14 Trillion and What Do You Get? Deeper in Debt!

Believe it or not, this dismal series on banking is going to end with a hopeful note. That’s because “debt” isn’t always a four letter word.

When Debt is Good to Have

Our world definitely turned upside-down over the past year. “Hedge funds” or “private equity” companies used to gobble up companies for profit and spit out the remains. Now they are being called upon to save our banking system. One of them is even financing highway rest stops in the state of Connecticut.

We’ve left the free market far behind too. The Treasury is now in hock for $14 trillion of guarantees in its attempt to stem the blood flowing from the financial crisis. The US government is fast approaching it’s debt limit of $12.1 trillion. Congress will shortly be embroiled in what is bound to be nasty debate over raising the statutory cap on US debt to $13 trillion for 2010.

Another odd thing about these times is that corporations are heading as fast as they can towards debt by selling corporate bonds. Eventually those bonds (or loans) will have to be paid back with interest to the buyers. Companies and banks don’t seem to care. One corporate spokesperson even told a financial reporter his company didn’t have any need for the cash but the company issued bonds because it thought it would be a good idea to have cash on hand.

Here’s where I had an idea about the future. Based on the work of Armen Alchian, it occurs to me we are likely to be in for a bout of inflation, even though the Federal Reserve protests that nothing of the sort is on the horizon. Here’s Alchian’s conclusion from research he did about business cycles in the decades following the Great Depression.

Alchian found that “net debtors” did better in times of inflation than “net creditors.” [“Net” simply means “overall” a debtor or a creditor.] Now remember, because this was true in the past, doesn’t mean it will be true in the future. But right now several financial writers have been suggesting, for various reasons, that inflation is on our horizon.

Inflation Ahead?

One reason given for possible inflation next year is that our cash-strapped, in-debt-to-it’s-hairline, federal government will need to print more money to pay for some kind of support to boost the mortgage market and/or small businesses.

Another reason put forth is that the issuing of so many US government bonds, many of which are being bought by banks, may create a new danger. There may come a time when there is a surplus of government bonds for sale and fewer buyers than now. Banks will again have a financial liquidity problem when they can’t cash in government bonds.

A more compelling argument is one by David Bowers, a strategist at Absolute Strategy Research. Bowers argues that it is businesses, not consumers, who will lead any recovery. When the financial crisis hit, businesses were caught with large inventories. Producers have been selling off these inventories and not replenishing them. In some cases, such as that of Delphi, the biggest car parts supplier, providers of inventories have gone bankrupt over the past year.

Bowers suggests that corporations will eventually use the cash they’ve raised to hire new employees and reorder supplies only to find that supplies are now scarce. And here we have the traditional definition of “inflation” as “too many dollars chasing too few goods.”

Banks as Net Debtors

According to Armen Alchian banks are “net debtors” by definition. This is because banks make money by taking in deposits from customers and loaning out that money in order to earn interest from the loans. Because banks loan out the money they receive from depositors, they’re net debtors. They owe more than they have at any given moment. Which is why we have the FDIC insurance fund in case there is a run on a bank by depositors.

Alchian’s research showed that banks and other net debtor companies did better during periods of inflation than companies that that weren’t in debt. Interest rates tend to rise during a period of inflation because everyone needs more money to pay higher prices. Banks sitting on a lot of cash during inflationary times do well. They can make lots of high-interest loans.

It would seem that any banks that survive the current bloodbath (124 out of approximately 800 FDIC member banks have disappeared this year) and accumulate enough capital reserves will come out winners during an inflation. And this, perhaps is why hedge funds are so willing to sign on when the FDIC comes calling to ask them to help it bail out a bank.

What About Us?

So what does this mean for us? Alchian concluded that the net debtor advantage during inflationary times applied to both governments and individuals as well as to corporations. Is it possible our government has not been certifiably insane in running up such a huge debt in its attempt to keep the economy from imploding from the credit crunch? Could the U.S. come out smelling like a rose in the end?

And what about us? What will happen if we find ourselves in an inflationary period? What do we do?

First, we need to better understand how “debt” is not necessarily a four-letter word. As Robert Kiyosaki points out in his Rich Dad books and classes, entrepreneurs and the rich think differently from the rest of us about debt. For entrepreneurs debt is a good thing as long as it is used in a way that involves assets and creates wealth.

So, am I saying go into debt or into more debt if you see inflation coming? Not necessarily. But you’ll need to learn to think like an entrepreneur, a banker, or a government economist. If you do go into debt, it should be for an asset that you are sure will make money for you.

A house (mortgage) is a large long-term liability. You must pay and pay for it, unless you are a landlord and have renters bringing in an income for you. A truck could be a money pit or it could be an asset if you can make money by using it. The same goes for a computer. It can be an asset if it brings in money for you or your family, but it’s just another expense if it doesn’t.

How can you use your money and/or time to acquire an asset or assets? If you buy a foreclosed house now, will you be able to afford the mortgage if prices for other goods go up? Will you be able to move elsewhere and rent out the house if inflation bites you? Or will you be able to rent part of your house, condo or apartment if times get really tough?

If you don’t have cash or credit, can you eke out enough from your budget to stockpile canned goods or start a garden? Can you trade for a more gas-efficient car or give up driving?

If inflation comes, will you be able to get your cash out of where it is now to use it before its value drops? Where will you spend your money to make money before your cash loses its buying power during inflationary times?

These are the kinds of questions we should all be asking ourselves right now or any time the economy might bounce from an long tiring recession into the beckoning arms of a brand new inflation.

And finally, remember that assets are not just things. They can include intangibles. “Goodwill” in business refers to clients or customers. Family, friends, and community are all assets too. Assets are the bounties we need to remember to be grateful for.

Copyright © 2009 Nancy K. Humphreys