personal finance debt

Editorial
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Consumer Debt and Bankruptcy

Fred Foldvary
by Fred E. Foldvary, Senior Editor

According to economic theory, your income is either spent for consumption or investments. Goods get consumed when their economic value gets used up, such as when you eat up your food. So when you borrow money in order to take a vacation, at the end, all the money and resources have been used up. There is nothing left except, hopefully, pleasant memories.

If the economic value does not get used up, the goods are an investment. For example, when you buy a house, that is an economic investment just as much as if you bought stocks. The house gets consumed by its depreciation year by year, not when you buy it.

When you borrow money for an investment such as a house, the borrowing can be beneficial, because that property will provide housing services which you otherwise would have had to pay a rental for. Instead of paying rent, you pay interest, and indeed, part of that interest is really rent that you are paying the lender.

But if you borrow for consumption, you enjoy the goods today, but at the expense of fewer goods tomorrow. In the future, you not only have to pay back what you borrowed, but extra as interest. When you borrow for consumption, you shift your consumption from the future to the present day. If that is your choice, then fine, so long as you know what you are doing and it does not impose hardships on others, such as your family.

Consumer debt as such is not a problem for the whole economy. If one person is borrowing, someone else must be lending. Total borrowing equals total lending. If lending to a borrower becomes too risky, the lender will add a risk premium to the interest rate, which will discourage further borrowing. Consumer debt as such neither helps nor hurts the overall economy.

The problem of consumer debt is that government intervenes, interferes, and mucks up the market for loans. Lenient bankruptcy laws let borrowers cancel their debts, which makes lending more risky, increases the risk premium, and provides lower interest payments to savers. In a pure market, lenders and borrowers should decide on the terms, without government interference.

Another intervention is taxes on interest income. Some borrowing, such as when secured by real estate, is tax-deductible, subsidizing the borrowing, while interest income is taxed, penalizing savings and investment. With inflation, the tax is on the nominal interest, the dollar amount you get, which includes the inflation part, so the tax does not just tax interest income but also eats into the capital. This creates a perverse incentive to borrow more and to save less.

Government policy regarding land further skews the system to dysfunction. In a crystal-clear pure market, there would be no taxes on wages or returns on capital. Folks would be better able to save money, and the interest would be tax-free, with no need for complicated IRAs and pension funds. Taxes would come from land rent, which would make the price of land low. So there would be no need to borrow to buy land. That would shift lending to consumers and capital goods. Interest rates would be lower, since there would be no demand to borrow to buy land.

Inflation also messes up the credit system. Money becomes worth less and less each year. So there must be an inflation premium to make up for it, increasing the money interest rate. In a truly free market, the money would be private rather than issued by government. Private money based on commodities or services would be non-inflationary, making interest rates lower and simpler.

In a pure market where all action is voluntary, there would be lower interest rates and probably much less debt. Folks would be better able to save money, and need to borrow less for consumption. Employment would be more secure. Borrowers would have to pay back their debts, reducing the risk of lending. It would not matter to the economy how much or how little people borrowed for consumption, since over the long run consumer borrowing just shifts consumption over a lifespan, and over time, it all evens out.

As a matter of personal finance, it is wise to borrow only for investment or emergencies, not for normal consumption. Borrowing too much, such as with credit cards, just reduces your future consumption, as you then have to pay a large chunk of your income in interest payments. Some folks do this because they just declare bankruptcy, but if you can't or won't do this, then wise folks do what sound economics suggests, borrow for productive investments such as a house or home improvements, and consume only what you earn today.

-- Fred Foldvary      



Copyright 2002 by Fred E. Foldvary. All rights reserved. No part of this material may be reproduced or transmitted in any form or by any means, electronic or mechanical, which includes but is not limited to facsimile transmission, photocopying, recording, rekeying, or using any information storage or retrieval system, without giving full credit to Fred Foldvary and The Progress Report.


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