Sunday, May 24, 2015

The Invention of Debt and Inflation

In early society a debt was generally a moral or social obligation to repay someone for a good or service rendered.

Once money became the dominant form of exchange ( a commodity ), a debt came to refer to money owed by one party, the borrower or debtor, to a second party, the lender or creditor.
And these debts are commonly subject to contractual terms regarding the amount and timing of repayments of principal ( the amount borrowed ) and interest ( the extra money charged for making the loan ).

As the Rule of Law and the concept of Property Rights expanded, so did the idea of requesting a security over the money lent - a guarantee asset to be offered in place of the commodity money should there be a failure to repay all or part of the loan.

This securitisation of the debt shifted the idea of a loan away from the personal and short term - from having trust in the person or venture receiving the loan, from carrying some of the risk that the future status matched the planned outcome, to one that was both impersonal and low risk.

Debt became a business, and markets in Debt evolved.
The first step was to use the Rule of Law to allow the loan agreement, and its attached security, to be passed to another legal entity ( person or business ). Once this concept was established, loan agreements could be legislated as Bonds and these could be traded, and regarded as assets.

Dealing with individual loans and their securities was seen as inefficient and limited the scale of debt markets - so loans were pooled, sold to securitisation trusts, who bought them using Bonds ( Securities ) sold, in turn, into the Debt Markets.

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The critism of debt as a business is two-fold - firstly, that divorcing the lender from sharing the consequences of a future that does not match that envisaged on creation of the loan, unfairly pushes those consequences back onto the community and society that supports the borrower ( ie: can create public debt, environmental damage, social disruption ), and secondly, that as the Debt Market is a source of wealth creation, there is pressure to create levels of debt in excess of real and reasonable needs.

Economists historically identify three factors that cause a rise in the price of goods and services:
  • a change in the value or production costs of the goods, 
  • a change in the price of money, which occurs when either the coins themselves are debased or an inflow of similar commodity dilutes the value ( eg: gold and silver flooding Europe from the Spanish invasions of South America ),
  • or currency depreciation - an increased supply of currency, usually note printing.
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Basically each unit of currency buys fewer goods and services - a reduction in the purchasing power  per unit of money – a loss of real value. The measure of price inflation is the inflation rate, the percentage change in a price index, usually the consumer price index or similar basket of goods.

Negative effects of inflation include:
  • an increase in the opportunity cost of holding money, making spending cash a priority,
  • uncertainty over future inflation which may discourage investment and savings, and 
  • if rapid inflation, shortages of goods as consumers both hoard out of concern that goods will disappear, and buy goods as inflation resistant assets or as barter items for future use.
Mild Inflation can have positive effects:
  • it gives everyone an incentive to invest, as their money will be worth less in the future.
  • it reduces the real burden of debt, but only if salary or income increases over time due to inflation, but outgoings or mortgage payments stay the same.
  • it can keep nominal interest rates above zero, allowing central banks to reduce interest rates as a means to stimulate the economy.
  • it can reduce unemployment by reducing the real value of wages, increases the demand for labor.
Historically high rates of inflation and hyperinflation have been due to excessive currency printing ( 1920s Germany), or floods of currency-like commodities (1500s Spain), or periods of failure of confidence in the government guaranteeing a note or bond based currency (1990s Yugoslavia ).

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This is all historical information, and internally logical if simplistic. However, recent trends in country and global economies have not followed the expected patterns. Interest rates have been close to zero, wages growth is zero or negative, and in theory the increased money supply ( quantitative easing ) should have caused mild inflation and economic stimulation.

Investment in infrastructure, education, and preventative or primary health care can grow an economy in greater amounts than the investment spending. They act by reducing the cost of living, or increasing the apparent purchasing power of currency won through wages.

However, current government policy, in the face of slowing economies, is to reduce government spending, limit wages growth, and encourage private spending funded by increased debt.

One half of government is acting as if inflation was rising - using fiscal policy to reduce wages growth, and cut back on government spending on community; and the other half is using monetary policy, as if we are in recession - boosting public debt by transfers to private corporations.

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