Translate

Sunday, February 22, 2015

Debt Taken On By Fools

Debt Taken On By Fools
Never a Zero Sum Game

It is often touted that total debt carried by a government or total debt in general does not matter because debt is one person’s liability and another's asset thus a zero sum game.  This is plugged most loudly by Paul Krugman in an attempt to explain why the enormous debts of nations such as the United States and Japan do not matter.  Nothing could be further from the truth. 

For example consider a productive farmer and an adjacent town full of people.  The townspeople accept the farmers’ food but do not repay the farmer using money earned by providing production and services; they pay him back with IOU’s also known as debt.

The farmer is happy to accept this debt because he has big plans for his future.  He has been working hard and accepting these IOU’s for 35 years and is nearing retirement.  He and his son love to hunt on his land and after retiring he is planning on letting his land grow over, all the better for hunting he concludes.  He never teaches his son to farm, he would rather his son spend time doing what he loves and hunt with his father in his old age.  The farmer believes he has plenty of IOU’s to maintain his family’s lifestyle in retirement.

Unfortunately the townspeople have never had to grow their own food and have not taken the time to consider how they are going to pay back the farmer.  When the farmer attempts to collect on the debt it is possible they could then take the time to learn how work the land and try to pay the old man back but there is no incentive to work hard if they are not going to enjoy the fruits of their labor.  In addition, farming skills would take time to develop, not to mention they don’t have any land to work even if they wanted to.  

In this light we can understand that looking at debt as a zero sum game without considering the ability of the debtor to pay that debt in what the creditor will need in the future is a fallacy.  In our example above someone is going to lose.  The farmer will either realize he does not have an asset in those IOU’s or the townspeople will have to work without present compensation.

Many may think the answer to this problem is for the townspeople to figure out how to farm and properly repay their debt.  This sounds fair to me as well, until you consider that the townspeople that wrote the IOU’s are old like the farmer and could not be productive on a farm anyway.  The burden would have to fall to their children who didn’t even know the IOU’s were being written.

In this example it is clear that the town’s ability to create money to pay the debt back will not provide the services the farmer needs in retirement, thus is no solution.

This is the situation that has come about in most developed economies, particularly Japan, but since most readers will be from the United States I will stick with using the US as an example since we are not far behind the Japanese.  There are plenty of creditors and debtors in our system but to draw parallels to our above example, the baby boom generation is similar to the old farmer, the government is the older townspeople and their children are Gen Xers and Millennials. 

As with the farmer the baby boomers collected IOU’s in the form of government bonds in their pensions, 401k’s and the SS trust fund, as well as promises made such as Medicare.  The benefit for the government came in the form of paychecks to government employees or entitlements paid for using borrowed money as well as wars and putting a man on the moon.  Elected officials also gained power by distributing those payments.  The younger generations, X and Millennials, are the ones who will be expected to make good on those incurred debts.   

The tug of war over the next 15 years will be between who will lose in how these debts will be rectified.   There are two choices; the baby boom generation will have to accept default on the IOU’s they own and live a life at a much lower (possibly dangerous) standard of living, or the younger generations will have to work without compensation in the form of goods and services.  This is truly a battle between juggernauts, the baby boom generation is the largest voting block and controls the majority of the wealth, and capitalism does not function without proper compensation for production.  It will be fought in the financial markets, particularly the debt markets, around the table of the Federal Reserve, and in the ballot box.  The outcome of this battle cannot be known, but it is fair to say there will be pain on both sides and the turmoil in financial markets will be immense.

This pain and turmoil brings us back to why large debt loads will not end up being a zero sum game.  The reason is the debts create an illusion that warps the participant’s preparation.  In the above examples the debtors or those who depend on the debtors, the townspeople, government employees, or entitlement recipients believe they will be always be maintained by the creditor, and this is all they know.  The creditor, the farmer or the baby boom generation is under the illusion that the loans they have made throughout their life will support them just when they will need the support the most. 

These debt illusions dictate how both groups prepare for the future; this causes misallocation of resources/piss poor planning, and emotional pain when the illusion disappears.   The disruptions triggered to a complex society take years or decades to repair.

Another misconception used by Krugman to bolster his zero sum game theory is the idea that we owe the money to ourselves.  Much of this concept is dispelled in the arguments above but it also assumes ‘ourselves’ is one entity.  Thinking of ‘ourselves’ as one entity allows the thought that if one portion of that entity is benefiting and one is suffering it all equals out.  But in the case of debt this is not the case.  If nonproductive retirees benefit to the detriment of the productive working generations the disincentive to produce eventually negatively affects the whole society.  

The inevitable enormous debts that occur with any debt based monetary system are far from a zero sum game due to the fact that one person’s asset is another’s liability.  How the likes of Paul Krugman can spout such nonsense is beyond comprehension. 

Quote from the Movie Dumb and Dumber (1995)

Nicholas Andre What is this? What is this? Where's all the money? 
Lloyd Christmas:  That's as good as money, sir. Those are I.O.U.'s. Go ahead and add it up, every cent's accounted for. Look, see this? That's a car. 275 thou. Might wanna hang onto that one.


Confused?  I suggest reading my first post History and Introduction to understand where we started.  http://debtcrash.blogspot.com/2015/02/history-and-introduction.html

3 comments:

  1. I've been telling my family for years the stock market only provides them with paper assets that "tell" them they have so much value in some account, somewhere. They are literally banking on using those accounts in later years to support themselves. In fact, some of my relatives are retired and have gone out and purchased larges homes based upon their retirement savings, which of course are tied up in the Stock Market. When said Market takes a dump, and they have nothing left to pay the note on the house....what will they do? The bank that loaned them the money to purchase the house will certainly want their I.O.U in some form or fashion, but since the market ate up their retirement savings, and they have no job prospects..... Seems like diversification of skills and hard tangible assets may be the way to get through this coming crises...... Maybe.

    ReplyDelete
    Replies
    1. @Hunt4Steve. I'm going to be making another post you may want to show to you family in a few days. Thanks for the reply.

      Delete
  2. eToro is the #1 forex broker for newbie and pro traders.

    ReplyDelete