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Financial Matters: Good debt, bad debt

Financial Matters: Good debt, bad debt

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Borrowing and lending is the necessary life blood of our economy. Debt is the fuel that drives consumer spending, homeownership, entrepreneurship, business expansion, investment, and risk taking -- all of which are good and necessary to make a free market economy grow.

Borrowing and lending is good. Without it, the economy stalls. This is why following the “financial crisis” of 2008, the U.S. Federal Reserve lowered interest rates to near zero, where they still remain, and poured trillions of dollars into the monetary system through massive bond purchases, also known as quantitative easing. Over the past several years the Federal Reserve has been extremely active in trying to promote borrowing, lending, and risk taking. It has been their official policy.

Entrepreneurs who start a business and put everything on the line by borrowing against the value of their home have a pretty good incentive to succeed. And when they succeed, they add value to our economy. They create jobs. They enhance productivity. And they improve the general standard of living. The same can be said for a corporation that borrows to expand production or the services it offers. In both cases, fortunes are on the line, and there is a very high incentive to succeed.

The motive for success is conducive to the efficient allocation of resources. In other words, borrowed money is spent very wisely and efficiently. However, not every venture is successful; failure weeds out poor decisions and poorly allocated resources. This is the key to good borrowing; the proceeds of borrowing and debt must be efficiently and productively employed, and poor business ventures must be allowed to fail.

With very few exceptions only the free market, the profit motive, and the risk of failure can and will promote efficient borrowing and subsequent investment and risk taking.

The world as a whole has never been so in debt. The concerning part of the world’s increasing debt is the growing trend away from private debt toward public debt. For example, over the last several years U.S. households have been deleveraging while the Federal Government continues to leverage up. In other words, the U.S. deficit has grown rapidly while U.S. households have pared back their borrowings, with the exception of student loans and auto loans.

The trend is even more evident in countries such as Japan where the federal debt to gross domestic product (GDP) ratio is nearly three times what it is in the United States.

China also has a significant debt problem. At the national level, the debt to GDP ratio is relatively tame, but China's total debt to GDP ratio, which includes corporate and local government debt, far exceeds that of the U.S. And it is troubling that their government is at an increasing rate propping up and nationalizing municipal and corporate debt.

It is an undisputable fact that bureaucrats and governing bodies will never borrow and allocate resources as efficiently as a free market that is subject to success and failure.

In the case of China, watch closely as the government attempts to loosen credit and lower interest rates in order to prop up a speculative stock market and rescue indebted local governments, failing business and excessive home building and land speculation. While it might not implode immediately, it is not likely to end well.

Supporting bad business decisions by placing government guarantees on debt creates a “moral hazard.” It removes the consequences of bad decisions and promotes excessive risk taking.

In the U.S., it is arguable that there are currently a few speculative bubbles that have been driven by the Federal Reserve’s easy money policies. A couple of them are mentioned above: student loans and auto loans. Additionally, corporate debt has expanded rapidly, much of which has been used for stock buybacks.

When a corporation repurchases its own shares, it is effectively saying that the best way for it to create shareholder value is to decrease the denominator in the earnings per share ratio rather than increase the numerator. In other words, stock buybacks increase earnings per share, but not total earnings. Earnings are generally increased by investing in plant and equipment, additional hiring, product development, etc. Stock buybacks do not speak well of future business prospects.

In conclusion, debt is good for the economy, but only when the proceeds of borrowing are allocated efficiently, leading to increased earnings and productivity gains. Bad business decisions must be allowed to fail in order to promote good borrowing and lending practices. If these general rules are not followed, individuals, corporations and nations end up with a large amount of unserviceable bad debt. Greece is a good example.

Barry Nielsen has worked in capital markets for over 20 years with a focus on fixed income portfolio and risk management. He has an MBA from George Mason University and holds the Chartered Financial Analyst designation. He currently works for Opportunity Bank of Montana.

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