Debt is very simply a commitment to pay back money (or other resources) that have been borrowed. The act of borrowing is inherent in human beings and it is evident, such as when a child wants to play with a ball and asks to borrow one from a friend. The friend lends the ball with the understanding that it will be returned in the same condition and with the expectation that when the friend would like to use something the favour will be returned.
As adults, ventures and nation-states financial resources are borrowed in order to accomplish a specific task. The source of that financial resource is considered to be the lender. Sometimes the lender is an individual, bank or even foreign government.
Borrowing has been one of the most effective tools for economic development. With access to capital through borrowing individuals, companies and governments can invest in projects that produce specific benefits. These benefits can be purely leisure, e.g. one borrows to go on vacation or buy a boat. For governments it is expected that the money borrowed is for development of industry so that jobs can be created, tax-base expanded and from the additional taxes collected the debt can be repaid and the country will have benefited economically.
Sometimes governments will borrow for reasons other than to invest in industry so to improve economic competitiveness and financial returns. These other reasons for borrowing include, financing war, or creating social programs for reasons of political support. Too much borrowing for these other reasons creates an additional burden on the government and therefore to the taxpayers. As a result, tax rates are increased, thereby decreasing the ability for industry within a country to compete internationally. Jobs are then lost, which in turn reduces the tax base and makes it more strenuous to repay the debt.
As an example, the United States now has such a high level of government debt that rating agencies are reviewing their rating for purposes of issuing debt. Greece is another example. As the quality of American debt is revised downward the cost of carrying that debt (interest rate) increases. That fact alone means that the American budget will have a greater deficit with each downward rating revision.
America’s high level of debt also means that it will have a tough time borrowing to invest in industry. Even if it does invest in industry, the amount of return it would need in order to carry all that additional debt that was used to fund the war and other social programs is, well, daunting to say the least.
On a recent trip to Beijing, China I couldn’t help notice the speed of investment in infrastructure. Most of the cities buildings were built in the last 15 years. Highways are new and efficient. Construction is done on large scale to capture economies of scale. The people are working and productive even if it is at wage levels that the developed world frowns on. Many cities have skipped the old telephone-landlineroute altogether and moved directly to cellular networks, a much more cost-effective investment.
China’s economy is growing at a very fast rate, but then again almost all its programs and expenditures are focused on borrowing external technology and designs (thus saving on the research and development costs) and geared to building its exports. Most of China’s billionaires have made their fortunes in manufacturing. Ask yourself how America’s recent billionaires have made their money.
As a result, America now finds it impossible to compete with China for the manufacturing of most consumer products. Industry is suffering and jobs continue to be lost. Unemployment levels are the highest they’ve been since the great depression. Yet over 80% of every dollar an American spends leaves the country, primarily to places like Chinese factories. In other words, the more Americans borrow the more they give to countries like China, which countries like China use to develop their industry further and create more jobs. Sadly, American political discussions haven’t mentioned how the country can regain its competitive position and rebuild industry to create jobs, grow the tax base and repay its debt. Even if the American politicians got around to discussion such a plan, there still remains the issue of how they can borrow the money to invest in industry when they seemed tapped out. The near future looks grim for America.
The American example shows how the misuse of debt can destroy even a nation. The same holds true for individuals and companies. For example, if you borrow money to buy sports cars you are increasing your cost of living. Meanwhile, your friend may borrow to invest in a revenue generating venture, such as a rental property or business start-up. Who do you think will be better off in the long-run?
The message for individuals, companies and national governments is very simple – if you’re going to borrow make sure that you use that money to improve your ability to compete and results in an improved financial position.