In the national conversation about the economy the continual refrain is that we need to create more jobs. However, one of the main reasons for the unemployment problem around the world is excessive debt. Only when we eliminate the underlying source of our problems will we be able to sustainably reduce the unemployment rate.

A little bit of debt is never a problem. Most households borrow money to buy a home and a car and successfully pay back these borrowed funds over their lifetimes. Financial institutions are the vehicle that allows some people’s savings to be used to finance other people’s consumption. It is important to remember that banks receive money from people who say, “I want to forgo consumption today and wait to consume in the future instead.” to other people who say “I want to consume more today and pay it back by consuming less in the future.” These institutions create contracts, what we commonly call loans, which specify the terms of the repayment. These are promises that borrowers have made to pay the money back with extra interest payments according to some predetermined schedule.

Debt becomes a problem whenever a borrower discovers that he cannot repay the lender according to the original contract. Actually, the problem may occur even earlier when the creditor begins to suspect that the borrower will not be able to fulfill the contract.

Consider the US mortgage market. In the US today more than 20% of home mortgages are underwater (over 11 million in number). Because of the collapse of home prices, the home values, which serve as collateral, are less than the value of the mortgages. If a household stops making payments, the bank will foreclose, reclaim the house and try to sell it at the market price to recoup as much value as possible. This process takes time, is costly, and results in the bank receiving much less than the amount of money originally owed. It also means that someone’s savings, the bank depositors for example, will not get back all of the money they lent. This is an example of a partial default: the lender/saver didn’t lose all of their principal and interest, only some of it.

What is the best way to resolve this situation? Well, that depends on whether you are the lender or the borrower. The lender wants the original contract fulfilled; it wants to get all the principal and interest that was promised. The first best option, then, is to hold out and demand full repayment. If the borrower really can’t pay now, one way to fulfill the contract is to agree to an extension. Simply give the borrower more time to pay it back, but of course, charge more interest as well. This way all the money gets repaid with interest, but it takes longer to get it back. This is the second best option for the lender. The third best option would be to renegotiate the contract, agree to a partial default, and accept less than was originally expected. This is what happens in a foreclosure when the borrower is underwater.

From the borrower’s perspective it is not clear what the best outcome is. If borrower continues payments for long enough then he can hope the value of the house eventually rises above the mortgage value. But what if the price remains depressed for a very long time? Imagine paying on a $500,000 mortgage every month when the house is now worth $300,000? If that situation persists, it will not inspire household confidence and consumer demand. Furthermore, the household is stuck. The family can’t move anywhere without coming up with an extra $200,000 to pay off the old mortgage. (Imagine 11 million households in this situation to understand why consumer demand and confidence is so low.)

If the borrower walks away from the mortgage and suffers foreclosure they will have to leave the house and move elsewhere, most likely into a rental unit. The household will also suffer a stain on its credit rating for many years. Its reputation will be tainted and the household would have to live for a while without being able to borrow. On the other hand, all of the negative equity will be erased so the household’s balance sheet will immediately look healthier. The family is also free to move elsewhere and is no longer mired in a depressing situation. To use a fishing analogy, this is the “cut bait, and run” approach. One advantage to this latter approach is that both the household and the bank can accept the losses and move on, rather than being mired in a long, drawn out struggle to fulfill, perhaps unrealistic, promises.

One reason for the poor economic performance we now are living with is that there are millions, maybe hundreds of millions of debt contracts in the world, similar to the one described above, that are in jeopardy of full or partial default. That means there are numerous financial institutions that will not be getting back the full amount that was originally promised. Now some people might be inclined to say, “so what if the banks lose money?” That’s fine except for the fact that the banks didn’t use their money to make all these loans .. they used our money. By that I mean any money deposited in a financial institution. It means checking accounts, savings accounts, and retirement accounts, etc. If you engage with any financial institution; a bank, an insurance company, a mutual fund etc. then you have contributed to the pool of savings that has been lent out to someone else. And therefore your money is at risk of not being returned to you in full.

The struggle that is playing out now and will continue for several more years is a struggle to determine who is going to pay more and who less. Banks are struggling to maintain the performance of their loans, so they can preserve value for their shareholders and depositors. They don’t want to be the ones to suffer losses. When banks receive government assistance it is a way of unloading some of their burdens on the taxpayers of the country. It also allows the burden to be spread over a larger number of people and over a longer period of time. This way somebody else pays for the losses incurred due to the decisions of the bank.

With this explanation as background, I can now say, in a very indefinite way, when we will be out of the current crisis. It will be once the number and value of the debt contracts that are in danger of total or partial default becomes manageable. Even in a healthy economy there are non-performing loans. There are always some loans contracts that are not fulfilled. But in good times these losses are just swept into slightly higher interest rates that all depositors and borrowers pay for. No one notices. In financial crises, those non-performing loans are too large to go unnoticed. They threaten bank failures, they threaten bank runs and they cause high unemployment, stagnant growth and a loss of confidence.

Once we clean up most of these nonperforming or partially performing loans, confidence will be restored, consumers will start buying more, banks will start lending more, and the economy will move along at a healthy clip. Only then will the unemployment rates fall in a sustainable way. How long it will take to get there though, is anyone’s guess.

In my next post I’ll discuss the problems with government debt, using Greece as the example. The government debt problems are also excessive but they have slightly different characteristics and raise other issues.

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