A time traveller from 300 years ago would be awed by new technologies and social changes. But the disoriented extra-temporal visitor would find some aspects of finance very familiar. Many of today’s monetary arrangements are historical relics. Take, for example, debt.
Some 5,000 years after the first recorded examples, debt has thrived. Government borrowings are at record levels in much of the world, while the companies in the U.S. S&P 500 stock index report having as much debt as equity on their balance sheets.
Government debt, at least, hasn’t changed much. Now, as in 1700, or in 500 BC, governments use interest-bearing loans to close the gap between tax revenues and desired expenditures. The only alternative is to clip coins to create new money, or manufacture new paper notes or electronic funds. Such techniques are generally frowned upon, now as always.
That used to make sense, sort of. Borrowing monarchs knew additional taxes would be fiercely resisted, and that debasing coins hurt their image. The only way to go was to cajole rich people to lend. Merchants who lent could get a pretty good income, although sovereign defaults were alarmingly frequent. Powerful creditors kept profligate borrowers in check.
None of those reasons is still valid. Governments now routinely collect 30 percent to 60 percent of the funds which pass through the society in the form of taxes. That is usually enough to pay for needed goods and services. Even in today’s sclerotic and partisan democracies, people will generally accept additional temporary taxes to pay for natural disasters and other emergencies.
In the world of Keynesian thought, government deficits have become not just standard practice, but actually desirable. If states try to keep budgets balanced, they cannot help the economy absorb shocks as easily. But running deficits is less important than spending the money wisely. And if doing so encourages activity that would otherwise not take place, it should not be too inflationary.
The idea that lenders restrain unruly governments is also no longer true, because banks can provide the authorities with effectively unlimited quantities of money. Eventually, the debt lands in investors’ portfolios. And increased borrowing does not necessarily lead to tougher terms. In Japan, it has been the reverse: the greater the borrowing, the lower the interest rate.
For private borrowers, it’s different. They can’t issue legal tender as an alternative to loans with fixed interest payments and mandatory repayment. However, there is a better way to finance investments – old fashioned equity.
Back in the day, debt was the natural way to structure most investments, because information and trust were scarce. Loan contracts were clear and relatively easy to enforce. In contrast, shares pay dividends at the discretion of the issuer and are never redeemed. Outside shareholders depend on a strong legal system and active secondary markets.
Those are now readily available, so economies can harvest the many superiorities of equity over debt. To start, dividends which vary along with the issuer’s fortunes are more equitable than fixed interest payments. Equity also leads to less financial vulnerability. In bad times, interest and principal payments on loans can become unbearable, while shares just sit there.
The use of equity instead of debt has another advantage – it cuts down on financial crises. Fixed interest-rate debt is a magnet to dangerous speculation. The prospect of huge gains when the price of debt-financed assets rise is hard to resist, but so is the stampede of sellers trying to get out as falling asset prices lead to bad debts. If equity-like capital was used to finance everything from large companies to small apartments, leverage could probably never reach crisis levels.
It is easier to imagine a better world than to improve a worse one. But that’s no reason not to challenge the basic idea that debt is natural or inevitable. Venerable economic traditions such as slavery and animal-powered agriculture have been all but eliminated in the rich world. Debt could follow them on the road to extinction.
That won’t happen, of course, while economists, politicians and businessmen all take the reliance on debt for granted. A global financial crisis and seven subsequent years of overall disappointing growth have not shaken this orthodoxy. More suitable finance may not come until the antiquarian reliance on debt inflicts even more damage.