Debt Essay

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Debt is generally defined as a sum of money or some other valuable that is owed by one individual (or group) to another. Debt is created when a person or company turns over a sum of money to be repaid at a later date, usually with interest.

The recorded history of private debt can be traced back to the second millennium B.C.E., although debts between individuals almost certainly date back much further than that. The existence and rules for dealing with debt appear in the Torah (all debts must be erased every 7, and every 50 years) and are subsumed into both Christianity and Islam, together with prohibitions on “usury,” which at least initially simply forbade the charging of any interest. However, the need for ready cash to pay for raising armies and maintaining royal lifestyles drew monarchs into taking out loans from wealthy banking families when they were unable to raise sufficient tax revenues to meet their immediate needs. These private debts, together with the needs of the trading houses of northern Italy, created a demand for a new kind of financial service that both encouraged enterprising individuals to find ways to circumvent the usury laws and created new financial institutions that were to become essential for large-scale public borrowing.

By the 12th century, bills of exchange were in use in Genoa, and negotiable bills that were transferable to a third party appeared by the 14th century. These instruments, together with predictable revenue streams from taxation, allowed the earliest public debts to be taken out by the Venetian state in the 12th century, using future revenue from the salt taxes to guarantee the loans. In northern European city states a different system developed that involved selling redeemable, life or perpetual annuities. These loans were generally secured on some immovable asset such as the town itself, and interest was designated as a “gift” to avoid charges of usury. The monarchies of Europe began to imitate these urban loans by the 16th century, with the nascent state bureaucracies taking over the role of issuing annuities and ensuring reliable repayment of the loans. The creation of public banks in the 16th century and of chartered trading companies in the 17th provided new forms of public borrowing, secured by shares in trading companies or government issued bonds.

Public Debt

Public debt is also known as government debt and occurs when any level of government (national, regional or local) takes out a loan. Generally, governments borrow money by issuing securities or bonds, although governments that are considered high risk may turn to commercial lending institutions and international lending institutions such as the IMF or World Bank. Government bonds are generally issued in the national currency if that currency has a strong track record of stability. Government bonds are generally regarded as “risk-free” because governments have the power to raise taxes, reduce spending, and even print money to pay the bond when it matures. The primary risk associated with such bonds is that of fluctuations in the value of the currency over the life of the bond. Consequently, countries in which the currency is not stable may be forced to issue “sovereign bonds” in a more stable foreign currency. While this makes the bonds more attractive to borrowers, there is the risk that the government may not be able to purchase sufficient foreign currency to redeem the bonds when they mature.

The accumulation of pubic debt, particularly in a state with limited assets or poor economic prospects, can lead to the threat of default on the loans. In the 18th century, the Spanish government defaulted on its loans seven times, and in 1917 the revolutionary government of Russia repudiated the debts of the previous Imperial regime. More recently, the very high levels of debt accumulated by many developing countries have resulted in the intervention of intergovernmental organizations such as the IMF to prevent default and restructure the loans.

Tolerance for relatively high levels of government debt arises largely from Keynesian economic theory which asserts that government borrowing in times of economic slowdown provides capital for increased government spending. That spending in turn supports employment and fuels consumption, creating an economic recovery. At that time the loans can then be repaid. These theories became very popular in the 1930s and 1940s and had great influence on the Bretton Woods institutions (the IMF, the World Bank, GATT and the gold standard), which were created at the end of WWII to manage and stabilize global finances in the wake of the war and the Great Depression.

The problems associated with high levels of public debt largely depend upon the financial stability and economic strength of the government involved. In absolute terms, the world’s largest debtor nations are in the developed world; however, strong economies, stable governments and substantial real assets make these debts manageable. During the 1990s the Clinton administration in the United States proved that even very large public debts could be paid off during periods of sustained economic growth. The greatest danger to developed countries with high levels of public debt occurs when much of that debt is external, leaving the country vulnerable to political and economic decisions made by foreign governments. For developing countries, high levels of public debt pose a rather different problem. If the ratio of interest payments (debt servicing) to government income becomes too high, it drains revenue from domestic public services, infrastructure, and industrial development. This depresses economic prospects and makes future loans riskier. In addition, as these countries generally have loans in foreign currencies, poor economic prospects lower the value of the domestic currency relative to the currency in which the loan was made and thereby increases the size of the loan (see Debt Crisis).

Private or Consumer Debt

Private debt as a transaction between two individuals has been around for a long time, but like public debt, it did not become a widespread phenomenon until the advent of public banking. Private debts can either be unsecured, in which case the ability to secure a loan will depend upon the creditworthiness of the individual; or they can be secured loans, where another asset owned by the borrower is used as security for the loan. Real property such as houses, land, and business assets are the most common forms of security. Secured loans tend to be offered at lower interest rates than unsecured loans, and interest rates also rise as the credit worthiness, determined by previous credit history, of an individual declines.

Historically, personal debt has been viewed by many societies as immoral, but modern economic perspectives often see consumer debt as beneficial to the economy as it increases domestic production and enhances economic growth. Governments may even encourage debt through tax relief for certain types of interest payments, if the loans are used in ways that encourage consumption of domestic products (for example mortgage interest relief in the United States).

The most common forms of secured personal debt are mortgages. However, there has been a large increase in unsecured personal debt in most developed countries over the past few decades, and the rising use of credit cards, payday loans, tax rebate loans, and consumer financing has led to record levels of private debt in many developed countries.

The Debt Crisis

The most serious debt-related problem in the modern global economy, however, is the debt crisis afflicting many developing nations. Public borrowing by developing governments became common in the post-WWII period as international organizations such as the IMF and World Bank provided a secure framework for infrastructure and development loans. By 1970, the 15 mostly heavily indebted countries owed an average of 9.8 percent of their GNP in international loans. However, these loans were at preferential rates, made only for projects that were judged necessary for economic development and were held by non-profit organizations. By 1987, those same countries owed an average of 47.5 percent of their GNP. The 1970s saw radical changes in the international financial markets that were to greatly affect not only access to loans, but also the terms on which those loans were granted.

The initial impetus to increased borrowing by developing nations was the oil crisis of 1972-74, when the price of oil quadrupled over a two-year period. This increased price put tremendous pressure on the industrialization programs of countries that relied heavily on oil imports and at the same time sent a huge volume of “petro-dollars” into the coffers of the international banking community. Eager to recirculate this money, the banks began to offer low interest loans to even relatively high-risk borrowers, including many developing nation governments. For oil-importing countries, this provided capital to continue the development programs regardless of the increased cost of oil, and for those few countries that were oil exporters, the money was borrowed on the basis of the oil revenue bonanza to come. However, the second oil crisis of 1979-80 closely followed by the interest rate hikes of the early 1980s, and the deep global recession of 1981-82 left many developing countries with insufficient income to pay back their loans on schedule. These loans, often made for current consumption rather than to build economic capacity, also came at a time when the global economy had been destabilized by the ending of the Bretton Woods system and when there had been an overall decline in the terms of trade for products from the developing world. As countries came increasingly close to defaulting on their loans, the IMF emerged as the guarantor of creditworthiness for developing countries regardless of the lender. Part of the new guarantee process involved countries undergoing IMF structural adjustment programs, which were designed to address balance of payment problems generated by internal problems such as high inflation, structural inefficiencies, and large budget deficits. The IMF program was designed to reduce current consumption so that capital could be invested in future economic growth.

However, in the case of heavily indebted countries, it merely freed money to flow out of the country and back to the lenders, and led to austerity programs at home that had potentially devastating effects on human and physical capital as food and transport subsidies were reduced, health and education programs cut back, and taxes raised, even as public sector employees were laid off. In addition, requirements for increased export income often shifted agricultural production from local food supplies to export crops, increasing local food costs. Since the 1980s, the focus of the international financial community has been to restructure this debt to reduce the chances of large scale default. A wide variety of programs, including debt for nature swaps; debt for asset swaps, which give creditors the ability to buy physical assets in the debtor country at a deep discount; and cash buy backs, which allow the creditor to buy back the loan at a deep discount. More recently, as it has become apparent that such programs are only having a minimal impact on debt reduction, particularly in the poorest countries, the concept of debt forgiveness through programs such as the Millennium Development Goals is becoming increasingly common.

Bibliography:

  1. June Fletcher, House Poor (Collins, 2005);
  2. John Isbister, Promises Not Kept: Poverty and the Betrayel of Third World Development (Kumarian Press, 2006);
  3. James Scurlock, Maxed Out (Simon & Schuster, 2007).

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