Everybody Knows His Bright Red Bank Loan

My friend’s economic textbook has moved off the subject of division of labour, and taking time to look at markets and the use of money, has arrived at the subject of bank loans.

His explanation of loans is enlightening, but a little clunky. The best explanation of loans I’ve come across is that debt is like a van*.

As the above video, I hope, illustrates; a van takes goods from A to B – the driver getting paid for the privilege**. A bank loan takes goods from the future to the present, the interest on the loan taking the place of the driver’s fee.

Now there is often a lot of worrying about debt, with many believing that reckless bank lending was a big cause of the recent financial crisis. Here’s the Prime Minister, “This was no normal recession – we’re in a debt  crisis. It was caused by too much borrowing, by individuals, businesses, banks –  and most of all, governments” – although he seems to have changed his mind somewhat lately. Is he right, though, that there is a correct amount of borrowing?

Let’s think about the van. Imagine the van, planning to take goods from A to B, turned up at A only to find that goods there, there was none. A pretty silly ass he’d look!

Similarly, imagine our loan, taking money from the future to the present. If the future rolls up and the money’s not there, then there’s trouble.

A person taking a loan is taking a bet on the future. They’re betting that there will be the money in the future that they’re bringing into the present. If they’re confident that they will have the income or other assets in future, then they can take the loan without too much worry. Unfortunately though, the future is essentially unknowable. The job might not be there, or the house and shares might not be worth as much as you expected.  If not, that’s too bad for you. If large numbers of individuals make the wrong bet on the future when taking on debt, the consequences can be worse. But, they won’t know in advance.

So, in answer to my question, as long as the future is uncertain, we can’t be sure of what, within reasonable rules of thumb, the correct level of debt is.

.

*I owe this to Chris Dillow’s excellent Stumbling and Mumbling blog.

**Although the payment aspect was largely ignored in Postman Pat, whose public spiritedness overwhelmed the money motive.

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