By Bob Goodwin, a medical device entrepreneur
Yves here. Bob’s post highlights a shift in attitudes that is entirely logical and is the inevitable result of financial firms, taking an increasingly predatory posture toward their customers. Borrowers are responding in kind, by taking a cold-blooded and legalistic look at their agreements with lenders.
Banks may find themselves hoist on their own petard, and the larger implications are even more significant. A calculating, contract-driven mindset eats away at the foundations of commerce. When I was young, it was possible to deal with most clients on a handshake (I’d still write the arrangements up, but it was mainly a device for confirming that we had heard each other correctly). Now pretty much every one I know has very carefully crafted agreements precisely because if things stray outside the bounds initially contemplated, it is much less likely that the party on the other side of the table will try to reach a middle of the ground resolution. It is now the norm that parties to a contract will try to exploit ambiguous or unforeseen situations to their advantage.
An erosion of trust leads to much greater contracting and dispute-resolution costs, a de facto tax on all commerce. As I discuss in ECONNED at greater length, it’s prohibitively costly and time consuming to negotiate agreements that contemplate every scenario (although banks increasingly endeavor to do that when they can dictate terms; credit card agreements that were one page in 1980 are now a full 30 pages when all the attachments are included).
I very much look forward to reader comments. From Bob Goodwin:
What we are experiencing is called the global credit crisis for a reason. There is too much debt in the world. More and more economists are talking about the threat of a deflationary crisis ahead. What does this mean for you? Well, if you have a house that is under water, or more debt than you can reasonably hope to repay, your best options may be the unthinkable. But it really should not be unthinkable to default on a loan or even to declare bankruptcy. Don’t stop reading. It is really a good option for many, it is moral, legal and good for the country. It is also become very common. You and your children will look back in a generation with pride.
In small amounts, debt is good. Home ownership is only possible for the young with mortgages, and many college degrees are partially supported with student loans. Working capital for growing businesses allow for inventory and distribution expenses. Lenders benefit as well: high interest rates are paid to pensioners on their life savings.
When debt exceeds a certain level it becomes a cancer on society. Easy credit fuels speculation which triggers bubbles. These bubbles lead to a temporary lift in apparent wealth, which increases economic activity beyond its sustainable level. But eventually more and more debt triggers economic decline with the inevitable glut of goods produced by an overheated economy.
What people are discovering too late is that their debt is not repayable. Ever. They once had a hope they could wait out their bad times. This is true of many homeowners, many businesses and many governmental bodies. The “great unwind” is going to be deflationary. Prices and salaries will decline, jobs will become more scarce, and debt will continue to increase.
The earlier you pull the rip cord the better off you will be later. In many states mortgage loans are non-recourse. Never make another mortgage payment. Turn over the keys after foreclosure. You will lose all of your down payment, but the lender can never get another penny from you. Your credit score will fall. But you do not want any more credit. Right? If you are trying to quit crack, how would feel about your pusher reducing your crack score? Stay off credit for a few years, and they will take you back with open arms.
There should no longer be any moral question about whether it is wrong to walk away from debt legally. The advent of limited liability corporations and the legal ‘personhood’ of corporate shells have allowed business to create one sided bets for years, and they happily walk away when the tide shifts. This is the calculus of 21st century finance, and you are a bit player in this game.
But it is the macro effects of a large transfer of wealth from creditors to debtors that interests me the most. I am not talking about ‘redistributive change’ in a liberal political sense. Creditors are not all bad, and debtors are not all good. There is a terrible corrosive force that excess debt has on societies. Ken Rogoff and Carmen Reinhart have written an excellent book on the subject “This time is different”, and suffice it to say the outcome for societies can be a generation of high unemployment and low economic growth. No serious economist challenges this data. However there is a lot of debate about what to do about it.
The current administration is implementing a policy of recapitalizing the banks (whose assets are still worth far less than their own debts) by lending them money through the Fed for nothing and borrowing back the money through the treasury for a lot more. This is called transferring debt from the banks to the government. But government debt has the same drag on societies in the long run, they can just hold their breath longer.
In the end deft default always occurs in these situations. The debts cannot be paid by the combined debtors in a society. The default may occur when inflation destroys the value of the debt over time. Or the default may occur with the eventual death of the debtor. Or the debt is discharged legally.
The longer this process takes, the more damage occurs to the society. There are strange incentives that a person has when their debt is unpayable. Why would you try to earn more? The more you earn the more debt you pay. But you cannot earn enough to get out of debt. So you stop trying. If you owe too much on your house, you might decide you have nothing more to lose on your house. So you will simply decide to wait it out. You will minimize the repairs and improvements on the house, rent the house out to frat boys and hope for the best.
The banks are great examples of distorted incentives. They have sucked up a $1T of government money. They are still paying huge bonuses. They are not lending to businesses in need. Distorted incentives indeed.
In the ancient days the Christian nations would have a debt Jubilee every 30 years. It sounds like a party because it was. Debts were forgiven en-masse when societies became constipated with debt.
The economy will continue to stagnate, and unemployment will increase. Asset values will continue to decrease until the defaults begin. When the rot is finally purged from our system, the great American wealth machine will start anew. It is time to party like its 1454. Start your own personal debt jubilee.
Update: A revised version of this post appears at Max Gardiner’s blog.