Tuesday, June 12, 2012

The Debt Culture

We are born into this world without debt, and we leave the same way.
Why are we encouraged to borrow so much as individuals, today?

To understand our debt culture, you first have to understand debt and how it evolved over our vast human history.   When man lived in caves and hunted for meat and foraged for berries, there was no money, and hence, no debts.   Tribes were bonded together by tribal bonds and rituals, without any formal accounting of who "owed" who.

Agriculture and civilization created the conditions for the invention of Money, which as I have noted before, is an invention of mankind, not some natural phenomenon (although many people think the latter).

Money was a powerful invention, too - and a useful one.   Someone growing crops could convert these into money and then give that to someone else in exchange for tools or other goods.   The money could then be carried over long distances and reconverted into other goods.  It was almost magical in power, and allowed mankind to move beyond primitive tribal groups and form larger societies.

But the concept of debt soon came on the heels of money, and mankind quickly realized the dangers of debt - but also its importance.   Many Western Religions have proscriptions against debt.  Both Islam and Christianity have been interpreted to prohibit debt or at least the loaning of money.   As a result, the business of debt in the West was often foisted off upon the Jews, who were probably quite puzzled as to why control over entire economies was handed to them on a silver platter (and you can understand why they would think they were the "chosen few" after a windfall like that).

Debt has its legitimate uses - and can be quite profitable for borrower and lender, if used correctly.   Debt allows people to hedge risk and spread risk.   It also allows a person to increase their wealth by sponsoring projects that they could not themselves undertake.

For example, consider your typical farmer of the 18th Century.  He grows crops and sells them.   But to convert corn or wheat into a useful end product, such as whiskey or flour, it is necessary to grind these grains in a grist mill.  He looks about and realizes the nearest grist mill is 20 miles away, which involves a lot of transportation in an era where walking and wagons were the only means of travel, over very poorly maintained roads..   If he had his own grist mill, he thinks, he could grind his own grains, and thus sell whiskey or flour, which are worth far more.   What's more, he figures, other farmers in the area would pay him to use the mill, as it would be more convenient than hauling their grains 20 miles to be ground.

The problem is, building a grist mill is expensive, and the farmer doesn't have the money to build it.   He also doesn't have the expertise or time to do so.   If he tried to build his own mill, it would take years to construct.  However, he could borrow the money from the bank, hire masons, millwrights, woodworkers, wheelwrights, blacksmiths and the like, and have a mill up and running within a year.   And by his figuring, if he can sell enough whiskey and flour, as well as take in fees from neighboring farmers to use the mill, he can pay back the loan, with interest, in a few years, and own a profitable mill, outright.

And so, such projects are undertaken.   There is risk, of course, as if the mill  doesn't get built, or if it fails to make a profit, the farmer could lose all his lands to the bank.   He is taking a risk, but if he is smart about the risk, he reaps huge rewards.   If he is lazy, fails to calculate the risk properly, or just has bad luck (e.g., flood takes out the mill), then he may lose it all.   Such is the nature of debt.

Debt allows someone without money to start a profitable business.  And without debt, many businesses would not be started.   Back in the 18th Century, you might inherit a farm from your parents, or perhaps they might stake you as you start out.   But if you did not have any money, the only way to raise it would be to sell your own services (work) by working for others.   To try to accumulate enough wealth this way to start your own business would be nearly impossible to do.   Debt was the way that people without wealth could take risks and build up a business and accumulate wealth.

So, clearly, debt had its positive uses.   Then why did some religions have proscriptions against debt or money-lending?   Well, debt also has its evil uses as well, particularly when people do not understand how debt works or when you should and should not use it.   Taking on debt to pay for a business enterprise that will generate income or save money is a good idea.   Taking on debt just so you can spend today and pay tomorrow is a very, very bad idea.   The latter technique is how many people end up in debt-slavery, owing money to many people, and never getting out of debt, and never making money from their debts.  And they voluntarily sign up for this form of slavery, too!

Consumer debt falls into this latter category.   When you borrow money to buy a car, or a television, or even to pay for a meal at a restaurant (with a credit card) there is no possible "profit" from the transaction.  There is no whiskey or flour to sell, no profits to be had by building up capital equipment, just expenses that are financed over time, with interest.   It just takes your daily expenses and makes them more expensive.

There are two exceptions, of course, but even these can be abused by the consumer and made into bad deals.

First, if you are young and starting out in life, an education may qualify you for a higher-paying job than you could get as just a high-school graduate.   You can borrow money and go to college or technical school, and receive training that will make you more attractive in the labor market.

But of course, consumers abuse this, by borrowing money for worthless degrees, and paying too much for them.   It would be like our 18th Century farmer, instead of building a grist mill, building a roller-rink instead (hey, everyone likes to roller skate, right?) and then paying three times market value for it.   A college education can be a great investment - or a really crappy one - depending on what you are investing in.

Second, if you going to live in one area for at least five years, and you can buy a home for less than the cost of renting it, then it may be a good idea to purchase a home using debt (a mortgage) as it will provide you with a flat rate of payment, which over time, will seem less and less, due to inflation.   You may pay about the same as in rent, but over time, too, appreciation in the home will yield a slight (tax-free) profit that will "pay back" those mortgage payments.

But again, consumers abuse this - paying so much for a home that it costs 2-3 times per month as renting the same home would.  And then they buy more home than they can really afford, and end up taxed out of the home as property taxes skyrocket.  And then they borrow, using the home as collateral, again and again, and never pay off the mortgage.  These are all bad decisions, and all examples of debt abuse.

So you can see, there are at least two situations where consumer debt can "make sense" in that it pays you back more than the cost of borrowing.   But these two types of consumer debt represent only a portion of overall consumer borrowing today.

Today, people borrow money for everything - we have created a culture of debt and are obsessed with the idea that your credit score and how much you qualify for, in terms of loans, is a sign of "wealth".  Nothing could be further from the truth.

When you borrow money to buy a consumable, like a car, a jet-ski, a boat, a television, or food, you are just adding to the cost of the item, in terms of interest.   And none of this borrowing is necessary to your daily living.   A basic used car in sound condition can be had for as little as a few thousand dollars.   It may not be fancy, but it will get you around.   But many folks convince themselves that they need a fancy brand new car in keeping with their station in life.  And helpful bankers are there to help you do this.  That does not make it a good deal for you, however.

And since such purchases are made "on time", it is easy for the consumer to convince themselves to spend more, as the incremental monthly cost does not appear to be that big.

Worse yet, people charge even the most trivial purchases on credit cards, and then pay revolving interest payments every month.   These interest payments can be as high as 25% or more - in an era of low inflation and low interest rates!  And yet, many folks think this is "normal" and how things are done.

Our debt culture is so pervasive, that people fail to recognize this, or even analyze it.  Borrowing money is just how it is done!  Or so they think.  If you want a car, you borrow money.   If you want to go on vacation, you get a vacation loan.   If you want to buy a new toy, you put it on a credit card.   If Christmas time is here, you buy everyone presents and finance it all.   Nothing is paid for with real money anymore.

In fact, many folks hardly use cash anymore - or even checks.  The only checks they write, in this day and age, are to the credit card company, who applies the money to the balance owed.   And they justify this on the grounds that they are getting "flyer miles" on the debt.

It is a sick way of living and an unprofitable one.   The consumer risks bankruptcy, but not for some business venture that might actually pay back, but rather, just to have the appearance of wealth, while squandering it.

And you start to understand what Christianity and Islam had prohibitions against debt and money-lending.   But as I noted before, not all debt is bad, just consumer debt and poorly thought out commercial debts.

How do you break free of our debt culture?  It ain't easy.  The media constantly hypes it, and the debt industry advertises heavily in the media.  "What is your credit score?" a "news" article shouts.  The normative cue they provide is that you should worry about this as the primary indicia of your fiscal health.  How much you can borrow is more important than how much money you actually own.

To go against our debt culture is to threaten the very basis of our society.  As well, you threaten the thinking that underlies most consumer spending choices today.   If you jump off the debt bandwagon, you can expect to be ridiculed by friends and neighbors, institutions, banks, the media, and even government.  Not being perpetually in debt is viewed as, well, Communist.

Even my financial adviser thought being debt-free was a bad idea.  But of course, he is in his 30's and owes money on a house, car loans, credit cards, student loans, etc.   To him, debt is how you get the things you want out of life.   And he suggests, not surprisingly, that I should have stayed in debt and invested more money with him - leveraging myself further, with the idea that I would make out in the end.

And while there is a modicum of logic in this, like the grist mill owner, there is always a chance that a flood will take out the mill, leaving it a ruin of broken timbers and tumbled stone walls.  And to me, the idea of keeping a 5.5% mortgage in order to possibly make 10% in the stock market, made no sense.  It was building a grist mill in a flood zone.  And the possible net profit (about5%) was equal to the money I would save by not having a mortgage.

But he didn't get that.  And he still thinks I am the fool for being debt-free, such is the strong pull of debt-culture in our society.