Stone Pigs

Posted By Alan Partis on April 26, 2009

A gun is a very powerful and effective, yet risky, tool. Correct use requires knowledge and discipline. Incorrectly used, it can cause serious unintended injury, even death. So it is with debt.

The concept of debt as a financial tool has been around for quite some time and has become the bedrock of most modern economies. Debt allows money supply to be expanded with a multiplier effect when it is used by many people simultaneously. Person A puts extra money into a bank account of some kind. The bank then loans that money out to Person B who uses it to buy a new machine for his business from Person C. Person C might well deposit that money into their bank account thus making it available again for loan making. In the mean time, Person B uses their new machine to produce new wealth that they use to pay back the original loan and add to their own net worth.

Like guns, our banking and finance system is a very powerful and effective, yet risky, tool. It too requires knowledge and discipline by all involved parties to use it correctly. In the hands of fools, there are serious, and often unintended, consequences, injuries, and yes, death.

Debt is great when it is used to acquire tools that increase productivity and wealth¹. In the short run, the tool helps create new wealth to repay the debt and in the long run, helps increase the wealth of it’s buyer. Debt can also be effectively used to purchase assets of appreciating value, whose value over time increases at a rate greater than the cost of the debt. Sometimes debt is used to acquire expensive items so the cost of the purchase can be spread out over a long period and thus be made more affordable.

Even when used correctly, there is risk in the above scenarios. If the purchased tool breaks down, or is expensive to maintain, its effectiveness is greatly decreased. The market for the products it’s helping to produce might change in unforeseen ways thus making the tool itself obsolete before it is able to pay for itself. In the second scenario, the purchased asset may not appreciate as expected. And in the third situation, the risk is that the expensive item may simply depreciate over time and need replacing before the initial loan is paid off. Using debt to finance the purchase of non-appreciating assets (such as televisions and vehicles) is unwise altogether.

It’s easy to see then how the economic condition in which we find ourselves today is a direct result of the improper use of debt. A great many individuals used debt to purchase homes at inflated values in the incorrect belief that a home is an appreciating asset, only to find that home values can go down just as fast, or faster, than they go up. In some cases, the cost of the debt service on those homes exceeded the borrowers’ income. At the same time, many businesses borrowed money to buy tools to make things for consumers that consumers could no longer afford to purchase and have now found themselves unable to lower their production costs enough to remain solvent. In a vicious cycle, this has further eroded consumer purchasing power. Clearly, we’ve shot ourselves in the foot and we’re bleeding profusely.

At this point, common sense says we need a bandage to help stop the bleeding and a moment or two to step back and analyze the situation to see what went so horribly wrong. Having a bloody foot was not the intended result of our gun use. It’s unlikely that our next move should be to fire the gun again … but that, sadly, is precisely what people like Barney Frank are suggesting².

One of the problems when purchasing an asset whose value is expected to rise, is correctly assessing its current and future value. This is a crucial part of investing, especially when using debt to make the investment. Our financial system has devised a way of dealing with that: ratings agencies such as Standard & Poor’s, Moody’s, and Fitch. These agencies provide the analysis on various assets and commodities and give a rating to help investors make good decisions. In many cases recently, it has been determined that these ratings have been falsified, or just plain fancifully ignorant of the content of the rated item (as was often the case when rating so-called Credit Default Swaps, bundles of mortgages with a mix of good and bad risks either because the borrower would likely default or the home price was highly inflated due to a bubble).

As Mr. Frank looks out over the nation from his seat perched high atop Capitol Hill, he sees mountains of public debt accumulated by municipalities in the form of municipal bonds. He’s afraid that many of these municipalities will be unable to meet their payment obligations. His proposed solution is to help these municipalities finance their existing debt with new debt (something akin to shooting your foot again), and to force the ratings agencies to raise their ratings of these municipalities (and further erode confidence in the value of said ratings). His rationale for the increased ratings is the creation of a new Federal Government ‘insurance’ program much like the FDIC and financed with premiums paid by the borrowers (the municipalities) and ultimately backed up with tax dollars, of course³.

Mr. Frank’s proposal is very bad medicine, but is at least consistent with his well documented governmental philosophy. His past actions have proven that he is incapable of properly using debt and the the US financial system. The voters of his district in Massachusetts should replace him in office at their next opportunity, not just for their own good, but for the benefit of the Nation as well.

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¹ Wealth is ‘stuff other people want’ and ‘Wealth Defined’ is a Stone Pig that helps expand on that simple definition.

² Barney Frank’s Double Indemnity, The Wall Street Journal, April 17, 2009.

³ Government imposed taxes are a drag on GDP, and thus the wealth of a nation, because they take money away from the means of production.

Category: Economics
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