Wednesday, July 15, 2009

Financial assets are debt

Credit economy includes both borrowers and lenders. The growing value of financial assets is just another side of coin which is the growing amount of debt. Financial assets are debt.

The growth of assets needs to equal interest payment and the growth of debt. When interest payments are in default, the whole system fall apart. When creditors discover that borrowers won't have the ability to pay back interest and maturing debt, they will pull back the credit extended to borrowers.

In real world, the situation is a little more complicated with the role of financial intermediaries. The same creditor might at the same time be the borrower. For example, when pension funds invest in mortgage-backed securities, the beneficiaries of pension funds could equally possible take out mortgage loans from one of the major banks in the country. The bank then might pool large number of mortgage loans together, package them into mortgage-backed securities and sell them to pension funds.

Another example is government debt. Pensions and mutual funds invest nearly 30 percent in government debts. The government uses borrowed money to cover its revenue shortfall and spend on health care, education, social security etc. for the interest of its people. The beneficiaries of pension fund can at the same time be the borrowers.

When creditors pull back their investments, the cost of borrowing goes up and it will be more difficult for borrowers to pay back their interest and roll over their debts. The taxpayers are now both borrowers and creditors. Now the same taxpayers are suffering from both sides. The value of their investments are going down and debts are blooming.

I am not arguing that we as a society should not have the financial intermediaries to share the pie of real economic output. In fact, they are absolutely necessary to lubricate the real economic activities in complex world. The more extra savings they can turn into investment, the more people will get employed to produce something. The real argument is that how big share this financial sector should be in the whole economic pie and how large the debt level should be in terms of not threatening the borrowers' ability to pay back their interest and maturing debt.

The key to run a successful credit economy is to have a sufficient large real productive economy. That means borrowers' real income from wages has to grow at least equally with the growth of interest payment. In most developed world, the staggering real income growth came from both the lower productivity growth and greater income inequality for the last three decades. There is no short solution for quick recovery in terms of real economy.

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