Imagine a world without debt

August 7, 2013

I have a dream: a world without debt, and with much more equity. It’s not just that summer holidays are a good time for fantasising. The fifth anniversary of Lehman Brothers’ bankruptcy is a month away, and regulators have recently forced both Deutsche Bank and Barclays to issue more shares.

Some regulators’ beach thoughts may drift to the magic numbers of bank capital ratios. My approach is less technical and more philosophical. I wonder why the financial system relies so much on debt. Loans and bonds are poorly designed for their primary economic purpose – investment.

This observation may sound shocking. Interest-bearing debt is considered totally normal. Financial theory unquestioningly treats risk-free debt as the standard instrument. Savers usually compare all investments to a similar standard: safe bank accounts which pay a steady interest rate.

But a little reflection on the real economy shows that the typical debt arrangement is an unfortunate holdover from a more primitive age. Loans are unnecessarily distant from economic reality. If we were starting now, we would never rely on such rigid instruments to fund investments.

To start, loans carry a maturity mismatch, because temporary debt funds permanent investments. Depositors can take money out of banks, banks can pull lines of credit and loans are supposed to be repaid or refinanced at maturity. But the factories the credit finances cannot then be unbuilt. The research cannot be undone and the people cannot be untrained.

The way that interest rates are usually fixed in advance is another problem. Unless both sides agree on floating rates, loans are bets on future inflation rates. Sometimes borrowers gain, sometimes lenders do, but either way a totally unnecessary risk is created.

The most important problem with debt is the so-called economic mismatch: the interest payments on loans vary much less than borrowers’ cashflows. Temporary difficulties can lead basically sound companies to skimp on economically valuable investments, or to default.

Banks are supposed to be able to absorb the losses from defaults. They charge riskier borrowers higher interest rates, a burden which makes default more likely. They also have a hierarchy for taking losses. Shareholders lose out first, followed by holders of subordinated debt. In most countries, the government comes to the rescue when losses get really large.

The arrangements are complicated and uncertain – thus the debate over how much capital banks need. The problem, though, is largely created by the duality of loans: either good or bad. If borrowers’ payments were more flexible – lower and higher depending on economic conditions – banks could have financial structures which were both simpler and sounder.

What is needed? Financial instruments which have no maturity, which are protected from inflation and which have variable payments. There’s nothing fantastic about that wish list. Common shares tick all the boxes.

Then why don’t common shares, or something like them, dominate finance? Well, the disadvantages of debt are clear, but it has one crucial advantage: a crude but clear duality. It is easy to tell whether counterparties are living up to the loan terms, so strangers can deal with each other relatively easily.

In contrast, equity only works if the companies that receive the funds can be trusted to make fair judgments on how much to pay investors. Within families and other tight-knit groups, the tug of loyalty and the desire to avoid shame promote the necessary honesty. Much more is needed for shares in enterprises run by strangers to be trustworthy: bureaucratic competence, effective governments and powerful auditors.

Today’s developed economies meet those requirements, but they still rely extensively on debt. The refusal to relegate this obsolete tool to the dustbin of history helps explain the peculiar vulnerability of modern economies to financial distress. With a more resilient financial system, it would not take more than five years to recover fully from the failure of a single big bank.

Indeed, with an equity-based financial system, leverage – effectively building large debt structures on small equity foundations – would be almost impossible. Instead of making unrealistic promises of safe nominal returns, banks would offer a plausible commitment of fair real returns. They would fail far less often than now, and far less spectacularly.

Common stock in its current form is not a suitable replacement for debt. Something new is needed; call it flexi-debt. Unlike shares, flexi-debt would not give funders voting rights. And while dividends on shares are discretionary, flexi-debt payments would be indexed – to GDP, income or some other objective variable.

There is many winters’ worth of work to be done before flexi-debt could replace standard debt. Education, financial design, law and experiment are all required. But stable finance need not be a pipe dream.


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Great dream. Maybe in 100 years or so, if man survives that long.

Posted by tmc | Report as abusive

Great article showing practical and progressive thinking. But take a step back for a moment – where does all the debt come from? Mostly not from individuals or businesses – they invest in equity and their operations, respectively. It comes from fractional lending. The powers that be allow banks to loan more than they have – say 10 to 1 or 100 to 1 (to stimulate the economy to make politicians look good). This means these banks are technically insolvent if it were not for a (implied(US) or explicit (my country)) government (and thus the taxpayer)guarantee to be the lender of last resort to the banks. The banks then try to match their balance sheet with this government debt (which by the way normally does not appear on their balance sheet). The best and permanent solution is constitutionally fix fractional lending at 1 to 1 – of course banks would have to call up most of their loans so the pill will be too bitter to swallow. Since this is a bridge too far I think you suggestion would achieve the next best thing – loans which are measured in real terms and not in nominal terms to prevent big swings between boom and bust.

Posted by BidnisMan | Report as abusive

A wonderful, intelligent speculation.

“…equity only works if the companies that receive the funds can be trusted to make fair judgments on how much to pay investors.”

Let’s expand this concept to our federal government. Let’s consider instead that “our tax system only works if politicians and the existing army of bureaucrats are both competent and willing to select and prioritize government functions to be funded and allocate ONLY that required to effectively accomplish their purpose.”

Unfortunately, experience has shown us again and again that bureaucratic incompetence, ineffective government and timid auditors are instead the “arrows in our public quiver”. Every one of today’s developed economies exhibit these deficiencies to varying extent. The very structure and culture of government is inherently toxic to efficient function.

I see no magic wand that is likely to change that which is fundamental to universal “human nature”. Excellence is never the norm. Exceptional performance is present only so long as there is a culture supporting or demanding same and constant supporting priority and conscious effort applied. While it is observable on occasion in private sector efforts, it is exceedingly rare and never sustained in public administration.

Posted by OneOfTheSheep | Report as abusive

I”m sure the greed machine Banks would not like that. It’s expensive to influence the Beltway gang.

Posted by rikfre | Report as abusive

No debt? How the hell would we manipulate and control the weak minded masses? Why, we’d be left with only fear and brainwashing. You also don’t want the “consumers” to figure out that possessions really don’t matter. Shoot, if they couldn’t run up frivolous debt for frivolous items, they may actually learn what is important in life. No, we need indebted masses with frivolous minds or we may actually have to supply some value ourselves.

Posted by brotherkenny4 | Report as abusive

There is a big flaw in this idea. The flaw is the idea that equity is good and debt is bad. Equity is not necessarily good. It has a big flaw that debt does not have, which is that it separates ownership and control. This separation of ownership and control is what creates the class of professional business managers who run publicly traded companies that they do not own — often making decisions that benefit themselves more than the shareholders.

What is good about equity is that is accounts for risk. You may have a venture with a 1 out of 10 chance of creating assets worth $100 for ever dollar invested and a 9 out of 10 chance of creating assets worth 10 cents for every dollar invested. The expected value would be approximately $5 for every dollar invested, and, therefore, the risk may be worth it for someone who can afford the wager (such as someone who can diversify the risk by investing in multiple startups). But is not the kind of risk that will qualify for bond financing or other interest-based financing. Why would you lend money at any near-market rate — where your possible return is limited to the amount of interest on the face of the bond or other loan instrument — for a venture that has a 10% chance of paying back the loan and a 90% chance of not doing so? Equity is a good alternative, because it allows the investor to benefit fully from the upside side on those one-out-of-ten occasions where the venture does not fail.

When risk is low, interest-rate financing should be better for the borrower, because the cost of obtaining the funds is fixed.

What this has to do with government borrowing is that nations that are not stable enough to effectively employ interest-based financing are not serving their people. That is because equity-style financing makes sense only where the risk of non-payment is too high to justify interest-based financing. In other words, stock is for financing ventures that need more money than a borrower’s credit can justify.

Who wants his or her nation to be in that situation.

Keep in mind, as well, that the overwhelming majority of the stock sold in daily stock market transactions is not newly issued stock but is instead stock that was issued 5, 10, 25, 100 years ago, which is being traded in aftermarket transactions that have nothing to do with the original financing for which the stock was issued.

The subsequent purchasers of that stock have the right to vote for the directors of the corporation, which choose the managers, and can decide against the recommendation of management to sell their stock in a hostile takeover. How can this kind of separation of ownership and control lead to stable government?

Using equity to raise funds requires some form of ceding ownership in exchange for capital. This can make sense for new ventures, but we should remember that the stock markets reported in the daily news are markets largely for aftermarket transactions in shares of the most successful companies, which were issued many years ago — in some cases more than a century ago.

For a nation to say, “our credit is so bad that we cannot afford to borrow, so we are going to sell ownership shares to financial investors who will be able to buy and sell ownership of our nation for the indefinite future,” would be the same as admitting that the state had completely failed. It would be better to sell important national icons (the Parthenon, for example) than to do that.

Finally, what form of ownership rights would accompany the equity instruments suggested in this opinion piece? Would they be a perpetual lien against national tax revenues? A share of the ownership of government property (with a right to force the sale of such property in a dissolution proceeding)? Would it include the right to prevent taxpayers from leaving the country? In what court would the equity owners’ rights be enforceable?

I think that Edward the Confessor tried something like this when he was in Normandy, and the result was the Norman Conquest.

Posted by Bob9999 | Report as abusive

Thank you Mr. Hadas for writing about the debt situation. It is obvious that much of the debt will never be paid. The only way out is to modify or junk the existing system. Silvio Gisell writes about free land and free money and many other economists have written about other schemes. The current system results in Kings and vassals. There must be a better way.

Posted by yusa1928 | Report as abusive

@Bob9999, great dissertation, but you did not get the point. You need to let go of the current system in all of its forms and start again without depending on debt. That would include Government. It really could do “Pay-Go”.

Posted by tmc | Report as abusive

Debt that represents prior value creation (or, under Real Bills Doctrine, credit that will be retired as a product moves through the next phase of its commercial life) is fine and dandy.

We got into trouble because, with a government-granted monopoly on creating credit from nowhere, the central bank and fractional reserve system violated Say’s Law with arrogance and impunity, not to mention seeming (legal) immunity.

Money is supposed to be a store of value (purchasing power). Any institution that harms this key attribute should be dissolved, with a hangman’s noose if necessary.

Unfortunately, politicians are the single largest benefactor group from a policy of continuous debasement of a currency.

Posted by dc.sunsets | Report as abusive

Don’t be misled by the current state of affairs where megabanks new primary activity is gambling with OPM (Other Peoples Money). Debt is a necessary part of capitalism. Very few companies could have succeeded without debt at some point in their life cycle. Small businesses are crying out for more loans while the megabanks are gambling money on derivatives etc. that they should be loaning. If you look at the pattern of retirement savers, most folks are reluctant to put very much money into equities. If capitalism were to rely solely on equity financing, there would never be enough investment capital to achieve the economies of scale that have driven our current level of affluence in material goods.

Posted by QuietThinker | Report as abusive

Our kind is destined for liberation, nothing else will work, we need to deploy freedom from want technologies to make peaceful renaissance more probable.

Posted by satori23 | Report as abusive

Imagine a world without debt | Edward Hadas…

The Slave of the Husband…

Posted by jalia parsnip | Report as abusive