Oct 132015
 

Debt is Freedom

I once read in a book, “the borrower is slave to the lender” Proverb 22:7. But I don’t see it that way. I think debt is simply a loan between a borrower and a lender which usually involves a contract to pay back the loan over time. Nobody is a slave to anyone in this voluntary transaction. If I have a car loan and continue to make my payments on time, then the lender can’t tell me what to do with my life. It can even be said that I’m less of a slave now because I’ve gained more personal freedom by having a reliable vehicle, which wouldn’t have been possible without going into debt in the first place. 🙂 So hooray for convenient transportation. I’d like to give a big shout out to my car, for giving me the drive I needed to succeed. ?

Illusion of Debt

It’s often assumed that more debt is bad and leads to more financial risk. But debt is a funny concept. Japan has a debt to GDP ratio of 230%. This means Japan owes 2.3 times more than its annual economic output. Holy frankfurter! 😯 On the other hand, Canada’s debt to GDP ratio is a much more manageable 86%. Naturally we would expect Canada to be in a better financial position to take on additional debt. However, as of this post global lenders are demanding 5 times higher interest rate when Canada borrows money than when Japan does. (Sources: Japan gov’t 10Y Yield,  Canadian gov’t 10Y yield.)

Part of this disconnect between risk vs return is due to central bank manipulation. But debt itself is not always what it seems. Consider the following comic strip I found on the internet awhile ago.

The illusion of debt in Greece and Europe

Wow, that German traveler sure took his sweet time inspecting that hotel room. I wouldn’t be surprised if he secretly took a nap in there. 😉 Anyway, the moral of the story is that the stress of financial debt exists more in our imaginations than in reality. This illusion of debt prevents us from seeing what’s really important. The little Greek village went from having loads of personal debt to a debt free status! even though no economic activities happened. 😐 That’s because one person’s debt is another person’s asset. And everyone has assets. Even human capital is an asset because it can produce income, lol. The average consumer needn’t worry about living on credit. Just like in the comic, most of us have more assets than debts. So getting out of debt doesn’t objectively improve our quality of life. But many people still think it does.

Another great point the comic demonstrates is how important liquidity is to an economy. All it took for everyone in the village to get out of debt was to infuse temporary cash into the the system. This is essentially what central banks in the real world have been doing for the past 5+ years. But who knows how effective this has been. 😕

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Random Useless Fact:

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32 Comments on "The Illusion of Debt"

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Josh
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Interesting commentary. Debt is inevitable for 99.9% of us if you are going to own a house, transportation, etc. The difference is being responsible or reckless. Also didn’t know that Canada had higher rates than Japan. Very surprising a reader from south of the border.

Anon
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Anon

Debt allows for production to be pulled forward from the future.

It might take you 5 years to save money to pay for the car outright, but with debt you can assume that good today.

(One reason why QE may have slashed market returns for the next 10-20 years.)

The enslavement aspect of the debtor exists, but perhaps only to himself. If you want to keep that car then you have to keep paying/keep working. But what you are really paying for is the perceived new-found “personal freedom”. You’ll keep paying as long as your desire/pleasure to have that freedom exceeds the pain of parting with money.

Debt can also cause a lot of negative reactions. If there were no student loans or mortgages available, education and real estate prices would be nowhere near the outlandish levels they are today.

In the end, debt is merely a monetary device. It can be used constructively or wielded destructively (or not at all).

Finance Journey
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Another interesting post Liquid,

If we scare for debts, then we wouldn’t have invested ourselves for better education and we wouldn’t have bought house. We will be saving money until get age 40 to get education and 60 to buy a home.

If you use your debts in a good way (as you do), you will be rewarded.

Cheers,

Retire29
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Retire29

I think the story raises a good point. However, debt tends to be negative given that debt is typically used to purchase assets that do not equal the value of the debt. Additionally, debt provides the illusion of wealth, causes those in debt to spend more than they would have had they used existing assets.

However, it is a good point. Debt is certainly not inherently bad, particularly when your debt service is manageable and the debt balance is more than offset by marketable assets.

Eric

Vivianne
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C’est epic!! (What’s epic in French anyway?) I love the story, It’s a consumption economy now. It will continue to be this way until resources run out.

our next life
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Interesting to think about. We know that for us, debt is definitely not freedom, but you make a going point on a macro scale. We no longer have any personal debt, and will have the house paid off by the time we retire in two years, which will mean we have to earn less income each year to cover the cost of the mortgage payments. Having to earn less makes us more free.

ChrisCD (@jumbocds)
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Yes, the debt was temporarily relieved of all the people, but the only person that had any money at the end was the German who left town. Once he left, everyone was left cashless again.

HarperFanClub
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HarperFanClub
Ray Dalio has a famous youtube video where he takes his crack at explaining how the economy works (https://www.youtube.com/watch?v=PHe0bXAIuk0). In it, he explains that there are two types of debt: production and consumption. The first type of debt is a net positive to our economy, and the second is where you bring future consumption into the present. When you enter into productive debt, such as school loans or debt for a manufacturing company to grow, that’s one of the drivers for our economy. Essentially you are entering into an agreement where we pay X and make X + Y. IMO, this is the type of debt that LQ uses in their investments. Even entering into debt to buy a car is a good decision if that car helps you be more productive and/or get to work. The second type of debt is consumption based. Think of when you want to purchase a brand new tv or coat and put it on your credit card without being able to afford it. Those types of debt tend to destroy value more than create it. These are the debts that people should limit, unless there is some special case (one could argue that… Read more »
Anon
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Anon

“When you enter into productive debt, such as school loans…”

What exactly does a student loan produce?

Anonymous
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Anonymous

The differential in human capital and subsequent economic output between the person as a graduate versus a non-grad.

Anon
Guest
Anon

False.

Student loans (and mortgages) produce exactly zero output.

The price of a degree does not equate in any way, shape, or form to economic output.

HarperFanClub
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HarperFanClub
If we’re debating the value of a university education & beyond, there are some signs that the costs are beginning to eat into the value of the education. However, the facts remain that the world’s wealthy have higher levels of education. This value is compounded by individuals who seek master’s and doctoral degrees. The same holds for house mortgages, since people are able to earn more than what they pay on the mortgage rate–especially in today’s ZIRP environment. I believe your last sentence is correct in the sense that the amount of money you spend on education does not equal or drive the value you’ll receive. Simply spending Harvard or Stanford tuition dollars will not mean that you gain more knowledge and skills compared to a graduate of Western or UofT. Tangentially, it’s apparent that some of our youth are overly focused on certifications and education because of the lack of opportunities in the workforce. Skills learned in textbooks have to be practiced in life in order for one to benefit from the alphabet soup after his or her name. Without a chance to practice what is taught in the classroom, it’s unlikely that these individuals will be able to… Read more »
Chris
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Chris
Yea, I’ve read that one before. The problem of course is that none of these people were really in debt, as they were all owed exactly the same amount that they owed to someone else. All the transactions did was clear the books. That would be like me going to the bank and getting a loan for 1000, then adding that total to my net worth. I’m actually no richer or poorer than I was before, I just have 1000 more in my account and owe the bank 1000. The complication with real life of course is that both loans and assets have potential risks/rewards. Is the interest cost of the loan more or less than the return on the investment I purchase with it. What if the interest rate rises? What if the investment tanks? What if the investment doubles? What if I lose my job and can’t make the loan payments due to lack of cash flow? I am actually not against debt as long as it’s calculated – I still have a small mortgage and also have some investments purchases from the HELOC – but in both cases I’m well within my comfort zone so that job… Read more »
DivHut
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Great post and terrific example of that small Greek village. Debt, money, etc. is all created and all an illusion. Your post reminds me of a quote from Wall Street – Gordon Gekko: It’s not a question of enough, pal. It’s a zero sum game, somebody wins, somebody loses. Money itself isn’t lost or made, it’s simply transferred from one perception to another. This post made me think 🙂

Kapitalust
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I’d agree to a point it is an illusion. However, money is just the medium in which we exchange services amongst each other. At the core, all it’s fundamentally about is how much value you are giving to society.

If you create value and have a surplus – be it from excessive value creation or minimal consumption – you have stored up ‘claims cheques’ on society. These claims cheques are really just services that you are owed for exchanging services to someone else yourself.

Paper cash, gold coins, silver bars, seashells, bitcoins, whatever, are just the medium we use as a more efficient conduit to transfer services among ourselves. They in and of themselves have no intrinsic value – it’s just the faith we put in these mediums that prop them up.

Therefore, I don’t think it’s necessarily a zero sum game: if you can provide a service to others that is in demand, they will exchange their services for your services. And sometimes the rewards will be lopsided.

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[…] originally found this story on the Freedom Thirty Five Blog (highly recommended), and it really challenges the way that most people think about […]

Raf
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Raf
This story creates an illusion. Nobody in the story had debt, because they also had a “receivable” of the same amount. So their net was zero. Now i want to understand something below. .. because I believe debt is actually always “unpayable till the next crisis”, if you consider the big picture. The big pic would be the whole debt of a population. Here is the thing: =================== Let’s say all lenders lend a total of 1000 to everyone combined in a certain year. (lateryou can get that example and apply to the total world debt and population). I see no way for that money to be paid in full, simply because the new money/credit created was just 1000, therefore if they come up with over 1000 in total, that would be taken from savings. It would be a deficit. I’m saying this because the only way for that total 1000 to be invested and get a return over 1000 would be impossible unless the population itself consumes/buys over 1000. But they don’t have over 1000 (unless they use savings). That’s why the core foundation of capitalism is failed. There will be always bubbles of assets and increase of debt… Read more »
Concerned Citizen
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Concerned Citizen

Damn, that’s scary. What should average people do then?

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