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The overreliance on Debt - Outside View by Asad Dossani

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The overreliance on Debt
Feb 21, 2011

We hear a lot of debt crises in the news these days. First it was Greece, then it was Ireland, and now it is Portugal. While these countries have suffered to the extent that bailouts have occurred or are about to occur, many other countries have debt problems too. The UK is an example of a country currently working hard to reduce its debt. As a large country, the US has a huge debt burden. Why are so many countries in so much debt? In fact, prior to the financial crises, many governments had debt problems but it just wasn't in the news like it is today. Why is it so hard for governments to keep balanced budgets?

Debt is not something new. Debt contracts have been around for a long time, and were the first form of financing to exist (much before equity financing started). Yet, we still have not been able to solve the problem of taking on too much debt. Its very easy to increase our debt levels, but very tough to bring them down. Mind you, I'm talking about governments here.

When it comes to individuals, most people are hesitant about taking on large debt levels. People will be happy to borrow to buy a house, or invest in a business, or in their education etc. But people will be uneasy about borrowing money to finance their consumption or to go on a vacation. This is the right way to behave. We should borrow only to invest, and never borrow to increase consumption. This is because borrowing to increase consumption is unsustainable. Eventually, we will have to take a fall in living standards. However, borrowing to invest can be profitable. It is often advisable in many circumstances too.

It seems like a simple concept, yet most governments have a hard time following it. They are happy to borrow for nearly any purpose. Part of the reason is that government debt does not need to be repaid for a long period of time. Many bonds are issued for over 20 years; long after the current government will cease to exist. While governments are elected for periods of 4 to 5 years, their spending and borrowing decisions have impacts that go far beyond this.

So perhaps it is the case that a government may decide to increase spending today because it will make them more popular and more likely to get reelected. The fact that the debt has to be repaid after 20 years makes no difference because elections are much sooner. In the same way, reducing debt is hard. This is because if we reduce debt, we feel the negative impact right away. But the positive impact is not felt for many years, possibly by the next generation.

When it comes to governments taking out more debt - it is simply a case of short-term gain at the expense of the long-term. A subsidy here and a subsidy there will probably win you votes, but it certainly won't create long-term economic prosperity.

Disclosure: I do not hold the currency/commodity viewed/opined in this column

Asad is an Economics Graduate from The London School of Economics who has also been a part of the currency derivatives team of Deutsche Bank in London. Currently pursuing his PhD at the University of California San Diego where he's researching on Algorithmic Trading Strategies, Asad will be your direct line for answers to all the questions you might have on short-term investing. A part of the Equitymaster Team since 2010, Asad has been sharing his knowledge on short term trading strategies with our valued readers, like you, through our various services. In fact, at the last count, his weekly newsletter, Profit Hunter, was being delivered to more than 100,000 smart traders across the world!

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