Debt.

One of the axioms of the neoliberal project is that increased debt does not matter. It is difficult for me to understand the reasoning but it seems to go something like this:

Every time someone borrows money he incurs a debt: and that debt is precisely balanced by his obligation to repay: which belongs to the lender. Leaving aside interest, from the economists' point of view we have not created or destroyed anything: we have merely moved it about. Where could be the harm in that? If you do not consider the individual case, but rather the aggregate of debt across a region or nation that sounds right. Individual harm may arise: but the assumption is that most people will repay, and so all will be well. Indeed there are people who are paid to work out the likely proportion of debt default in particular sectors: so that the lender, if an institution like a bank, can factor in the rise. Also, the parties can insure the debt so that if the borrower cannot repay for some reason, either he or the lender can be reimbursed through the insurance. Actuaries work out the premiums for such insurance schemes too. What could possibly go wrong?

There are two types of debt: debt which is secured by pledging something: and debt which is not secured.

A debt which is secured is most familiar in the form of a mortgage. The person who wants to buy a house cannot afford to do that in a reasonable time frame, if they have to pay for it in cash. A house costs much more than the annual income of most people, and they can't save up that fast. But a house is a valuable asset. Traditionally the expectation is that a house will keep its value, at least.

So there you are, with excess cash and you already have a house of your own. You might decide to start a business: but maybe you are lazy, or the business you want to start costs more capital than you have, or you do not see an opportunity, or you are already doing what you want to do and don't have time to start something new. So what are you going to do with that money? Lots of options. You can keep it under the mattress. It is there for a rainy day, and that feels quite safe. Might need to spend some on burglar alarms and fire safety and stuff like that: and it isn't going to keep up with inflation over the long term (there is always inflation in the long term: not sure why) so it will be getting less valuable. But maybe that does not matter if you have a comfortable income from elsewhere. It does matter to lots of people though: they want their money to keep its value. Maybe you are one of them. You can put it in the bank. It will be safe and it will earn some interest there. The interest rate might be quite good, but it won't always be: sometimes it will be less than inflation. So again it might lose real value, though not face value. If keeping the capital intact is important to you that kind of option is good: as is lending it to the government. But if the money really is surplus to foreseeable requirements you might decide to take some risks with it. You might lend it to a business you think will do well. You can buy shares in that business and you will get a dividend, and the capital value of the shares will grow, if the business grows. That is reasonably attractive if you think you understand some aspect of business well enough to know whether a firm is a good bet: otherwise you have to trust someone else to advise you, and such people do not come cheap. You might lose your money altogether.

But everyone knows about housing. So the idea of lending the money to someone else to buy a house with is very attractive indeed. They do not take ownership of the house until they repay the debt: you do. So really you have just bought another house. You know all about that because you have done it before. In theory you lend the money to someone else to use to buy a house: and he repays you. But the whole reason why this is an attractive option is this: he does not really own the house till after he has repaid you. Effectively what you have done is buy a second house. He gets to live in it while he is paying you back the money which bought it: but if he does not pay you can throw him out. It is not quite the same as rent, because he has bought part of the house with the money he did pay you: but you sell the house and split the proceeds: he gets what is left once you have your money back, and the legal costs of the sale, and some interest for your trouble and ....whatever. You can't really lose.

Secured assets like this are supposed to be very safe, and this is the same thing that happens with financial companies. They borrow money to buy assets, and those assets are supposedly secure in the same way as the house is: they are valuable in themselves. Once again the lender cant really lose. If the borrower can't pay, the assets are sold to repay the lender. Simple.

As far as I can tell the international debt crisis arose like this. You had your surplus cash and you decided to lend it to someone who wanted to buy a house, as before. You wrote your agreement in just the same way, so he would pay you back over a fixed term, including the interest; and as before, if he did not pay you had control over the house and you could sell it to get your money back. But this time he did not buy a house. He told you he bought a house: he showed you a picture of a house; he showed a piece of paper that said it was a widget, and he explained a widget was a new kind of house, and that he had bought it:and because this new type of house was so well made it was going to go up in value faster than a normal house: and he would give you a bit more interest on your loan because of that. So you would share his good fortune in finding a widget for sale. It was really a bit of a movie set. The "house" was a flat piece of plywood painted to look like a house. And you did not take any time or trouble to discover that: you were dead excited about the new kind of house called a widget, because he told you that widgets were the coming thing. He was really quite persuasive, and after all he was paying you higher interest: which proved how confident he was in this new thing.

Your debtor made his payments for a time, so you had no reason to be worried. He had a lot more of your money than his widget cost. So he could pay you with your money for a while. But his widget cost something, which meant he could not pay you the full amount that way. So he bought another widget with someone else's money, in just the same way he bought the first one with yours. And again he borrowed more than it cost, so he could pay both of you out of that for a while. And obviously at some point that money runs out. Or if he carries on, somebody eventually discovers what a widget is: and when they do the people (including you) want their money back. He hasn't got it. You have lost your money and you have a widget. A widget is nowhere near valuable enough to cover your losses.

At this point you have lost, even though your risk should have been so minimal that it couldn't happen. But you are ok: the money was surplus, so it is unpleasant but not fatal. A lesson learned, just.

But the guy who lent the money for the second widget was a bit more exuberant than you. He really liked the fact he was getting high interest from the guy with the widget. So he borrowed some money himself at a normal rate of interest, and he gave that to the debtor to buy another widget. No risk: the widget was security and the payments and interest he was getting were higher than the repayments he was making. So it worked fine and he did it again. And again. When the money stopped coming in (or the nature of widgets was discovered) this guy owes a lot of money which he had borrowed to finance widgets: and he is not getting income in to pay that back: and he has widgets too. Now there are a lot of widgets for sale so they are not even worth what the early ones cost so that makes the situation even worse.

But this guy is a bank. He is too big to fail (that is if he goes down all the folk who lent him money to buy widgets are going down too) and so he runs to the government and says: you need to give me money or all those other folk are going bankrupt as well, and there wont be any jobs or any stuff made: and the government says yes. So the government gives him money to pay his creditors: but the government doesn't have that money really. So now the government has the debt he owed to all these folk because it borrowed the money to pay him with. Curiously, this second guy is said to be very smart: and we can 't afford not to have his talents: so the government agrees that nobody could possibly have been expected to foresee this: nobody could possibly have thought it necessary to find out a bit more about widgets: it is preposterous to imagine that this guy actually did know about widgets but didn't care. So they give him the dosh and let him carry on as before.

Now the government has all that debt and the second guy can pay his creditors, so he does not have any debt any more: he is back where he started. That means he has excess capital, which was what he used to finance he widgets at the outset. So he generously agrees to lend the government some money. But because the government has all this debt it is risky: and he demands a high rate of interest. This is apparently perfectly reasonable. But it means that the government is getting further into debt because it is paying him more interest on this new loan that it had to pay before it took on all this extra debt and so increased the risk. And of course the bank is making more money because of the high rate it is getting from the government bonds: so he is due a big bonus for being so clever. Trebles all round!!

As far as I can see the whole thing arose because secured debt wasn't secured on real assets at all. And that is the flaw in the theory: assets like houses do not usually lose value: but where there is a bubble on any asset the price is not related to the value in any meaningful way. Things like houses don't have a real value in that sense: they are worth what the market will pay. And a bubble means that the market is drunk: but it will be sober in the morning.