Wednesday, June 10, 2015

What Are The Three Types Of Bad Debt We See At Work In The Economy Today?.......GREAT INFO!

What Are The Three Types Of Bad Debt We See At Work In The Economy Today?

The first is what we call unproductive debt; and that's where the debt finances current consumption.

For example, if a household borrows to buy a new car. Well, you take on auto debt, spending goes up but the automobile doesn't generate an income stream and so that results in a decline in future spending. Same is true for housing or when the government sector takes on debt to finance current consumption on behalf of the household sector—that is also unproductive debt.

Now there are two types of counterproductive debt, one of which is readily understandable. That's where you make a loan to someone, you don't get back your principal and interest but you have to take them into default or bankruptcy and there's associated costs with that and your money is tied up for much longer time period than the borrower anticipated.

The worst of type of counterproductive debt, and the one that's least understood, was explained by the late MIT economist Charles Kindleberger. Kindleberger…explained that in asset markets like stocks or real estate or so forth there's a fundamental demand and supply curve but when there's excess debt creation, you can shift the demand curve outward and cause the market price of stocks or other assets to move above the fundamental price, which Kindleberger referred to as over-trading and is the direct result of excessive debt creation.

Then the next phase is discredit where some start pulling their credit back because they can see that the market prices are not related to the underlying fundamentals and then the final phase is revulsion where everybody tries to get out at the same time. That destabilizes the economy…

The greatest risk right now is the one described by Kindleberger, that when you get excess debt creation it tends to inflate the market price of assets like real estate and equities relative to the fundamental price—what Kindleberger called overtrading and then that leads to discredit where some people start pulling their debt offerings back and then the final phase which is revulsion, which we saw in 2008, 2000, 1929, 1873, 1838…

We are clearly in an overtrading phase; it doesn't mean that it comes to an end quickly. In fact, Kindleberger was quite clear in making the point that this period of overtrading fueled by excess debt creation can go on but at some point in time it destabilizes the system.

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