A response to our readers; more on good versus bad debt.

In our last blog post we got some questions regarding the distinction between good and bad debt.  Since we have used these terms at several occasions we found elaboration worthy its own post.

We have taken the liberty to break down the comment / questions in our response, but the reader may look at the original comment from Der Wille Zur Macht (DWM) on the previous post called Debt Excess and the Liquidation Process in a Historical Context to get the whole context.

The main question is how to precisely distinguish between good and bad debt. DWM proposes a continuum of different degrees of goodness and also correctly points out that capital accumulation involves saving properly defined, id est. an excess production over consumption.  Further, DWM note that this implies a loss of liquidity. We could not agree more!

We propose the following definition good debt:

Debt used with the intent of making a subsequent sale”

All debt that does not comply with this intention can be classified bad or destructive in nature. That said, it does not mean all debt taken out to make a sale is good. On the contrary, business men make mistakes every day, but its underlying intention is to increase capital.

In order to fully understand this concept the reader need a good grasp on capital theory, something that unfortunately we find lacking among most economist today.

Imagine a man working at an iron ore mine. He is paid monthly for the iron ore he helps produce.  Assume 100 men work at the mine, so our guy contributes 1/100th of the monthly output at the mine.

After one month, the iron ore is moved to a furnace to extract iron which then needs to be transformed into steel. From the steel one make steel girders which are used in a factory that makes some consumer good. The factory building depreciates by, say, 5 per cent per year, which means an economic life of 90 years! In other words, one month’s production is economically paid back over the next 100 years! Obviously, the iron ore worker need to eat today and cannot wait for 1/100th share of production paid out over 90 years with the first payment due in 10 years when the factory is up and running.

Naturally, the iron ore worker cannot wait this long for payment. He is in desperate need to be paid monthly. But if his product is paid back over 100 years there is a need for accumulated capital in order to sustain the worker today. In other words, the capitalist steps in and uses his excess saving over consumption to pay the worker. As a side note, the workers cannot be entitled to the “full product of his labour” as the Marxists tend to believe, as this would rapidly consume all capital and drive society back to the days of barter. Rather, the worker is entitled to the discounted value of his product today. The capitalist can pocket the difference as payment for not consuming today.

Through this simple example, we can see that capital is not defined by any specific nature, but rather by its usage. The worker uses his payment to buy bread and milk, but the bread and milk comes out of saving and is considered capital. The capitalist essentially paid the worker bread and milk today with the intention of making a subsequent sale.

The funding source is theoretically irrelevant. If the entrepreneur owning an iron ore mine cannot fund the project through equity, he may take on debt from people that have already accumulated savings.

Can we say good debt should be defined in a continuum with different degrees of goodness? In an optimal world defined by Ivory Tower economists the answer is yes. Every capital project should be considered according to their respective yield against available capital. The real world does not allow for this, but in a relatively free world with objective non-manipulated prices and interest rates, the capital allocation will tend to move on a scale of goodness.

DWM then comes up with a couple of examples that suggest the distinction between good and bad debt can vary by place and time. For example, would it not be a considered good debt if you bought a house in a bull market? Or alternatively, would it not be a good idea to take on a student loan if you could get a high paying job afterwards?

These are good questions but we will argue they spring out of two misconceptions. First of all, money is not wealth. Money is just a medium of exchange. Secondly, if markets are manipulated and the price signal is distorted individual rational actions may not be rational for society writ large.

On the first point even esteemed economists are confused. For example, Chairman of the Federal Reserve suggested that the housing bubble was not caused by inflationary policies, but on a global savings glut. Since people saved too much, Americans went all bananas and flipped houses in the naive belief that it would make them all rich. This is utter nonsense!

During the housing boom the US inflated the dollar supply enormously, but to their own surprise it did not have any immediate negative consequences. The reason for this was that export oriented Asian economies pegged their exchange rates to the US dollar and had to inflate together with the Americans. More specifically, as the Americans sent dollar to the Chinese to pay for all the stuff they bought, the Chinese soaked up all the dollars they could and recycled them back into the US market. Stated differently, the Chinese gave the Americans a vendor loan enabling them to continue consumption of Chinese savings for the better part of two decades. The simple fact that capital were allocated from capital scarce China to capital rich America should be proof enough to understand that capital was misallocated. In addition, through perverted incentives created by US politicians, mortgages issuance to unemployed people from Alabama and strippers from Las Vegas helped misallocate capital domestically. First the Chinese misallocate capital globally, and then the Americans misallocate it at home.

There was no savings glut! There was massive dollar inflation which helped consume capital until the productive structure could no longer be maintained. Capital consumption had to come down and production chains had to be shortened. This was what market signals tried to tell us in 2008 and 2009. Instead of accepting this as grown-ups, we blamed excess savings and ventured on to continue capital consumption by stimulating a new housing bubble!

But a lot of people became rich flipping houses. Should we consider debt financed house flipping in a bull market good? No! This is the very definition of bad or even destructive debt. Yes, some people made money doing this, but that is not through genuine capital creation. It is just the effect of inflation. Monetary inflation does not create value, but it help redistribute it. Those with access to debt on the market for loanable funds could take advantage of the other effect of inflation, namely increasing house prices. But if House Flipper A made USD200k on his endeavor and this enables him to increase his consumption it means Saver B has made an equivalent loss since House Flipper A did not create additional capital in the process.

As the perverted financialization of increasing house value turned houses into private ATM`s capital consumption kept rising in tandem with dollar inflation.

We hope this helped clarify questions that have arisen from our introduction good versus bad debt.

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