The Debts We Choose

Posted by on 06/03/10 in Debt, Philosophy

Memorial Day ushers in summer, opens neighborhood pools, instigates block parties, and says farewell (hopefully) to May’s mayhem. It also serves as an important opportunity to explore the meaning of “debt” in the truest meaning of the word.

Conceived in honor of those who had fought and died in the Civil War, Memorial Day has evolved to be a day of honoring all who have fought and died in military service to our country. As such, Memorial Day reminds us that we not only borrow from the future, but from the past as well, that our lifestyles, human rights, and political and personal freedoms were paid for in advance by others, almost all of whom are complete strangers to us, anonymous even.

Assume that how we borrow from others says something about our character and value system. What then have we learned about ourselves over the past several years of economic contraction and crisis? What kind of borrowers are we as individuals, families, and communities?

In his Financial Instability Hypothesis (FIH), Economist Hyman Minsky identified three types of borrowers: Hedge, Speculative, and Ponzi.

  • Hedge Borrower—can fulfill all of their obligations by their cash flows. Imagine the person who borrows to buy a home and every month pays back from their income some of the principle and interest they owe.
  • Speculative Borrower—can cover the cost of their interest but cannot pay the principle back out of their income. This is the person who needs to keep refinancing the debt every time the principle comes due. Consider the person who buys a home through an “interest-only” mortgage.
  • Ponzi Borrower—does not have enough income to cover the cost of the principle or the interest. This is the borrower who buys a home expecting the value of the home will increase so much that the borrower will be able to sell it and pay off the principle as well as any accrued interest.

According to Minsky, these three borrower types behave in a manner that facilitates economic cycles of growth and decline in asset values. Minsky felt that this cycle better described the natural rhythm of capitalistic economies than does a focus on extreme events catalyzed by factors external to the economy.

In his view, a system of predominantly Hedge Borrowers will, over prolonged periods of stability and wealth creation, transition into a system predominated by Speculative and Ponzi borrowers. As those more aggressive borrowers come to dominate, the financial system becomes more unstable, making it more difficult for the Speculative borrower to get refinanced or for the Ponzi borrower to experience the growth in asset values required to remain solvent; they fail to meet their obligations.

As the Speculative and Ponzi borrowers crash, they bring the Hedge borrowers with them because the stress on the overall financial system makes it difficult for even creditworthy borrowers to take out debt.  Theoretically, as the economy gradually heals, Hedge borrowers become attractive customers to lenders due to their reliability and potential profitability to the lenders. As Hedge borrowers become more common, the financial system stabilizes. As it stabilizes, the cycle again tilts toward Speculative and Ponzi borrowers.

This framework provides grist for some interesting questions:

  • What kind of borrower am I?
  • What about my family? How do we borrow money together?
  • How does my organization or company borrow money? How is that borrowing consistent with our mission?
  • How do the elected officials and bureaucrats that lead our municipalities approach borrowing?
  • What value or judgment do I assign to the three types of borrowers? (e.g. Hedge Borrowers are too risk averse and thus irresponsible, Ponzi borrowers are too aggressive and thus irresponsible, etc.)
  • What risks do my family, my organization, my community and I experience because of our borrower types?

America’s strength long has been grounded in risk-taking and self-sacrifice. In many ways, debt embodies the best and worst elements of both. Managed poorly, debt can personify all that is ugly about self-indulgence, narcissism, and greed. Yet managed well, debt can represent a willingness to invest in the future, to defer reward to a later date, to plant seeds today that may not flourish for many years or even generations to come.  It can be a way of giving back.

Perhaps one way that we as a country can repay those whom have made the ultimate sacrifice is to be extremely thoughtful about what we loan to the future. When our children and grandchildren look back, will they resent the debts we accrued to their name for our own benefit? Or will they honor us for the sacrifices we have made on their behalf? Elections and popularity pools are fickle friends and fickle fiends; history, however, is a much more exacting judge.