Saturday, January 28, 2017

On Debt

I wrote a comment on Anatoly Karlin's blog today about the 1990s in the former USSR, and that started me thinking about politics and economics in general. One such thought led to another, so that in the end I decided to describe my attitude to credit here on my little blog.

I'll start with a simple observation: the more responsible, conscientious, hard-working a person is, the less likely he is to ask for a loan. But this is exactly the kind of person who's most likely to repay a loan if he gets one.

So the people who come to a banker, asking for his services, giving him business, are disproportionately of the kind who aren't likely to repay him. The people who are most likely to repay him need him the least. How does a banker normally solve this problem, this contradiction?

Very simply. He establishes private relationships with government officials. Loans on favorable conditions, bribes, job opportunities in his bank after the officials retire. When debts go bad, as they always do, the government bails out the banker with taxpayer money.

In this way a responsible person (the taxpayer) is made to subsidize an irresponsible one (the debtor). Remember that the more responsible, hardworking individuals tend to pay more in taxes than the less responsible ones.

At this point everyone remembers the 2008 economic crisis which was caused by banks loaning money to irresponsible people. Sub-prime loans, zero down payments, no checking of credit histories. And of course there was a government bailout afterwards. Too big to fail, etc. At about the same time in Europe German taxpayers were bailing out Greeks. A couple of decades before that there was the Savings and Loans scandal.

I don't think the average person realizes how common this is. A few years ago I read Niall Ferguson's 2-volume history of the Rothschilds. Since the Rothschilds were the world's chief bankers from about 1815 to about 1914, Ferguson's work comes close to being the financial history of the world in that century.

Banking crises followed by government bailouts happened all the time then. What do I mean by banking crises? Loans going bad, debtors not paying. The bailouts weren't exceptional events. They were an essential part of the banking cycle, of the business model of banking. As they still are I think.

Ferguson described a hierarchy of credit-worthiness among 19th century countries. Of course Britain and the various German states were on top, France a little below, Spain and Italy lower still, and Latin American states in the gutter. It was every stereotype confirmed.

At one point in the books the Rothschilds start loaning money to the pasha (or whatever he was called) of Egypt. And you think "well, this pasha doesn't seem like a very creditworthy person. How would they get their money back?" As I remember, Ferguson was good at creating a feeling of suspense here.

They asked their friends in the British government, one of whom was Gladstone I think, to invade Egypt, making it a colony. After that the British government assumed responsibility for Egypt's debts to the Rothschilds. So in effect the average British taxpayer (shopkeeper, colliery owner, whatever) ended up subsidizing the pasha's harem. For a while at least. Think of all those orientalist paintings.

To me this is a symbol of how credit works in general. It's a transfer of money from responsible people to irresponsible ones, from those who do to those who spend. Often on bling.

Would it be possible to eliminate the corruption factor from the banking cycle? I don't know of any countries where that was ever done. I recently reviewed here a book about the history of Florence from 1200  to 1575, and it was full of banking crises and taxpayer bailouts. By the way, all of the biggest bankers there were Italians.

I know of countries that completely dispensed with debt internally. The post-WWII USSR, modern Saudi Arabia. Though obviously I don't know the latter from the inside. And I know of countries where credit works in the corrupt manner that I described above. But I don't know of any places where it's ever worked honestly. And of course, if bribery and bailouts were eliminated, the banking business would shrink considerably. Bankers would only loan to those whom they truly considered creditworthy, and that's not a lot of people. And these are exactly the kind of people who need credit the least.

Why is bribery so hard to eliminate in this context? Because the bankers' profits exceed government officials' salaries by many orders of magnitude. This is almost like gravity. Why does the Moon revolve around the Earth?

I'm sure that this reality is partly behind the condemnation of banking by several religions and by much of humanity's wisdom literature. Quoting Shakespeare, "neither a borrower nor a lender be."

I freely admit to being hypocritical on the issue of immigration, but I've never been a hypocrite on this. I've taken out zero loans in my life. I bought the apartment in which I'm typing this outright, by saving money when I was working while living with my parents in my younger days. The only bits of debt that I've ever had were two or three overdue credit card bills. I've always had enough money to pay them, but I sometimes forgot to do it on time. So I've been assessed a little interest. Probably $20 or $30 in total. Never had any other debt of any sort.


  1. The contradiction is resolved by interest rates and collateral. The less credit worthy have to pay higher interest rates and put up property they own as collateral that gets seized by the lender if the loan isn't repaid. The government is involved in protecting property rights and enforcing contracts. The government uses force and the threat of force to ensure that the terms of loan contracts are fulfilled.

    Compounding interest grows exponentially, faster than any physical process on the earth, faster than economic growth and the ability to pay. The subsidy is in that the government doesn't charge for property rights protection and enforcement. There's an incentive to make loans because the interest grows so fast and if it can't be repaid, you can seize the collateral, all done by the government.

    1. "The government is involved in protecting property rights and enforcing contracts."

      And with bailouts. Which often happen and are expected. I understand them as, essentially, transfers from responsible people (taxpayers) to irresponsible ones (defaulters).

      "The Emergency Economic Stabilization Act of 2008 (Division A of Pub.L. 110–343, 122 Stat. 3765, enacted October 3, 2008), commonly referred to as a bailout of the U.S. financial system, is a law enacted in response to the subprime mortgage crisis authorizing the United States Secretary of the Treasury to spend up to $700 billion to purchase distressed assets, especially mortgage-backed securities, and supply cash directly to banks."

      Banks make bad loans expecting to be bailed out later.

    2. According to that Wiki, the government bought bad mortgages from banks. Obviously at higher prices than what the banks could get for them in the market. Otherwise, what was the point of the government getting involved? I'm sure the banks always knew that they would get bailed out like that in an emergency. And I'm sure that this knowledge made them lend more liberally, to people with the kinds of credit histories that would have scared them away otherwise.

    3. I said that these bailouts happen often.

      A savings and loan or "thrift" is a financial institution that accepts savings deposits and makes mortgage, car and other personal loans to individual members (a cooperative venture known in the United Kingdom as a building society). By 1995, the RTC had closed 747 failed institutions nationwide, worth a total possible book value of between $402 and $407 billion. In 1996, the General Accounting Office estimated the total cost to be $160 billion, including $132.1 billion taken from taxpayers.[2][3] The RTC was created to resolve the S&L crisis.

      The Federal Savings and Loan Insurance Corporation (FSLIC), a federal government agency that insured S&L accounts in the same way the Federal Deposit Insurance Corporation insures commercial bank accounts, then had to repay all the depositors whose money was lost. From 1986 to 1989, FSLIC closed or otherwise resolved 296 institutions with total assets of $125 billion. An even more traumatic period followed, with the creation of the Resolution Trust Corporation in 1989 and that agency’s resolution by mid-1995 of an additional 747 thrifts.[22]

      A Federal Reserve Bank panel stated the resulting taxpayer bailout ended up being even larger than it would have been because moral hazard and adverse selection incentives that compounded the system’s losses.[23]

      From the Wiki on moral hazard:

      Economist Paul Krugman described moral hazard as "any situation in which one person makes the decision about how much risk to take, while someone else bears the cost if things go badly."[2] Financial bailouts of lending institutions by governments, central banks or other institutions can encourage risky lending in the future if those that take the risks come to believe that they will not have to carry the full burden of potential losses. Lending institutions need to take risks by making loans, and usually the most risky loans have the potential for making the highest return. So-called "too big to fail" lending institutions can make risky loans that will pay handsomely if the investment turns out well but be bailed out by the taxpayer if the investment turns out badly.

      I'm not endorsing Krugman in general, but he's making a simple and obvious point there.