Debt White Paper
Table of Contents
Debt is a bad thing
Debt and HIPC (Poor Countries)
Debt and HIRC (Rich Countries)
Personal debt becomes national debt
What can we do about debt? – putting a limit on debt
Could outlawing commercial debt work in a global economy?
Is this a serious idea?
What might a debt-free world look like
“Bank” lending to business
Commercial property lending
Issues to tackle
The banking system
What is value
Personal mortgages and house lending
Safe haven for savings
How do we get there from here
Use a cut-off date well in the future
Change the banking sector
The purpose of this paper is to suggest that lending as a business should be outlawed. What do I mean by this? Probably the simplest answer is to say that no lender may charge anything for lending money; in other words interest, commissions, arrangement fees and all the other charges that are regularly levied by banks when loans are set up and administered should be banned.
What I’m not suggesting is that lending itself should be outlawed. There is nothing wrong with a friend helping someone out with a short-term or even a longer term loan.
What I am suggesting is that commercial lending should be banned simply because we do not seem as a world to be able to manage debt.
The starting point of this argument is that debt itself is a bad thing not just for individuals but also for world economies and the world as a whole.
The existence of highly indebted poor countries (HIPC) is an example of this. The definition of such countries has been argued over but the basics are that the debt run up by the government far outweighs the benefits received by the population of the country and that the servicing of the debt in terms of repayment and interest far outweighs any other financial considerations in that country so that education and healthcare, which are considered basics of what most governments should do, cannot be funded properly.
We now have a seemingly new phenomenon which is highly indebted rich countries (HIRC). The acronym PIGS which stands for Portugal, Italy, Greece and Spain (or is Ireland in there somewhere) illustrates the point. Greece has for a number of years struggled and the result of these troubles is now a Euro debt crisis. In other words the level of debt that Greece has accumulated over the years as a country is now threatening the stability of the European Monetary Union itself. Italy and Spain have similar problems Ireland has been bailed out and Portugal has been suggested as another country on the brink of a similar debt crisis.
Why is debt such problem in world economies? There are arguments about how HIPC countries have got into such substantial debts and there are terms such as “immoral lending” which suggest that the lenders themselves should not have been lending to the sorts of regimes that were in place when the loans were made. One argument is that the money was often not lent to the country at all but paid directly into the bank accounts of the country’s leaders who became rich at the expense of the population of the country. Another is that the projects being financed by the lending benefited the lending country (in terms of export sales often of arms) more than the country being lent to.
However the same cannot be said about HIRC debt. The problem here seems to relate to something different.
Gordon Brown famously said that he had ended the cycle of boom and bust and since then we have had a minor and now a more major financial crisis which has caused a recession; in other words another “bust”. However important the steps he took to lessen the blow and make sure that the world financial markets did not collapse as a result of this latest bust, this clearly shows boom and bust has not disappeared.
I want to suggest that a major factor in boom and bust is debt. The problem can be illustrated from the UK market where house prices have been rising and therefore people have seen a growing amount of equity in properties they own; they can borrow on this equity to pay for anything they like and this in turn seems to have fuelled a consumer boom. What has happened is that instead of a normal output of say 100 being generated by the economy, consumers have been able to borrow another 10 increasing the output to 110 (these figures are of course only examples for the purpose of explaining how debt makes a difference to boom and bust). If in the following year the same thing happens but everything has grown by 10% – normal output would have increased to 110 and borrowing has increased to 11 so that total output is now 121. What happens when the economy begins to shrink? The simple answer is that debt becomes less available so that in the third year let us assume that debt is no longer available but that output continues to grow at 10%. In the third year output has therefore grown to 121 but there is no debt available to finance additional output so that total output stays the same as the previous year. What happens if the crisis is such that debt has to be repaid? For example normal output continues to grow by 10% (to 133) but debt from years 1 and 2 has to be repaid (-21) In those circumstances total output has to fall even though there is plenty of capacity for production simply because of debt.
If it helps these figures can be put in a table:
In other words the existence of debt actually creates the circumstances for boom and bust.
Another problem with debt is that of speculation. When everything is going well and stock markets are rising people want to invest in the stock market. If they do not have the money to invest but they see returns higher than the cost of borrowing then they are tempted to borrow to invest in the market. If the increase in the market is purely speculative — we have had examples of this over the years including the most recent dotcom boom — then investors can be tempted to borrow to acquire assets which have no intrinsic worth.
What is the end result of this? If the assets do not have any value they simply do not have any value so the investors no longer have those assets. However they still have their debt. The end result is that the ability to borrow against rising markets can potentially create debt from nothing if those markets are rising as a result of speculation rather than real increase in value.
The debt funding a boom and bust cycle can either be personal debt — consumer spending on the back perhaps of house price values — or it can be national debt as governments seek to kick-start the economy by spending money they don’t have on projects which increase employment.
There is an argument that people making the mistake of speculating have themselves to blame and will end up poorer themselves and that it does not affect the economy as a whole. If this were true then we could ignore the effects of speculation.
However the recent banking crisis suggests that that this isn’t the case. What has happened is that governments across the world have bailed out failing banks creating national debt to cover the fact that the personal debt of individuals has had to be written off by the banks because those people have become insolvent.
What I am suggesting is that it does not matter whether debt is available on a national scale or only to individuals and companies that the end result is the same. In other words that debt becomes national debt one way or the other.
The first thing to say is that borrowing to get out of a debt crisis does not appear to be a sensible solution. The illustration I used earlier of debt fuelling a boom and then creating a bust when the debt has to be repaid could in theory be turned on its head. A government could take the view that instead of allowing debt to decrease it could simply increase sovereign debt borrowing to boost the economy.
If debt is never repaid, the end result is an ever increasing amount of debt.
Why is this a problem? At the end of the day the whole of the world trade system relies on money (whether denominated in dollars or sterling or Euros) having an underlying value. If debt is allowed to increase without limit then money does not have any underlying value — it will be valued on a very short-term basis because the amount of debt has increased. In other words the whole of the trade system in the world will breakdown unless debt is going to be repaid.
In any case would any government want to be accused of running a Ponzi scheme? Because borrowing to pay back what has been borrowed already is the essence of a Ponzi scheme.
If borrowing is not the answer then how about some method of restricting the amount which can be borrowed?
There are some religious precedents for restricting or writing off debt and the Jubilee debt campaign (which has been the major campaigners for getting rid of HIPC debt) has picked up on one of these ideas. In the bible in Deuteronomy 15 there is a stipulation that debts can last for no more than seven years and that every 7th year all debts should be forgiven. In other words, you may only be able to lend and borrow for a few weeks or you may be able to borrow for up to 7 years but no more. However these rules only apply internally — Jews were allowed to lend to foreigners and expect repayment at any time.
There is also have a tradition of Jubilee which adds a further year of forgiveness of debts every 50 years and it is this idea which has been picked up by the Jubilee debt campaign.
Islamic culture also has a prohibition on usury by which is meant that no interest can be charged when money is lent to someone else. As a result we now have Islamic banks with Islamic lending which makes sure that the return has not come back to the lender in the form of interest but in some other way — some other form of profit.
One of the problems with debt highlighted above is that of speculation. If borrowing is still commercially available even if only for a very short period (of up to 7 years) than the possibility of speculation still exists. Furthermore if borrowing can exist for a period of seven years will this create a substantial “bust” effect when all that debt is either repaid or written off in the 7th year?
When looking at the possibility of a seven-year debt write-off we could look at this in a number of different ways. We could say that all debts will be written off in (say) 2057, 2064, 2071 etc. and have a fixed time at which all debts are wiped off. Alternatively we could have a requirement that no debt could last for longer than seven years.
I would suggest that the only viable solution is the first possibility where all debts written off at the same time every seven years. My reasoning is simply that the alternative would be an incredibly expensive and difficult policing regime to see when debts were actually incurred and whether they have been extended beyond their legal seven-year limit. It also allows for the possibility (and bankers have demonstrated their ability to be ingenious) that debts could be rolled over in some way which is not obvious and therefore avoid the seven-year restriction.
Both of these problems suggest to me that if we are going to deal with the problem of debt then the solution needs to be the much more radical Islamic solution of outlawing commercial lending altogether.
The economic consequences of this are of course very very substantial and the world economy will be very very different from what it is at the moment.
One could argue that the fact that borrowing can no longer take place would actually mean that the growth of the world economy will be stifled unnecessarily. There is a counterargument that the growth of the world economy has been stimulated not only unnecessarily but fatally by the existence of debt or the availability of debt.
We are now facing a debt crisis not only in “poor” countries but also in the heart of the “western world.”
Sometimes a crisis requires a solution which goes back to basics (i.e. a radical solution) rather than trying to build on and fix a system which got us in the mess in the first place.
It might well slow the economy because the sorts of investments which will be undertaken will be different – possibly much less risky. But the effect of failure will fall on investors rather than (at present) on the banking system underpinned by governments which cannot afford for it to fail.
When a business needs a new piece of equipment, the way in which this is financed is often by borrowing from a bank or similar lender. Is there an alternative way or working?
The answer is that we already have a rental market. I would suggest that equipment leasing could take up much of the asset finance which is currently filled by lending.
This may limit the ability of some businesses to acquire equipment since larger pieces of equipment are not easily hired on a short-term basis. However leasing companies may come up with ways of renting larger items effectively and business can perhaps look at hiring other smaller pieces of equipment (such as cars or property) to release funds for buying larger equipment.
In this context I would suggest that the “leasing” agreements must be operating leases as defined by accounting standards (IAS 17) rather than finance leases which are lending agreements in almost all respects. In other words I would suggest that a possible back door to commercial lending needs to be closed if a world free of commercial debt is to be achieved.
A much more difficult are to consider is replacing overdraft or other forms of working capital lending, since there is no obvious asset to rent to a company. For example banks may lend to help a company grow, funding its cost between producing a product and being paid by a customer.
When joint stock companies were first developed they enabled larger ventures to be undertaken than could be afforded that one single individual. The idea was that they would be joint ventures and that everyone involved would invest some of their capital. I would suggest that removing the ability to borrow on a commercial basis will take us back to those days when wealth will be invested rather than money borrowed speculatively to fund ventures.
In other words businesses will have to find investors to help them start up or grow, rather than going to banks.
Of course banks were always commercial in their approach to lending so that they would often lend to businesses that had assets rather than to businesses that had good ideas, In other words many potentially profitable businesses are unable to find bank finance even when less profitable but more secure businesses could find finance. Going back to equity funding (through shares) may improve the quality of businesses being financed or change the way in which finance is provided so that joint ventures (more like Dragons’ Den) become more common.
Properties have traditionally been bought using commercial mortgages which last for a number of years. If commercial lending is to be banned then commercial mortgages will also be banned.
As with other assets, a business can consider renting rather than buying property.
Or an alternative might be for some form of equity finance which relates specifically to the property. For example a company could issue preference shares which are “secured” on the property so that should the company go into liquidation the preference shareholders would be able to sell the property to get their money back (in other words they would accept a risk that the property falls in value without taking on the full commercial risk of the company’s trading by buying ordinary shares).
When banks first started in businesses, they were primarily sources of finance. These days most of what banks do is processing transactions for us.
In a rural economy the purchase and sale of (say) a sheep would involve two people meeting agreeing a price and swapping the sheep for whatever alternative goods was agreed on.
In a global economy it is not practical to travel half way around the world to acquire one small part to complete a project. So the banking system provides a mechanism for payment to be made using a commonly agreed value (such as US Dollars).
Put another way, we will still need banks to provide a payment mechanism even if we do not allow them to lend us money.
This means that banks will have to change what their main function is and come up with efficient ways of dealing with and charging for transactions as they will not have the underpinning of a lending business. However the existing add-on financial services will no doubt still be offered by banks.
I would suggest that the relationship with the bank will change and that banks will be looking after our money as trustees rather than as creditors. In other words banks will not “owe” us the balance in our current account; instead they will be looking after money for us. The annual accounts banks produce will look very different as the only assets they will hold will be property and equipment they use to operate – they will cease to own large amounts of debt due to them and owe large amounts of money to others.
The underlying concept of monetary value may have to change. At the moment the system is based around debt since there is nothing of real value underlying the world’s currencies. At one time we did have a “gold standard” which meant that there used to be actual gold held in vaults underlying a country’s wealth. But the situation changed in the middle of the last century and, although there may be some gold, there is nothing like enough to act as “security” for the amounts owed around the world. And even if there were, gold does not have any intrinsic value – it is just what we have used as a measure of wealth in the same way other cultures used to use seashells or leaves. Gold does have some intrinsic value – but as a useful metal like copper or nickel, not as a “precious” metal – this just means it looks pretty and we want it.
If debt is removed from the global financial system how can “value” be measured? Will we have to come up with a new system? My expectation is that it will happen by default in the same way that currency exchange rates are set largely by markets comparing the underlying economies of the countries which back individual currencies. In other words not much will change.
There is another difficult issue to be dealt with. Whilst commercial mortgages can perhaps be replaced by some form of equity finance, personal mortgages (to buy your own house, not buy-to-let mortgages which are essentially commercial lending) cannot be replaced in this way. No-one would invest in you as a home-owner since there would be no return on the investment.
Home ownership is usually a long-term investment and to enable people to own their own homes requires either a substantial amount of personal equity or some way of deferring payment over a number of years. Perhaps some form of “home-owner societies” could act as a clearing house for the payment of deferred consideration, but it is likely that the period would have to be much less than the current mortgage term of 25 or 30 years.
This would in turn reduce the number of people who could afford housing at its current price and the likely effect would be a slump in house prices. Whilst this may seem a bad thing, in the long term it should not matter since the only time a person really cares about the value of a property is when they need to move – and relative price is then the most important question. House prices are likely to stay in much the same proportion as they are at present – the bigger the house or more prestigious its location, the higher its relative value.
In the short term there could be negative equity – people who have borrowed on a mortgage for more than the house is currently worth. Provided lenders can be satisfied the loan will be repaid, unsecured loans are not necessarily a problem – problems only arise where borrowers get in to difficulties with repayment – and this is when problems arise now.
The transition from mortgage-led to mortgage-free property purchase will have to take place over a long period of time (see “how do we get there from here”) so that price adjustments should take place over the same period rather than all happening immediately.
At present money is often put into a deposit account by cautious investors. Interest rates are currently quite low on these accounts. But if commercial debt is outlawed, the rate will become zero – indeed banks and other institutions may well need to charge for managing accounts.
Some suitable investment might be needed to replace bank deposits. Or perhaps a collective investment scheme could be set up to invest in the safer preference shares that may well come into existence.
There is a lot of debt in the system at the moment with repayment dates 30 and perhaps more years away. Rather than create a crisis by outlawing debt immediately, I would suggest that the change is set to take place at a fixed future date – say 30 years from now.
The effect of this would be to change the market gradually. For example where you can get repayment dates 30 years away at the moment, in 10 years’ time you would be able to get no more than 20 years (and probably less than that).
As we get closer to the cut-off date fewer loans would be available and more alternatives would develop. The leasing market for example may expand and new forms of equity market (for smaller businesses) could develop. Whilst the lending sector would shrink in size, staff could be redeployed in these other financial areas
At some point in the process (probably a few years before the loan cut-off date) the banking sector would cease to owe or be owed money on current accounts and balances would instead by moved to trustee accounts. Banks could perhaps make this style of accounts available years earlier for those who can and want to make a change earlier – but perhaps at the risk of paying higher prices for managing their money.
As the cut-off date comes closer the loan books of banks (and governments) will gradually reduce and final repayments will be made before the cut-off date or will be lost altogether.