Prosperity through insolvency, or the merits of consumer credit

I got irked by one of Bill Mitchell’s latest, where he claims:

A reliance on credit-driven consumption is not sustainable overall.

This is a well accepted orthodoxy, but is it really the case?

Let’s look at how consumer credit operates. To avoid introducing irrelevant systemic issues that are not salient to the main point, let’s suppose that all consumer credit is issued by specialised operation who raise the funds they lend to consumers from the stock market via share and bond issues.

Now what happens if enough consumers default to take (some of) such organisations into bankruptcy? Nothing special. People putting money into ventures, some of whom are not successful, is the basic function of open markets. Who, then, pays for these failures?

  1. Consumers who do not pay back their borrowing and go bankrupt and will, for a little while, “pay” in the form of losing access to credit, though they do benefit from what they spent before bankruptcy (more on that below)
  2. Consumers who are in the same risk cohort as those who go bankrupt but do pay back,  via inflated interest rate
  3. Investors in failing consumer credit companies

All these are transfers within the private sector that do not change public/private sectoral balances. But do they impact aggregate demand?

  • Transfers from #2 (diligent borrowers) to #1 (dilettantes) should be neutral as both groups are net borrowers with a maxed out propensity to spend
  • Transfers from #3 are directly a conversion of savings into consumer demand, and it’s unlikely any other form of savings would indirectly cause more demand, so they seem clearly positive for aggregate demand

How is this sustainable in the long term? In efficient markets, investors should learn and stop losing to insolvent consumers, but there seems to be heaps of evidence that people are attracted to high risk by illusory high returns — it’s a corollary of the high returns from low volatility anomaly. As long as this remains true, the transfers from these investors willing to lose money to consumers is totally sustainable, and even desirable from a social justice viewpoint as it’s a way to realise transfers from the well off to the less well off.

Distressed but diligent borrowers are not so clearly benefiting, though the extra cost may allow them to do things they couldn’t do otherwise if completely locked out from borrowing; but in any case there is no doubt this category will remain in existence.

So, there doesn’t seem to be any reason for policy-makers to try and restrain exuberant consumer credit when they want to support aggregate demand. It seems overall socially beneficial, and, within the limits of the supply of agents willing to lose money to the operation, totally sustainable.

~~~

There is an interesting side question: does it make sense to be on the “dilletante” side of the deal, and as a consumer borrow when you know you’re unlikely to be able to pay the loan off? For people with positive net assets, or merely assets larger than the scale of consumer loans, clearly not, as they have something to lose of greater value than typically modest consumer loans.

For people who have virtually no assets, if they can borrow, even at relatively high interest rates, it may make sense, at least in jurisdictions where bankruptcy proceedings are not too taxing. Spending a few years without credit might be a mild price to pay for some years of extravagance. The important thing is to spend the proceeds of the loans on things that the creditors can’t seize, such as education (you keep the skills), travel, or edible substances (you keep the memory of the good times).

It could be argued that if it becomes socially acceptable for relatively poor people to do a runner on loans, social cohesion will be reduced. This is entirely correct. That said, should poor members of society be expected to have higher moral standards than financial industry high fliers, some of whom have certainly done things that are much less socially cohesive than spending a few thousands on a holiday and not pay it back?

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