Different types of debt

When drafting my white paper, I did not deal with different types of debt separately, but I think it would help to say something about debt because there are differences and it helps to understand them when considering the consequences of debt.

I will classify debt very broadly into

  • personal debt
  • institutional debt
  • sovereign debt

and try and explain what I mean by each (because the boundaries are not always clear).

Personal debt

This should be the easiest debt to deal with as it is something we are probably all familiar with – the amount owed by an individual (a physical person, a human being). What is important is the person who owes the debt – it does not matter whether it is owed to another individual or to a bank or some other institution.

The basic characteristics are that the debt is personal – it is owed by someone who can be named – and no-one else can be forced to take on responsibility for the debt. If the person dies, the debt dies with him (or her).

And now we will blur the boundaries slightly, because one debt can be taken on by a number of individuals together – a house mortgage for example – in which case the debt is usually the joint responsibility of all of the individuals who have taken it on. And the death of an individual does not mean the debt dies – this only happens when the last one on the mortgage dies – but there will be some mechanism which makes sure that the debt is repaid; perhaps an investment which pays out on each death, or more commonly debt payments which mean that not only interest on the debt but the whole debt is repaid by the time the last debt payment is made.

Corporate debt

This does not mean money borrowed by a company, but is more likely to be borrowings by large businesses.

The distinction between personal and corporate debt is who is borrowing the money.

Some companies will not have “corporate” debt because the nature of the business is so personal to the owner that the business will cease when the owner retires or dies. This means that the debt is still “personal” in nature.

On the other hand there are other organisations which will have “corporate” debt even though they are not companies. For example a large partnership which has a large number of partners may be able to continue to carry on when the senior partner or even a large number of the partners retire. The partnership may even be set up and managed so that it will continually change the managing group at the top so that it can continue in business.

The essential difference (by my definition) between personal and corporate debt is that “corporate” debt is taken on by the organisation and the organisation is expected to continue even though the people managing and owning it will change.

The essential difference between personal and corporate debt is that there may be no fixed repayment date for the debt. The corporate body cannot die, because the people owning and running it change, and so the debt can extend for periods longer than a lifetime. Of course most debt is set up with repayment terms – overdrafts for example are often repayable on demand – but the corporate body can refinance the debt effectively deferring repayment. An individual can refinance but there is a limit (his or her lifetime) to this process.

Corporate debt is not totally risk free of course. The underlying business could fail for a variety of reasons and the debt will then be repayable (and with a failure there may not be sufficient assets to pay back all the debt). But potentially debt can go on for ever as long as the corporate body continues to have enough income to cover its liabilities. And even when it does not, someone else may be prepared to cover the debts to buy the business.

Just for fun, have a look at Wikipedia’s List of oldest companies. Sadly the first company on the list “Kong Gumi” was taken over in 2006 and no longer exists, but there are a number of businesses which still date back to the first century AD. For some reason the oldest British, Irish and German businesses all involve alcohol.

Sovereign debt

What I mean here is debt owed by a country; whether it has a king or queen, is a republic or some form of dictatorship or democracy does not matter. The debt continues even when the government changes (and even when the form of government changes for example from monarchy to democracy).

Sovereign debt can be even better for lenders than corporate debt since countries are generally based around holdings of land and land tends to last. Environmental factors can reduce (coastal erosion and rising sea levels for instance) or increase (volcanic islands) the amount of land, but it is comparatively constant.

Another economic reason for sovereign debt being a good investment is that repayment depends on the country’s ability to generate income. Providing the natural resources of a country are unchanged, its ability to generate income does not change. So we would expect countries rich in oil or minerals to generate income from extracting and selling these to the rest of the world; agricultural economies will continue to be able to farm and produce crops (providing there is no catastrophic climate change such as desertification).

Of course countries do disappear – generally as the result of war, but sometimes for political reasons. So Scotland is at present part of the United Kingdom and is not a sovereign country in its own right after it shared the same monarch as England (for over 100 years) and eventually the two countries decided to become one.

But countries are generally stable which means that debts incurred by one government will usually be honoured by a later government.

It also means that, like corporate debt, sovereign debt (what we in the UK call the National Debt) could go on for ever. Providing the country is reasonably stable, it can choose to refinance its debt and will be able to find lenders happy to lend to it. Indeed some economists think that it is good for a country to increase its debt every year, since the increase helps the economy to grow.

Does this matter?

In simple terms, yes.

We need to understand the differences between different types of debt if we are to understand what matters.

When politicians stand up and liken our country to a corner shop, whatever they say needs to be considered as poor economics. Why? Because when we think of a corner shop, we think of a small family business dependant on the head of the family. Therefore its debts will all be “personal” debts which will need to be repaid during the lifetime of the head of the family. A new generation may take over but they will usually carry on the same style of business and if they borrow it will again be “personal” debt.

If politicians liken our country to a big business, this is closer to the mark, since corporate debt can usually be refinanced. But businesses can fail for no fault of the managers (for example the industrial revolution destroyed cottage industries making cloth).

Countries on the other hand do not fail in the same way. The industrial revolution changed the landscape and the economics of Britain, but it did not cause the country to “fail.” Different industries took over and employed people from the industries that failed.

 

Advertisements