|Your Debt is My Asset. Not.
Steve Keen at Real World Economic Review Blog writes about his frustration with an academic audience who insisted the aggregate level of debt relative to GDP was irrelevant because ďone personís debt is another personís asset, therefore the level of debt doesnít matter.Ē
That assumption is not true but to understand why it is not, it is useful first to consider under what circumstance it would be true. (nb: the following is Sandwichman's analysis not Steve Keen's). It would be true IF AND ONLY IF the creditor was certain that the debt obligation would be honored. It is not true under uncertainty and the real world is uncertain. If the creditor is certain the debt will be repaid, he or she will not need to take any additional steps to secure payment. But the greater the uncertainty, the more precautionary steps will need to be taken to give the creditor security in the event of default.
If ďone personís debt is another personís asset" there would be no securities industry. Naturally, as the aggregate level of debt increases relative to the resources for servicing that debt, the proportion of resources diverted to securing the debt must increase. Why? Because the cash flows for servicing the debt and the collateral assets for securing the debt are riskier at the margin.
That increased risk is recognized in the risk premium of higher interest rates. But the "risk premium" doesn't tell the whole story. The risk premium is a composite. Part of the premium is indeed an increased return for a riskier investment, but part of it is consumed in higher transaction costs -- more sheriffs, lawyers and paper work. Not only more sheriffs, lawyers and paper work because the debt is bigger but more sheriffs, lawyers and paper work PER DOLLAR OF DEBT.
So here we arrive at the limit. At some point, the additional transaction cost of securing increasingly risky debt completely absorbs the margin for risk premium on the interest rate. At that point the only additional loans a creditor can continue to make are either at a loss or effectively unsecured (or insufficiently secured). Now arrives the "Minsky moment" of elaborate financial fraud. Collatoralized Bond Obligations are actually unsecured debt disguised as securities.
Expansion of debt can continue only until creditors balk and/or debtors walk. At the point that expansion stops, contraction begins because the cash flows of the formerly less-risky debtors relied on continued expansion. With cash flow problems, marginal credit risks become poor credit risks and good credit risks become marginal.