Personal Finance for Inflationary Times - Chapter 3: The Danger of Debt

Chapter 3: The Danger of Debt

There are two types of debt: consumptive and productive.

Consumptive debt is used to purchase consumables (items that will be used up), as well as debt used to purchase assets that were expected to be productive, but failed to earn a profit. Because assets in the hands of government are consumed, any debt incurred by governments is for consumptive purposes and therefore consumptive debt.

Productive debt is used to purchase a productive asset; i.e., one that will produce a profit while servicing the debt. Debts used for the purchase of a rental property, equipment for a business, or perhaps dividend-paying stocks can be considered “productive” if they earn a profit.

Consumptive Debt

People who borrow money to purchase consumer goods (consumptive debtors) eventually consume their purchases. They have less to show for their debt in the long run than people who have borrowed money to buy productive assets (productive debtors), regardless of whether there is inflation or not.

Consider the person who borrows money to take a vacation (a consumptive debtor). In the long run, the vacationer may have some good memories and maybe some nice photographs of his travels, but he is economically poorer for having spent borrowed money on a vacation. He must use his future labor income or proceeds from a productive asset to pay off his debt. Generally, it is better to avoid debt for consumptive spending. It is better to save up for or use current income to purchase consumptive items. A worthy long-term goal is to use only the proceeds of one’s investments to cover all consumption.

The less debt governments incur, the better off society is.

Productive Debt

Now, consider a person who borrows money to purchase a rental property. If he has purchased the property at a reasonable price, the rental income should cover the debt payments, taxes, and insurance, and provide a profit. The landlord will have a property that generates a steady cash flow with a long-term potential for a capital gain. In the long run, if he manages his property wisely, he will be able to take a vacation using the cash flow from his debt-free property.

Goods used in a business to create income, and the debt used to purchase them are productive debt. An office can be a productive asset if used to house an income-generating business, or if it appreciates in value. Other business-related items—accounts receivable, inventory, plant and equipment, machinery, investments—can be productive assets when they are used to create a profit.

Even before entering into productive debt, analyses should be done to determine whether the purchase will pay for itself. Such analyses may include: Payback Period, Net Present Value, Rate of Return (Return on Assets), Cash Flow, and/or Opportunity Cost.

Payback Period

The time needed for an investment to pay for itself with net projected cash flows is called the payback period. The payback period is generally used when estimating the time it will take to recover the original investment amount. If an asset costs $100,000, for example, and produces a net cash flow of $20,000 per year, its payback period is five years. Many businesses establish a maximum payback period for “acceptable” investments. If the maximum payback period is set at a relatively short time frame (three to five years), long-term investments may not be considered. This method also ignores the time value of money. On the other hand, by comparing the payback periods of competing investments, one can quickly and easily see which investment has a faster return.

During inflationary times, an adjustment for the inflation rate must be considered when using the payback period method for comparing investments. If we look at a $100,000 asset with a projected net cash flow of $20,000 during the first year, a projected $25,000 net cash flow during the second year, a projected $30,000 net cash flow during the third year, a projected $40,000 net cash flow during the fourth year, and a projected $50,000 net cash flow during the fifth year, we see that our projected payback period is 3.63 years. Of course, the dollars we receive are inflated dollars, which distorts the results, giving us the impression that we will have a faster payback period than constant dollars would.

Net Present Value

Net present value is another method for comparing investments. By estimating the current value of a series of future cash receipts using today’s cost of capital (to discount the future cash receipts to today’s value) and subtracting the amount of the original investment, this method takes the time value of money into account. Of course, by using today’s cost of capital during inflationary times, the resulting value will be understated by the rate of inflation. Nevertheless, if comparable investments are subject to the same rate of inflation, you still have a valid comparison. If an investment costs $100,000 and produces an income of $2,000 per month for ten years, we can calculate the present value (either with the help of present value tables, or a financial calculator) if we know the cost of capital. Assuming the cost of capital is 10%, the present value is $151,342.33, then the net present value is $51,342.33 ($151,342.33 – $100,000 = $51,342.33). In other words, by purchasing this investment now, your net worth increases by $51,342.33 now.

Rate of Return

For an investment where you have a one-time gain or loss on the investment, the return is calculated by dividing the gain or loss upon liquidation of the investment by the initial cost of investment. A more complicated formula applies for investments with streams of income over a period of time. For those investments, the rate of return is calculated by taking the annual cash flow for the life of the investment and equating it with the initial cost of the investment. The resulting interest rate is the rate of return. A comparison of rates of return for various competing investments reveals the best investment.

One thing to watch for during inflationary times is whether the income and expenses will be equally affected. If they aren’t, a compensation factor must be introduced.

Cash Flow

Cash flow is defined as “money coming in and money going out.” If more money comes in than goes out, there is a positive net cash flow. If more money goes out than comes in, there is a negative net cash flow.

When borrowing to purchase an asset, enough cash flow is needed to not only cover the debt payments (principal and interest), but also any other expenses associated with the purchase and maintenance of the asset. If an asset has enough of a cash flow to cover all of these cash outflows, then it has a positive net cashflow and is self-sustaining. If it does not have enough cash flow to cover all these outflows, then it has a negative net cashflow and must be fed by an additional source of cash. Obviously, it is better to purchase an asset with a self-sustaining positive net cash flow than to purchase an asset that needs to be fed.

Again, during inflationary times, the income and expenses may be unequally affected. If so, a compensation factor must be introduced.

Opportunity Cost

Opportunity cost is not a cost in the accounting sense of the word, but rather the expected yield on the best alternative investment. It compares prospective yields of competing (for your limited capital) investments. While a comparison of competing investment yields may reveal the highest rate of return, other considerations (transaction costs, undesirable labor practices, return-on-investment risks, political instability, early- withdrawal penalties, and tax treatment, to name a few) may come into play in the decision-making process. During inflationary times, alternatives must be reviewed regularly because inflation affects different investments at different rates and times. An economic bubble may occur in real estate one year, banking stocks in another year, and hard assets in yet another year. Furthermore, bubbles burst.

A combination of the foregoing analysis methods may be used to arrive at the “best” answer for you, your business, and other profit-seeking ventures.

Government Debt

A distinction should be made between governments that have the power to require their central banks to create fiat money and those that don’t. In the United States, this difference can be seen between the federal government which has the power to make the Fed create fiat money, and the states, counties, townships, and municipalities which do not have the power to create fiat money.

Governments without the power to create fiat money

Governments without the power to (indirectly) create fiat money are similar to individuals and businesses in that they must balance their budgets in the long run or declare bankruptcy. Revenues are raised through taxes, fines, grants, and/or borrowings (to be paid off with future taxes/fines). Generally, these governments issue two types of bonds: bonds that raise money for the general operating funds of the entity, and revenue bonds that are issued with the intent to build something that will generate enough revenue to pay for the construction in the long run.

Both types of bonds are easier to pay off during inflationary times because the revenues from taxes and fines rise. On the other hand, such bonds are generally poor investments from the investor’s perspective if the interest rate doesn’t compensate for the rate of inflation.

Governments with the power to create fiat money

Governments with the power to (indirectly) create fiat money also raise funds through taxation, fines, and borrowing funds. The U. S. government, for example, sells securities (including Treasury Bonds, Notes, and Bills) to anyone with the money to pay for them (including the Chinese, Japanese, and Iranian governments). For a government with a penchant for spending other people’s money, this can lead to:

A growing national debt with ever larger debt service expenses;
Competition for available funds in the credit markets, with individuals and corporation taking a back seat to government borrowing because of the government’s higher credit rating; thus, hampering business growth;
Foreign creditors gaining influence over government policies of the debtor nation as their debt holdings increase. (While third world countries can be influenced by the World Bank and its guidelines for borrowing funds, the U.S. government might be influenced by the Chinese government, which holds more than $1 trillion in U.S. debt obligations.)
An old adage says, “A debt creates a debtor, a large debt creates an enemy.” Does this make the U.S. government (the world’s largest debtor) the world’s largest enemy? Are there more wars to come?
A belief in the doctrine of inflationomics.

In addition to having the power to borrow funds, governments with the power to create fiat money can also avail themselves of their power to create funds when they can’t borrow enough to satisfy their spending appetites. By creating money (inflating the currency), these governments have “slipped the surly bonds of earth” and entered the stratosphere of spending’s limits. To understand how the U.S. federal government creates money, click here.

The Three Stages of Inflation

In the first stage of inflation, inflation leads to apparent growth and a demand for more “easy money.” In the second stage of inflation, governments benefit from their increase of the money supply and credit in several ways:

Government debtors that create fiat money benefit from the expansion of their money supplies. By inflating the money supply, thus making each dollar worth less, they pay off their debts with cheaper money. This is especially true for the United States because much of the world uses the dollar as a reserve currency. This gives the United States a much broader base of demand, thus allowing it to print more money before the inflation is noticeable in the United States . Of course, once it becomes noticeable, it will be noticeable world wide as the U.S. dollar declines relative to other currencies.
As prices rise, incomes rise, and if these governments have progressive tax systems (especially if they also have an alternative minimum tax) in place, they receive more in tax revenue as a result of incomes creeping into higher tax brackets.
Because inflation is a gradual phenomenon (at first), those who spend newly created money first benefit the most. Those who are farther down the line receive cheaper money. Governments obviously get the first crack at spending the money they create, so they get the highest possible value for their money.

Also during the second stage of inflation, people begin to anticipate future declines in their currency’s purchasing power, and the currency’s price (relative to goods) begins to drop faster than the supply expansion would suggest. Thus, an ever-expanding money supply is needed to provide the same purchasing power and/or stimulate the economy. In short, as existing money buys less, more money is needed to buy the same quantity of goods. More money is then printed to meet the ever-expanding anticipatory “need”/demand for it, reducing the currency’s price and pushing goods prices higher still.

If the government doesn’t get control over the inflationary spiral that it creates in the second stage of inflation, hyper-inflation can ensue in the third and final stage of inflation. If hyper-inflation is not brought under control, it will surely destroy the capital market in that country, leaving its inhabitants destitute and dependent on the savers and investors of sound money. For more on the three stages of inflation, see Age of Inflation.

U.S. Federal Government Debt

As of January 16, 2008 , the U.S. government’s debt was $9,202,448,329,313.54, and has been increasing by an average of $1.44 billion per day, according to www.brillig.com. For a current estimate, see http://www.brillig.com/debt_clock/.

As we recall, money in the hands of government is consumptive in nature, not productive. And the more money the government borrows, the less there is for productive endeavors. What’s more, the U.S. federal government doesn’t seem to care any more that it isn’t paying off its debts with sound money. It’s happy to pay everyone with inflated dollars—whether it is paying off debts, subsidizing states or cities, pursuing wars around the globe, caring for disaster victims, or sending a man to the moon. This irresponsible attitude will not lead to a strong dollar, a balanced budget, or a prospering economy any time soon.

In the long run, if spending isn’t brought under control, the U.S. dollar will reach a tipping point and be shunned by anyone who has a choice of monies. This could destroy the U.S. capital markets and destitute its citizens.

There is also the danger of short-term deflation. Because nothing goes straight up, and because the Fed does not always react quickly (or correctly) to the ups and downs of the economy, prices can decline. For example, during an inflationary spiral, more and more money is needed to satisfy market and government wants. If the Fed doesn’t supply enough money sooner rather than later, deflation could occur. Also, if enough collateral is lost from loan defaults, deflation could occur. The Fed is walking a tightrope between inflation and deflation. It could lose its influence in either direction. However, because the U.S. government is the world’s largest debtor, it seems most likely that the Fed will do everything in its power (including dropping money from helicopters) to lose it on the inflationary side rather than the deflationary side.

U.S. States’ Debts

While U.S. states can’t print money to get themselves out of debt, they can raise taxes, fees, and sell new debt obligations to roll over their existing debt. In time, this can drive businesses with high-paying jobs out of their state and into lower taxing states or countries. It also raises state government debt levels until services are hindered (they often cut the services that hurt the voters the most to get the remaining voters to vote for more funding). During inflationary times, more budget problems will occur as businesses seek states and countries with lower taxes (costs), presenting state politicians and bureaucrats with a dilemma. Should they raise taxes, cut services, or both? How can they attract productive business to their state? Will foreign businesses want to do business in a state with high inflation (yes, the states will have to deal with the effects of inflation even though they have no control over it), high unemployment costs, high taxes, and high costs of education, not to mention the cost of building modern facilities in a place with modern infrastructure (no collapsing bridges, please)? Will local businesses be able to continue when the state tries to raise funding for itself and its most fiscally irresponsible municipalities? For a perfect example of a state trying to bail out the governor’s former mayoral city, see I-80 Toll Road Proposal Expected to Hurt Modular Housing Industry.

While state governments will benefit from the effects of inflation on the repayment of debt (like all debtors), their costs may rise faster than their revenues at some point. Like every one else during inflationary times, they will be required to balance their slowly rising incomes with their more quickly rising costs. If they try to raise their incomes fast enough to keep up with inflation, their citizens will suffer and either leave the state or cheat on their tax payments. Obviously, some states will do better (the ones with fewer services, lower taxes, and the ability to obtain more federal grants) than others.

The bottom line is that all the money the states do raise will be consumed, thus reducing their citizens’ standards of living. Please note that as inflation rises, the money consumed for welfare, education, government employee salaries, and medical assistance rises as a percentage of total state expenditures (capital consumption). These items are consumed quickly while infrastructure expenditures (more slowly consumed items) are allowed to slide (until the federal government steps in with newly printed money) until bridges collapse.

U.S. Municipal Debts

As with the states, some counties and cities will be faster on their feet than others in recognizing the dangers of debt during inflationary times. The issues are similar—balancing the rising costs against a more slowly rising revenue and looking out for the deflationary pockets along the way. Some counties and cities that are more politically “connected” will be able to influence the state politicians more easily than rural areas, but in the long run, their fates will still be tied to that of the state in which they lie.

Many investors consider municipal securities to be as safe and secure as cash. Thus, it was met with shock and dismay on Tuesday, February 12, 2008 , that Citigroup has told the Associated Press that about $6 billion of mostly municipal debt auctions failed on Tuesday alone. That means that it is becoming very difficult for the soundest municipal borrowers to borrow money at a “reasonable” rate—the interest rate paid by the Port Authority of New York and New Jersey on $100 million of bonds rose to 20 percent on February 12 as compared with 4.3 percent on February 5, 2008. How much longer will municipalities be able to afford the rising cost of capital? Jefferson County Alabama made the news on March 3, 2008, regarding its debt load and the difficulty it is having making its payments. Vallejo, California is on the verge of declaring bankruptcy. At some point, many municipalities will no longer be able to borrow funds and will have to rely solely on tax increases to make ends meet. But if the tax revenues decline because of recessionary tendencies, raising rates won’t work either. What then? Perhaps the U.S. federal government and/or the state governments will have to bail out municipalities as well. Because the state and federal governments are already in debt, printing more money is the only politically viable alternative. More inflation will ensue.

U.S. Corporate Debts

In the first stage of inflation, when interest rates are low and inflation goes unnoticed, money is cheap to borrow. Businesses are encouraged to borrow money and expand operations as quickly as possible. In the second stage of inflation, interest rates go up (to compensate for higher inflation rates), old debt is more easily paid off, but new debt becomes more expensive to acquire. Borrowing slows down, stagflation ensues, and marginal businesses go bankrupt. Only debtors with the best ratings will be able to borrow. In the third stage of inflation, no one will lend money. The best businesses will leave for countries with sound money.

U.S. Individual Debts

Of course, all debtors benefit from the “easy money” stage of inflation, not just governments. As a result of this benefit, an attitude develops that favors debt and inflationomics because debtors gain during times of inflation. Debts become easier to pay off, incomes rise, and it happens so gradually that many people don’t notice it. In time, people grow accustomed to a small rate of inflation, and come to expect rising prices (including real estate prices). Many people borrow money against the equity they have in their houses to buy additional property (property is a good hedge against future inflation). And as long as property prices rise, this works, but when interest rates rise, it becomes more difficult to service adjustable rate mortgages and defaults rise. Rising interest rates also depress real estate prices as it becomes more difficult to borrow money. Sound money becomes king. In the third stage of inflation, hard assets will be traded whenever possible, instead of using fiat currency (this will become illegal and such assets will be confiscated). Wealthier people will leave the country first, forfeiting their property, and leaving the poorest people to fight over what is left. See Fiat Money Inflation in France. At some point, a new fiat currency will be issued or the government will just remove some zeroes from the banknotes. See Zimbabwe.

Debt Conclusions

Because inflationary times can be interspersed with deflationary times, productive debtors can find themselves in trouble if/when they are unable to service their debt load due to a loss of a job, customer, tenant, etc. Therefore, even productive debt should be used in moderation to make sure the productive asset it is used to purchase is self-sustaining.

Consumptive debt, whether used by an individual, corporation, or government, is doubly dangerous because it is totally dependent upon one’s current and future earning power to service the debt. Saving and paying cash for consumptive items is a better long-term approach.

Maintaining a supply of sound money is also important during inflationary times. As fiat money becomes worthless, survival may become a question of how much sound money you have stashed away in a safe place. Slowly selling off a stash of sound money as it appreciates may be a smart way to pay off debts.