Of Debt, Leverage, and Wealth

The air is filled with talk of cuts from all sides.  Companies are cutting workers.  Americans are cutting back on spending and trying to reduce their debts.  Even government, just possibly, might be forced to cut employment despite public-sector-union fury.

Reducing government spending is a thing of beauty and a joy forever.  Reducing your own spending, in contrast, is not much fun as we recently discussed.

And predictably came the response in the form of a reader comment:

If you can't pay cash you can't afford it.  When fiscal responsibility is defined as not having more debt than you can afford the end is, indeed, nigh.

Debt, like fire or government, is a fearful master; but that's only half of the story.  Wisely used, debt can be a powerful servant.  In fact, debt has made America the richest country on earth and given us the highest living standards in human history, no mean achievement.

Let's see how this can be.

The Fierce Urgency of Now

Many Puritanesque types look down on America's culture of instant gratification where most members of the middle-class expect to pretty much be able to buy what they want, when they want it.  Don't have the money?  Don't worry; someone will always loan it to you on credit.

This is a hazardous undertaking because when something goes awry you can easily get buried under an avalanche of creditors.  The middle-class mentality, though, is all about security - if you don't have confidence that your income will continue forward pretty much uninterrupted, you aren't really middle-class.  The root cause of so much fear and fury in today's America is that this security has been demolished: people who have done all the right things, gone to college, gotten a solid job, bought a house and so on, no longer have confidence that they can keep the job they've got or find another should the need arise.

Naturally, they're retrenching and cutting their debts wherever possible.  This is good and necessary - to an extent.  Taken too far, though, it will destroy America just as surely as excessive debts can.

Consider the choices involved in buying a house.  If, like the working- and under-classes, you live a precarious existence, buying a house is foolish.  At any time you could become unemployed and lose your home, destroying your credit and whatever money or effort you put into it.  Renting is a much wiser choice.

But the money paid in rent vanishes to the landlord, never to be seen again.  Mortgage payments, in contrast, are partially payments into your own pocket.  Yes, the interest cost is money down the drain, but principal payments increase your equity; and home-ownership is a hedge against inflation even if the real value of property does not rise.

To not buy a house until you have full cash in hand means, for most people, never buying a house.  You have to live somewhere; if you don't own a home you need to rent.  Most of your mortgage payment is covered by the rent you're not paying; it's much harder to pay rent and also to save the same amount towards buying a house.  The end result of that path is far less individual wealth.

Seen in this light, home ownership is wise and prudent even on borrowed dollars.  If you can buy a home today, and you have reasonable assurance that your paychecks will continue, you should buy a home today with the help of a loan.

The same can be true for a car.  For almost all of us, a car is required to get to work.  For 90+% of Americans, public transportation is nonexistent or unreliable; walking to work restricts your choice of employers so severely that you're bound to earn much less.

Yet a dirt-cheap clunker has some of the same problems: it can break down and strand you at any time.  Especially at the low end of the income scale, employers have no tolerance for absenteeism and a breakdown can lead to sacking.

Buying a newer, more reliable car might be the right choice even if you don't have the money.  Here again, a loan can be prudent and wise, despite sniffs of disdain from those more blessed.

When used in a way that reduces expenditure or increases income, consumer loans create a virtuous cycle.  They get Americans the tools they need to better themselves; they give other Americans jobs in sales, manufacturing, construction, and transport; and if you care about such things, they create tax revenues for government by allowing spending that couldn't otherwise take place.

Key words: when used in a way that reduces expenditure or increases income.  That's where we've run into trouble.

What You Buy Matters

When you apply for a loan or go bankrupt, the bankers or the court looks at your total income and total debt.  What you earn; what you owe; what you own; that's all that matters.

But under normal circumstances it's more complicated.  Yes, keeping debt down is important, but not all debt is bad.  It matters enormously what the debt was for.

We've already seen how debt for a house or car can actually make you richer in the long term.  That doesn't mean it's always wise to borrow for a car - you probably don't need a Ferrari to get to work on time.

Education is another investment that can be worth borrowing for, but it matters a lot whether you borrow to get a business degree, or one of Chicano Studies that nobody wants and no employer will pay you to have.

How about clothes?  Not many employers will hire you if you're naked or look like a bum.  Not many Americans are in this predicament, and those that are can usually get out of it cheaply or for free.  Yet an awful lot of American consumer credit goes towards clothes shopping that people don't really need.

How about healthcare?  Well, you can't earn anything or pay any taxes if you're dead, and some studies claim that pretty people earn more.  For most of us, we're lucky enough not to really need major medical investments; they are more "nice-to-haves" and thus not prudent targets for borrowing.

The trouble is, individual people need to make wise decisions based on their particular circumstances.

If you are an aspiring actress, getting a boob-job might be a perfectly rational, career-enhancing choice; not so much for the rest of us.  If you are working in academia or the government, getting a doctorate might pay off handsomely, but most private-sector employers won't care.

The question shouldn't be, why are Americans in debt?  Anybody trying to improve himself is bound to be in debt; every self-made millionaire had to borrow large chunks of his startup capital.  Donald Trump thrives on debt financing; he just tries not to let it get out of hand, and when it does, makes sure that the bank is in just as much trouble so they have to deal generously with him.

The real question is, why do Americans go into debt for foolish things?  That's precisely the same problem our government has.  Nobody minded the massive national debt run up during World War 2 - beating Hitler required every last cent and every iota of effort.

Nothing we are doing today is nearly as important; why, then, are we nearing the same debt level?  We've gotten the government we deserve, reflective of our own personal vices.

Fix one; fix the other; both us as individuals and we as a country will be better off.  But just because we've gone off the track to one side doesn't mean we need to go off the track the other way.