Saturday, July 31, 2010

The Debt Trap

Some time ago I heard the phrase "debt trap". A nation falls into the debt trap when they get into debt so far that they are borrowing more to service their old debt. Pretty quickly their lenders realize things are getting bad and jack up the interest rates. With the huge amounts of money we are talking about a point or two is a real problem and beyond that. A nation can then choose to deflate their way out (Argentina and Russia), default on the debt (pretty much every country in Africa and Central/ South America at some point or another), go to war (Germany) or do some combination of the three.

I think there is a debt trap of sorts for individuals. This trap is when you have so many payments that it is basically impossible to pay cash for anything. All your income is going to basic life expenses (food, shelter, etc) or to payments. You can't buy a damn toaster without financing it. How does it end? One option is that something happens and the whole apple cart is knocked over. When you have no savings and the whole paycheck has to go to pay for junk you already have it doesn't take much to have a real problem. The good news is that there is another way out. Go to the library and get a copy of Dave Ramsey's book and read it. Check out Suze Orman's stuff also. Make your own decisions about what is important. Get some discipline and come up with a plan that gives your finances some order, cuts expenses drastically and improve your situation.

Don't fall into the debt trap. If you are closer to the debt trap than you care to admit then start improving your situation. If you are in a good place then do not become complacent and continue to improve.


Brad K. said...

A government (or Federal Reserve) might choose to reduce the money supply; I am not convinced that is the same thing as deflation.

My understanding of deflation is that it is both a drop in confidence, and a resulting decrease in borrowing/lending.

One source I read distinguished between 'self-liquidating' debt and 'non-self-liquidating' debt. Self-liquidating debt is a loan that enables production, that is, a manufacture or process operation that converts physical materials into products with greater value - sales price - than the components. Self-liquidating debt is paid off by the production of a physical product. Think of a farmer taking a loan to buy seed and fuel to put in a crop. Think of a plant taking a loan to expand production of a successful product.

Non-self-liquidating debt doesn't finance production. Maybe buy a lamp, or a book, and put it on a credit card. Maybe buy a bond or stock, or precious metal. Or derivative mortgage fund. There is no process or manufacture that expects, at the time the loan is made, to directly generate income that would retire the loan.

When confidence in the economy erodes, lenders are less likely to believe that non-self-liquidating loans will necessarily be retired in a predictable fashion. The cost of servicing such loans, including late payments and forfeits, increases.

And that is deflation, the significant decrease in availability of credit - debt - and especially the collapse of non-self-liquidating debt.

Supposedly no government has the tools to counter debt deflation; Japan has been struggling with it for a decade. Stimulus is the wrong attack - it generates debt, consuming a dwindling resource and adding to the depressing pressure on the economy.

Ginnie Mae, Freddie Mac, sub-prime mortgage derivatives, the housing bubble, these are all bubbles of non-self-liquidating debt, grown far beyond anything sustainable. Deflation, either crash-crisis mode or gradual and moderated, is the process of recognizing that much of the value in said "debt" is virtual and unsupported - and writing it off. Some gets paid, some gets partially paid, some gets lost altogether. The Obama Government's shenanigans with GM and Chrysler's bankruptcies, where creditors failed to recoup expected losses, casts a further shadow over lending and debt, and directly erodes confidence in lenders about making loans for non-self-liquidating debt.

Ronald Reagan and his administration and Congress turned around an economy plummeting out of control. They reduced corporate taxes and reduced regulations (indirect taxes). 17 months later, recovery was noticeable. It was a dead-slow, painful wait, and about the quickest that could have happened.

Either B. Hussein Obama's intent is to cripple the US economy or he is monumentally inept. The stimulus approach, increasing taxes on the people that might have been likely to, you know, hire someone, and increasing both regulations on employers and the financial burden of a rapidly expanding government has been going gung-ho for 17 months, now. Rather than seeing things improve, I see my part-time job evaporate when the employer closes their doors come September 6.

tpals said...

I woke up on the brink of Debt Trap 18 months ago, surfing funds from one credit card to another. After making some major changes in lifestyle and how I view money I can sleep peacefully at night knowing that in another 18 months I will have paid off all credit card and mortgage debt.

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