Debt is a big scary word that has lots of bad connotations. But this is largely because we fear what we don’t understand.
In this amazing video by billionaire investor Ray Dalio, he explains in extremely simple terms what debt really is and how it works in economic markets.
While I really encourage you to watch it, I know you’re unlikely to, so I’ve done my best to capture the essentials in this short post.
What is debt?
- When you borrow money and promise to repay it, two things are created: debt and credit.
- Credit is the money in your bank.
- Debt is the promise (contract) to repay.
- Debt is an asset to the lender and a liability to the borrower.
- Credit is money.
- 95% of the “money” in the world is actually credit.
- “Credit is bad when it finances overconsumption that can’t be paid back. Credit is good when it enables people to increase their productivity.” – Dalio
- Markets are just the accumulated transactions that we all make.
- One person’s spending is another person’s income (important to grok).
- When spending goes down in the market, incomes (jobs) go down.
- When you borrow money, you are really borrowing from your future self.
- In order to spend more today, you agree to either spend less in the future or expect to be earning more (rise in productivity).
- Hence all lending creates cycles of spending (peaks of high spending and troughs of lower spending when debts are being repaid).
- When incomes rise faster than productivity, it means people are getting paid with a lot of credit (debt).
- This creates a debt burden (bubble).
- At some point in the future, incomes will have be to less than productivity, so that the debt burdens can be paid back (recession, crash, bubble bursting).
Why debt is good
- Debt enables short-term productivity growth.
- When borrowing money, if you’re productivity increases greater than the principle + interest, then you will have accumulated capital.
- Debt enables people without capital to accumulate capital.
- However, over time, your productivity has to increase more than your debt!
Why is debt risky
Using debt to finance unproductive consumption is bad.
- If you borrow money and don’t increase your productivity, you will have to spend less in the future to pay it back.
- You usually can’t afford this, hence why you borrowed in the first place.
Fractional reserve banking creates instability because there is always significantly more credit in the market than actual money.
- So if everyone wanted to get their money out in cash, the system crashes.
- It also drives inflation of housing and other assets.
- It also creates bubbles (debt cycles) which inevitably crash.
Debt gets bundled up and traded on the market as financial assets.
- Banks, companies, and wealthy people buy a lot of these.
- But sometimes people can’t pay back their loans and default.
- When a lot of people can’t pay back their loans at the same time, these financial assets become worthless.
- Banks and other financial institutions can go bankrupt.
There you have it; the crux of how debt works in 40 seconds. Love learning about his stuff? Try this one: In 40 Seconds: Capitalism