The Great Magnifying Glass

Regardless of whether the economy is surging or crashing, debt is always a topic of discussion in the media.  Whenever the news cycle shifts to US budget deficits,  it creates a renewed focus on the impact of debt.  This is important because most of the developed world is deeply indebted.  The most important thing to understand about debt is exactly what it is, and by extension, what it is not.

What’s the Deal with Debt?

Fundamentally, debt is a financial magnifying glass.  It will amplify your current financial situation by the extent of your leverage.  For profitable endeavors, debt makes them more profitable by allowing the investor to expand the reach of his capital.  For example, let’s say you can borrow $1,000,000 at 5% and earn an 8% return.  In this case, you would create $80,000 in returns while incurring $50,000 in expenses.  The $30,000 net profit would belong to you as the investor.  (So what’s the problem?)

What happens if your forecasts are inaccurate?  If you only produce an income of 2%, you now have $20,000 of income and $50,000 of expenses.  This leaves you with $30,000 in losses.  Now let’s assume that you don’t have $30,000 available to pay for upholding your contract?  Who is going to come up with the difference?  (OK, now we see the problem)

If your name is AIG (and by extension Goldman Sachs, who was the #2 holder of AIG contracts) then the answer is simple.  The taxpayer will pay for the debt.  However, the taxpayer does not have any money, since the government is running massive deficits and is effectively broke.  Again, the answer is simple . . . create the money out of thin air.  In political circles, this is referred to as “quantitative easing’.

Extended Impact

This begs the natural question of why anybody lends out to a borrower who cannot pay their bills.  The only way such a thing could happen is if politicians create laws that push the market into these bad decisions.  Rational people do not make loans of this nature unless the government steps in to assume all of the risks.  (The names “Fannie Mae” and “Freddie Mac” should be coming to mind right about now.)

Getting back to the notion of creating pretend money.  Whenever the Federal Reserve ‘eases’ the money supply, it pushes more currency into circulation and devalues the currency already in the economy.  Thus, by a feat of financial magic, a government that is so incompetent it cannot even pay its own bills can mystically satisfy its debts by reducing the purchasing power of every dollar in circulation throughout the economy.  This feat of financial magic is known in economic circles as ‘inflation’.

The Power of Debt in an Inflationary World

Now we come back to debt.  People who borrow prudently will find that inflation actually makes them wealthy.  This happens by increasing the nominal value of what they own while the nominal value of what they owe to the bank remains fixed.  This phenomenon is especially powerful if the asset produces income from rents or dividends.  The most frequent example of this principle is income property.  It is typically financed with fixed rate debt and produces rents for its owner.  As inflation rolls through the economy, its value grows, its rents grow, but the mortgage payment remains fixed.

Ultimately, what we see is that debt in and of itself is not inherently good or bad.  It is simply a magnifying glass that intensifies the current situation.  When used prudently and intelligently, debt can amplify investment returns and protect investors from inflation.  If used foolishly, it can plunge a person into inescapable debt and perpetual servitude to interest payments.  When used by governments it is an implement of massive financial destruction.  It lays waste to entire generations so politicians can be re-elected by spending public resources.

Debt Danger

Debt has uncovered the great hubris of people, business, and government as each assumed that their ability to pay would perpetually expand.  This induces them to spend in excess of what they produce under the assumption that there would be a better future that allows them to make good on their obligations.  For some, this fictitious salvation has seemed to be achieved in the form of a ‘bailout’.  However, there is a finite limit to how many bailouts can be undertaken.

When the ability of government(s) to subsidize irresponsibility reaches its ultimate limit, the harsh side of reality will come to bear.  This reality is that many people and countries across the globe have been spending in excess of what they produce for many years.  Some have attempted to save themselves by asking their ‘rich uncle’ (frequently named Sam) to rescue them from their own foolishness.  The fundamental problem with this fantasy is that the rich uncle cannot rescue everybody.

What it Means to You

For those of us who wish to enjoy a life of personal, professional, and financial success it should be obvious that nobody will deliver it except for ourselves.  The government can make all the promises in the world, but none of those promises can be kept without resources.  (Incidentally, attempting to defy the laws of economics by granting entitlements in the midst of deficits is akin to creating a law that declares gravity illegal.  Regardless of what a self-obsessed plutocrat writes down on a piece of paper, reality cannot be legislated away.)A  The great promise of government has been little more than a great lie to lure unsuspecting fools into sheepish support of self-important politicians.

The only future that awaits is the one we create for ourselves.  The world is splitting into those who create their future and those who depend on somebody else for their well being.  The fate of those in the dependent class cannot go anywhere but down.  The prospects of those who create their own prosperity are fueled by historic opportunities that unfold on a daily basis.  The only question that lies before each of us is which path we will take.  One is easy and one requires disciplined work.  One will create economic bondage while the other creates financial freedom.  The choice is ultimately up to you.  Which path will you take?