There are two essential forms of financing—debt and equity. Each form incorporates a basic element reflecting its historical development.
Equity arose from private activity. At its basic level, the equity investor shares in the success of an enterprise. In earlier times, picture a company formed to engage in a risky trade venture, say, sending a ship from Europe to the Far East to trade in silks and spices. The equity investor contributed the funds to help the venture pay for chartering the ship, engaging the crew and purchasing the goods and supplies needed for a voyage that might last a year (the “stock”). If the venture was successful, the investor received a handsome return as a reward for the venture’s inherent risks. If the ship foundered in a storm or the cargo was stolen by pirates, the investor came away empty-handed.
Debt, in contrast, arose primarily as a means of financing government. A sovereign might need to raise and fund an army to check the ambitions of a neighboring ruler, defend against a barbarian horde or satisfy his own greed and ambition. With no “profits” likely to result from the military adventure, debt came to have two fundamental components: a legally enforceable promise of repayment, and “interest” on the amount borrowed as an inducement to the lender.
In more modern times, debt has moved beyond government finance, driven in part by more favorable tax treatment, to become as important as equity for financing business and personal needs.
The legally enforceable promise of repayment places important constraints on the debtor, something we often lose sight of (to our detriment). Whether we’re referring to a person, a business or a government, those obligations can significantly restrict freedom of action, especially during times of financial turmoil.
Here are some principals that I think can serve any debtor well.
Rule 1: Borrow only what you can repay if the markets turn against you. The infamous 1929 stock market crash was primarily driven by the inability of those who borrowed to finance their stock purchases to meet the repayment terms of their debt, forcing them to dispose of assets at fire sale prices. The rapid decline in asset prices forced others into fire sales, forcing prices down even further in a sickening spiral.
In 2008, the story was pretty much the same, except this time it was mortgage loan terms that borrowers couldn’t meet as housing prices began to decline. As foreclosure sales caused prices to fall further, more and more borrowers became exposed.
Some have blamed the lenders, whose ridiculous, government-encouraged loan terms and lack of due diligence tempted many to sign up for impossible loan terms. In my view, we’re each responsible for protecting our personal freedom—a freedom that includes not having to answer to the demands of our creditors.
Rule 2: Borrow money for a term no longer than the life of assets purchased with the loan. The home mortgage is a classic case of appropriate borrowing. A well-maintained home has an indefinite life span. Borrowing for 15 or 30 years against our home lets us pay for the asset as we use it. In contrast, charging current expenses such as food, clothing, entertainment and travel on a credit card can cause untold financial pain unless we pay off the balance each month.
Another good example of following Rule 2 is the business that borrows the funds needed to build a new factory where the length of the loan is shorter than the life of the plant and equipment. Government borrowing, on the other hand, is rife with instances of violating this rule.
Today, the substantial majority of the vast sums borrowed at the federal level goes to pay for salaries, entitlement benefits and other ephemeral “goods.” Although economist John Maynard Keynes urged massive government spending of borrowed funds to halt a downward deflationary spiral during the Great Depression, he was opposed to long-term structural (permanent) deficits.
Had we entered 2008 with little or no federal debt, and had we borrowed funds to finance programs that would have produced long-term assets such as new highways, ports, schools and the like, I’m confident we’d now be seeing a robust recovery. Instead, Congress in 2009 and 2010 adopted “stimulus” packages and deficit budgets that represented an orgy of vote-buying, shipping money to favored constituents and programs.
Having violated both rules, the Greek government now stands on the precipice of a social breakdown as its lenders seek to impose heavy restrictions to force the Greeks to change their profligate ways.
Sadly, 19th century French economist Férdéric Bastiat seems to have hit the nail squarely on the head when he wrote: “The State is the great fictitious entity by which everyone seeks to live at the expense of everyone else.”
We spend money now that we figure either future generations or foreigners, like the Chinese, will pay for. Some economists—who should know better—encourage us to go deeper in the hole. Unless we, as a society, come to grips with our burgeoning deficits and debt, including the implicit debt of entitlement programs, we face a future replete with creditors’ demands that are going to be mighty obnoxious to live with.
