On Debt

[rowyn]

Several months ago, ladyperegrine asked if I'd write something about the US debt situation. I tried to wrap my mind around it enough to say something coherent. It's very big and complicated and I don't entirely know how I feel about it. So instead, I started this piece about something I understand better: debt in general. I finally decide to finish this up and post it today.

There are a multitude of reasons to borrow money, but I'll break them down into four categories:

Investment

By investment, I mean 'spending money now to increase your wealth in the future'. If you're a legal assistant making $40 an hour and you want to be a lawyer making $200, paying for law school is an investment. If you're paying $1000 rent & utilities now, and a comparable house would cost $900 a month for rent + utilities + maintenance + insurance + real estate taxes, then buying a house is an investment. If you need a car to get to work, buying a car can be an investment. If you run a restaurant, buying cooking equipment for it is an investment.

But it's important to recognize that these things are not necessarily investments, at least not in the economic sense. If the car you get won't let you earn more money than the costs of loan payments and car costs, it's not a good investment. If a fancy new appliance doesn't save/make you more money than it costs in your restaurant, it's not a good investment. I also want to distinguish investment from:

Speculation

It's hard to define 'investment' briefly in a way that excludes 'speculation'. In general, investments are long-term, or you are adding value to whatever you've purchased, or you are gaining a monetary benefit through ownership. In general, with speculation you are not adding value to your purchase and you derive no monetary benefit from ownership. Speculation is often but not always short-term. Day-trading in stocks is speculation. Buying collector's items or art to sell later is speculation. Buying a piece of land to sell it later is speculation. I tend to regard anything with a high likelihood of no return but a high potential upside as speculation as well. For a business person, an MBA can reasonably be viewed as an investment, because most people with MBAs are able to get high wages working in that field. For an actor who wants to be a movie star, a degree in the performing arts is more akin to speculation: most people with degrees in that field do not end up working in it for high wages.

Discretionary

This means 'stuff I want but don't really need and which will not bring me greater wealth in the future'. A vacation, a luxury car, a 2500 sq ft house for you and your spouse, a work of art for you to hang on your wall, are all discretionary spending.

Necessities

Much of what we think of as 'necessities' are not necessary to human survival: electricity, air conditioning, phone service, housing that conforms to American standards, etc. So I will define this as 'things needed to maintain your present level of wealth'. Living in a homeless shelter is not conducive to keeping a job, so a home that conforms to building codes can be considered a necessity. I would still discourage people from confusing 'luxury' with 'necessity'. Needing a place to live does not mean needing an upscale three-bedroom apartment.

On Spending and Borrowing

I want to emphasize that all four categories are perfectly valid ways of spending money. There are lots of reasons other than economic gain for purchasing something. Life is not a contest and money is not how we keep score. There is absolutely no reason that people shouldn't pursue a degrees in the fine arts if doing so will bring them happiness. I have an MA in English literature and I don't for a moment regret the expense or the time I spent getting it. (In my case, scholarships covered most of my college tuition, and my parents and I paid for the rest of tuition and expenses without borrowing).

That said, I would not recommend borrowing money for any purpose other than investment. Because only investment will allow the borrower to make money at the same time that the lender makes money. Only investment can create wealth. Borrowing money for other purposes means owing more money later when no extra money was gained from whatever the borrowed funds were spent on. It's losing proposition that generally leaves the borrower worse off economically.

Of course, sometimes circumstances force suboptimal behavior. It may well be better to borrow $1000 for necessities today and give up $1200 of luxuries to pay it back in a year. But borrowing money for necessities is inevitably a short-term fix.

And sometimes speculation is rewarded. A lot of people who sold houses in early 2007 were rewarded for speculating that housing prices would rise. People buying houses in early 2007, however, were the big losers on that bet. Speculation is at best a zero-sum game: for every person who buys low and sells high, there is another person who has sold low, another person who has bought high.

The Place of Debt

The point I most want to emphasize is this: debt has a valid place in the economy. It can let borrowers and lenders both enrich themselves, by giving borrowers the means to invest in goods and services that will increase the borrower's long term wealth. If you're going into debt for this purpose, that makes sense.

But if you are going into debt for some other purpose, I would encourage you to consider your other options instead.

I cannot recommend that you take on $50,000+ of debt to get a master's degree in English literature. It is not an economic investment. For that matter, I don't recommend that you go into debt getting an engineering degree if you hate engineering. You need to consider your own interests as well as what the labor market is looking for.

If you can rent a house for $1000 / mo, or buy it for $1500 / mo, buying that house is speculation, not investment. I'd recommend renting -- or if you want to speculate, or want to own for other reasons, then put enough money in as a downpayment that you can reduce your monthly cost of ownership to that of renting.

Banking institutions may well be willing to extend you credit for any of the above-mentioned purposes, and I do not favor legislating that away. I would like people to have the option of borrowing for a variety of reasons, even when I think many of them are foolish. I may be wrong. My position to judge your behavior and circumstances is generally not as good as your own.

That also means that we all must judge for ourselve the wisdom of our own choices. I cannot assume that a loan is a good idea for me just because I can get one, because even the best-intentioned lender doesn't know my circumstances as well as I do. So these are my guidelines on when I am willing to borrow money.

Comments

[sythyry.livejournal.com]

Thank you! That's very clear.

[level-head.livejournal.com]

Indeed, it's nicely done.

And as Lady Rowyn noted, it is hard to draw a bright line between investment and speculation. You can point to examples that are obviously one, or obviously the other, but a great many situations are close enough to a middle area that they tend to be categorized based on the result you want.

It's amazing what we can mentally classify as an investment if we really want to do it anyway.

===|==============/ Level Head

[rowyn]

It's one reason I don't really want regulations involved in deciding such matters. I don't want the countenance of the goverment to give people a false idea that it must not be that risky. Many wildly successful business started as extremely risky ventures -- along with countless flops. It's not a bad idea that such people are able to get loans, even if what they borrowed for turns out to be a flop.

[level-head.livejournal.com]

I agree. Individual financial institutions should make that decision for themselves, based on their own comfort level with the risk level involved.

For the financiers, those loans represent an investment, and the risk level should translate to the cost of the money. When government steps into that equation, "picking winners" as the expression goes, wrong choices are rewarded, with ultimately bad consequences.

There are three approaches, and we seem to default to the third:
1. Educating people out of foolish decisions
2. Making foolish decisions against the law
3. Requiring foolish decisions by government mandate

Most attempts at #2 above seem to inadvertently cause #3. I'm for the first choice, myself. And even that is not a government responsibility.

===|==============/ Level Head

[rowyn]

I'm not sure quite what you mean by 'making foolish decisions against the law'?

I don't think you can get rid of foolish decisions no matter how you divide things up, though. :/

[level-head.livejournal.com]

I'm not sure quite what you mean by 'making foolish decisions against the law'?

We do this all the time. "Safety" regulations, dietary regulations (the recent rise of "trans fat" legislation), the no-smoking and seat belt laws and so on.

Such regulations have driven up the price to get a new medicine approved to an average of $1.2 billion dollars, resulting in uncountable deaths.

On a radio show last week, the host (a personal injury attorney that I have met) asked "what would a car look like if it weren't for us attorneys?"[1]

The real answer is "about $2,500." And we would still be in the business of making general aviation aircraft, as well, as well as in thousands of other businesses that have been regulated out of the country to prevent people from doing something that might be foolish.

Such regulations are the height of foolishness, I think, however well-intentioned.

===|==============/ Level Head

[1] He got the answer he expected: his other guests were all personal-injury attorney buddies of his.

[sebkha.livejournal.com]

Liberalism is an idea about how you define good and evil -- that individuals are the authority about what's good for themselves. Democracy and markets are some of the practical systems we've developed that depend on this idea.

However there are areas in which the fundamental premise that people know what's good for them breaks down, simply because of the limitations of human psychology. Addiction, bounded rationality, confirmation bias, delayed gratification, and gambler's fallacy all hinder people from acting in their own best interest, whether it's to quit smoking (addiction) or to save adequately for retirement (delayed gratification).

"Making foolish decisions against the law" is how we patch over these gaps in individuals' ability to act in their own interest.

[rowyn]

I'm not as libertarian as I used to be, and I think there are many areas (in my own industry, even) where government regulation has been well worth the cost. But I think that many instances where the government has attempted to stop people from acting against their own best interests have been collosal failures (see: the War on Drugs).

[zeeth_kyrah]

This is because the root of the problem is closer to an economic and spiritual injustice rather than a criminal or medical issue. And the demand keeps growing even as we in the US refuse to allow domestic production, which says there's something seriously wrong internally that is not being addressed.

When a patient in a hospital needs increasing doses of painkillers, the doctors try to find the source of the problem, rather than telling the patient to try willing themselves well.

[rowyn]

I don't really have any special insight in how the problem of drug abuse should be handled, beyond observing that the US's attempt at abolition is counter-productive.

[rowyn]

Maybe Kismirth's banking industry will find these things helpful to reflect on, too. O:)

[terrycloth.livejournal.com]

Most of the people I know who got seriously in over their heads in debt got there because of necessities, basically. Something unexpected happened (eg, they lost their job, or had a big medical issue, or something they thought was a safe investment suddenly went bust) and they had to borrow to make ends meet. And then keep borrowing even after the crisis, because they were no longer in a sustainable situation because of interest on their debt.

[rowyn]

Most of the people I know who had debt problems got it from buying stuff they didn't need on credit cards. :/

Common but...

[tahkhleet.livejournal.com]

...remember 50% of all bankruptcies in the USA are from medical expenses. And a significant amount of financial strain is from the wealth destroying effects of divorce. Of the people I know trapped in pay check to pay check status, most of them it's one of those two things. (Or in one case, someone tied to the favor brokering network of her urban poor extended family who gives more than she gets back.) I do know two people who did get themselves in trouble with credit. But the other dozen or so it was emergencies like Terrycloth describes (in particular medical expenses) and alimony.

[terrycloth.livejournal.com]

I know a lot of people who are really poor and spend whatever money they get on frivolous things (and therefore have no savings and are vulnerable to a crisis), but I've never even heard of one of them *borrowing* money to do it.

[rowyn]

I know a number of people who use or have used credit cards to buy expensive stuff, or lots of small frivilous items, and just make the minimum payments on the cards. Or run the cards back up to the limit as soon as they make a pay down. :(

Opportunity cost and forecasting

[tahkhleet.livejournal.com]

As an aside, the bit about "if you want a home but its speculative, save up enough to get the interest cost down by borrowing less" only makes sense as a wealth improving move if and only if it is at least somewhat ambiguous there's nothing else you can do with that money to improve your wealth as much. Opportunity cost is one of those jargon bits that is a really important idea and one that is maddeningly difficult to use as a hard and fast guideline. It simply means the total cost is what you paid and the rough worth of the most profitable thing you could have done but could no longer do once the resources of the choice you did make are committed(Despite the fact some people try to.)

Why is it so difficult? Because it requires estimating future outcomes. Whenever you do that, small nuances of your assumptions can have major consequences. Moreover, because it's the future you can't prototype or practice or do other things that can drastically reduce error when assessing past and present. These two details together make anything we do in forecasting much more tenuous. All the same, refusing to forecast isn't a good idea either.

One of my favourite bits in an LE Modesitt book was where he reminded us that the idea of trying to forecast revenue used to be regarded as an arcane skill that only a tiny handful of people would do. It used to be believed that each forecaster was like an artist, following some degree of inborn spark combined with hard earned experience. So that how well this tiny demographic of forecasters did was very difficult to audit and your financial performance was essentially mostly a matter of fate once you'd picked your forecaster. One of the big improvements of our age is the idea that no, forecasting is something anyone can be trained to do at least rough quality work in. We are all be better off to the degree that everyone does remember to try and forecast at least on the "easy" calls. It has been a major improvement in human awareness and coping strategies.

Of course, with the advent of widespread forecasting has come a sickness of control-freakery. Being a new thing, we have even little collective experience coping with this source of human ills. (Not to say people haven't historically wanted to be control freaks. But they never had the tools we do now to make those wishes true to the degree possible now.) However, I think the problem that eclipses that is we've realized we need more high quality analytical decisions than we have talent available to make them.

The problem is that actually there is some validity to the earlier thinking about forecasting. It is maddeningly easy to accidentally stray out of the domain of knowledge and skills where "easy call" or even "kinda reliable harder call" forecasting is possible. It's even easier to stray into tasks where almost everyone (or everyone!) involved is too ignorant to even evaluate the results of the attempted forecasting accurately. Or to even have meaningful input into that evaluation process. We went from "almost all forecasting is too complicated to even understand how well our forecasters do their jobs much less do any of that ourselves" to "almost all forecasting can be judged tolerably well with some training and familiarity". Yet in fact, a lot of it still remains beyond the comprehension of non specialists. Typical human overreaction to having a new idea.

[rowyn]

You misunderstood my purpose in saying 'make a bigger downpayment'. Buying a house when a 30 yr mortgage payment on 100% of the price is more than the cost of renting the same house is NOT about increasing your wealth. Making a bigger downpayment does NOT make it about increasing your wealth, either. Buying instead of renting, when the cost of purchase over time is greater than renting, is about emotional or mental or spiritual reasons. Maybe you want to own because you want to paint the walls black or put in a hot tub or not have to deal with a landlord or whatever. There are lots of valid reasons for buying nstead of renting even when you know that the opportunity cost of buying is higher. Not all decisions about money are about becoming richer, and that's okay.


My point is that one shouldn't BORROW to finance purchases for stuff you don't need. And that includes buying a house, if the opportunity cost of buying exceeds renting. The downpayment doesn't change the fact that it's still a poor investment choice (and really speculation, not investment). It just reduces the downside if/when your speculative bet explodes.

[tahkhleet.livejournal.com]

but my point was its value in defraying your negative effects of a bad choice to get a house might not necessarily be the best use of the money. That the same amount of money spent to generate wealth in another way might have more offsetting effect. However, I would have to admit that yes, for most people, if they're caught in the mistaken idea a home is a good investment, odds are they'd be better off doing as you say. Their other ideas probably aren't that good, then. I just suppose I was trying to expose the "opportunity cost" calculation step you seemed to skip?

(cont)

[tahkhleet.livejournal.com]

(correction above:we usually -don't- realize when the demands of good decision making exceed our resources to make good decisions. The problem is we've vastly expanded the amount of stuff we try to consciously, deliberately decide presuming our resources to make decisions expanded in proportion to our wider scope of efforts)

To me, this incidentally is why I'm not a libertarian. This is the reason why Terrycloth's assumption that yes, sometimes the government can somewhat reliably stop or discourage you from being a fool isn't just ideological wishful thinking. Because there is a relatively small but significant realm of human decision making where "medium hard" calls are reliably made by specialists. Realms of decision making that a great many people are too ignorant to have much (or sometimes any) part in.

Of course,it is a great hazard to be too generous in describing the scope of this realm of decisions. It's important to have extreme caution assessing the accuracy of past assignments of types of decisions to this category. It's even more important to revisit and review the quality of "programmed decisions made for the people incapable of making them on their own". But it is not enforced immaturity to keep people from decisions that they are not equipped to make (and where no amount of life experience will often enough improve their ability to make said decisions.)

To me, this is why I've become vastly less ideological than I used to be. Yes, the wrestling over "where to be paternalistic and where not to be" is fascinating and even useful at times. (Seat belt laws saved a lot of lives after all, or things like analyzing paramedic routine tasks and removing human judgment from as many of them as possible.) But I feel the "real action" is in another arena. Namely "how do we inspire people to try their best at as much of life as possible" (within the limits of "caringness" people have to commit to their life). From what I've learned, it seems the _method_ and _reasoning_ they use isn't the main thing. While not irrelevant, it is much less relevant than the intensity and consistency of inspiration to do well. And frankly, I have only a rough idea (agonizingly slow to emerge) in how to inspire myself. I'm too ignorant to even speculate how to inspire others. And without settling _that_ question, discussion over stuff like paternalism vs individualism is much less pressing. (And I feel this is one of those issues where our ability to forecast is extremely limited and only a long term, multigenerational effort to experiment on ourselves could have any meaningful results.)

(Which btw was why I was so keen on Judaism; they were the only society I know of in their age group that had something sort of resembling such an experiment in progress. But in the end I had to realize it was not rigorous enough to be a useful experiment. That's why obligation-based Judaism has ended up in a dead end alley as far as i can see.)

But please go on with your series. You're a good writer and a thoughtful analyst.