their lost friends while attempting to rebuild the tattered bridge once more.
Thankfully, those grim events are rare. The last time the river flooded catastrophically was about ten years ago. It took time for the village to recover its optimism, but now spirits are bright once again. Most people have short memories, and things are looking up. They’ve been venturing back to the cave for a few years now.
There’s still a healthy pile of treasure there, but it’s not quite as big as it used to be — this is the worst-kept secret in town. There’s unspoken competition between households to collect more treasure more often. It’s usually the young, strapping lads who are sent over, since they can ferry more gold per trip. Fetching a larger haul has its own cost, though. The more weight they carry across the rope bridge, the lower it sags.
One day, the elders notice that several villagers have been bringing back larger sacks of treasure from the cave lately. They watch from shore as the bridge slowly bends ever lower under the increased weight, sometimes leaving only a few centimetres of clearance from the water as the oblivious fellow trundles across, delighted with himself.
Recognizing the risk, the elders write an open letter to the village and nail it to the church door:
We did observe that the journey o’er the river hast become more perilous of late. Though it may be difficult to say for a man crossing, our distant view from shore maketh plain that hauling weightier packages draws him near the waves.
We do bid thee, friends, to be both canny and charitable. The treasure yonder is not merely a shared bounty. ’Tis also a curse. For should a man venture thither and gather too hefty a load, he surely shan’t return.
Forget not Icarus, of lore, who flew too nigh the Sun, lest ye become Icarus of the water.
Word of the message spreads around town, stimulating discussion. A few people heed the warning. Alas, it makes little difference, for most of the villagers would rather take what they perceive as a small risk in exchange for free treasure, especially when all their neighbours are getting rich. Besides, the river hasn’t flooded in years, and since then the village council made a few minor fortifications to the bridge, to ease people’s minds. The council recognizes that gold keeps public spirits high, and any attempt to curb that enthusiasm would be met with displeasure. Nobody’s in the mood to snatch away the punch bowl.
You can probably guess what’s next. The good times roll for a while, until one day the sky darkens. It doesn’t even rain that much — the river swells by no more than half a metre, which would normally be just fine. But this time the bridge is so weighed down by the villagers’ enormous treasure sacks that they are swallowed by the current and washed away.
In a sense, the villagers were right. The risk of flood was low. When it came, it turned out to be relatively mild. What they forgot was that, thanks to the risks they took, the flood didn’t have to be severe to be dangerous.
K, so what does this mean irl?
In this allegory, the golden treasure is debt. The bridge is a scenario that makes someone eligible for a large loan — let’s call it a passable credit-rating. The periodic river floods are unanticipated events such as economic contractions of various degrees (a recession every ~10 years, a major financial crisis every ~50–75 years), or even just substantial interest-rate hikes. The village council represents politicians who act expediently instead of wisely. And the concerned elders are the economists at the central bank, and other financial analysts, who try to warn the public about the dangers of hyper-indebtedness. Much like an inflated housing market in real life, the mirage of easy money, with no strings attached, seduces the villagers. Nobody wants to be left out.
The moral of the story is that even though you might initially have a sturdy bridge available that lets you take on debt, the integrity of that bridge over the long term is no sure thing. If interest rates spike higher than expected, or recession strikes the economy and you suddenly lose your job, or you find yourself on the hook for a large expense without warning, that bridge could fail you. The more debt you take on, the less strain the bridge can withstand, and the more vulnerable you become to unforeseen shocks.
Fueled by the housing boom of the early 2000s, America’s household debt-to-income ratio peaked at 124 percent in 2007 before millions of mortgage defaults pulled it back down over the following years. In Canada, the same ratio has been hovering near 170 percent for some time — the igloo market in several cities up here is sizzling.
Many people might not realize that the current era of ultra-low interest rates is an anomaly, introduced as an emergency response to the Great Recession. That brief phase is now in its twilight — both the US Federal Reserve (the Fed, for short) and the Bank of Canada raised their interest rates recently. Those rate hikes will be passed on, through commercial banks, to consumers. (Even if, from a long-term historical perspective, interest rates may stay lower than past decades due to structural factors like demographic shifts and technological advances.) Meanwhile, the Fed is removing hundreds of billions of dollars from the securities market as it unwinds its quantitative easing (QE) stimulus program, which could spur economic volatility in its own way.
Half of all Americans and Canadians live paycheque to paycheque, teetering precariously on a financial knife-edge that leaves little margin for error — especially when it comes to mortgage payments. There are useful, socialistic actions that could be taken to relieve the pressure on millions of people, except that the prevailing political culture across North America is stubbornly resistant to bold ideas. Maybe it will become possible one day. In the meantime, popular attitudes will have to adjust and realize that even though decent, affordable shelter is something everyone is entitled to, home-ownership is not.
I write about politics, economics, and feminism. Check out my Table of Contents for a list of everything I’ve written on Medium.