21
Mar
2014

Debt, equity and imbalances

Many people think that capitalism is divisive.  

  • rich v. poor or
  • owners v. workers

but I think the most interesting division within capitalism, is between 

  • debt v. equity

When we talk about capital, we mean both debt AND equity, but in reality these two forms of capital are different.

Back in February 2011 Dr Maurice Glasman (who sits in the House of Lords) gave a talk at the LSE about the history of the City of London. There is a lot in the talk, but the most interesting part for me was when he talks about the economic systems in the ancient world, roughly half an hour into the podcast. 

Particularly there is a big debate about the status of the ancient economy of Rome or Greece. Contract or status?

Status economies allow debt, but there are constraints. It is not a coincidence that in popular uprisings, it is always the records of indebtedness, whether it is paper, papyri or tablets which are destroyed. Thus elites needed to constrain interest rates to save themselves, returns on capital were determined by political agreement between the ruling class and everyone else.

Contract economies allow unrestricted contracts, the underpining of laissez faire economics. There are few constraints on return on capital, or exploitation of other people. If you sign a contract, that’s it.

In the ancient world, particularly the Roman Empire, we see two contradictory things simultaneous: an economy based on status and an economy based on contracts.

Status economy: where things are not allowed to be freely traded.

  • agreements on interest rates (in Roman Empire interest rates never rose above 5%) 
  • agreements on wages
  • limits on rents, instead rents are determined by the amount of time you have stayed in your home

The last one still happens in Germany, where the majority of households rent their apartments. There are various constraints on raising rents (der Mietspiegel, Die Mietbremse) and tenants who have been living in the same building for a long time have a lot of protection. Or think of companies in mainland Europe, where it is almost impossible to make long term employees redundant, and very often pay increases with seniority, rather than with productivity.

The ancient world had markets, contracts and unconstrained returns on capital, particularly when it came to maritime trade. Maritime trade was risky – a storm could sink your ship and you could lose everything. By contrast, if you were a landowner, you had one bad harvest, it might wipe out your profits for a year, but you still had the land, and the future income it should provide. So there was a fundamental difference between the constrained returns to landowners, and unconstrained returns for sea faring risk takers. And this was the influence of a maritime economy on the ancient world.

The further you sail, the higher return you make. But the longer voyages were riskier, and there was a higher probability of loss. So maritime trade had no constraints on rates of return. In the ancient world, political elites could speculate on maritime trade, and that is one way they became wealthy.

In the modern world, equity tends to finance activities were there are high returns, but also the risk of losing your entire investment. There is no “collateral” secured against your money. Whereas with debt, very often the debt is secured against something, a field, a property that is valuable in it’s own right. An equity investor in the ancient world might part own a ship, but if the ship sinks it is worth nothing.

I have always thought it is possible to see this in the way different European countries look at investment. In the UK, but also the Netherlands, and the former Hanseatic league countries (Scandinavia, Baltic) and Italy tend to have an equity investors outlook. Germany, France investors tend to think more like status economies. One piece of evidence I would point to back this up, is pension systems and the importance of stock markets in different European countries. The table above shows equity investments to disposable income, plus debt to disposable income, which is mainly mortgages (remember: lenders like to lend secured against property).

This table appears to undermine my argument, because equity ownership among UK households is similar to Germany and Japan. But this ignores the UK pensions, which are £2.1trillion or around 4x times the amount of direct equity ownership (that is, 2x disposable income). By contrast Germans have saved less than 10% of disposable income, according to the OECD.

Denmark, Holland and the UK have pension systems, which encourage individuals investors to put money into the stockmarket – whereas in Germany and China households seem to save through the banking system, and rely on the Government to make sure they have enough money for retirement.

I think this is also significant for the debate on “global imbalances”. The IMF has just published a report on cross border imbalances, with the top two largest indebted countries being the US ($400bn) and UK ($114bn) – the two largest creditor countries are Germany $274bn and China $183bn. The majority of these cross border obligations are debt, not equity. And they are connected. Rising levels of private debt helped by shadow banking and growing international imbalances. That is, excess saving in the banking systems of Germany, Japan and China, enabled build ups of household debt in the US, UK, Spain and Ireland.

Largest Deficit Countries$bn% of GDP Largest Surplus Economies$bn% of GDP
United States-400-2.4Germany2747.5
United Kingdom-114-4.5China1831.9
Brazil-81-3.6Saudi Arabia13317.7
Turkey-65-7.9Switzerland10416
Canada-59-3.2Netherlands8310.4
Australia-49-3.2Korea806.1
France-37-1.3Kuwait7238.9
India-32-1.7UAE6516.1
Indonesia-28-3.3Qatar6330.9
Mexico-26-2.1Taiwan5811.8
Total-891Total1115

If this cross border lending and borrowing had not gone through the banking system, but instead through the stockmarket, in the form of overseas savers buying equity, it is almost certain that the financial crisis would not have been nearly so serious. Though people might have lost money, an equity bubble would have had many positive consequences, funding risky ventures, innovative new business ideas, providing employment. Sadly though, debt still rules the world. If in 2009, the Government had forcibly and systematically converted debt into equity, the financial system would be much less fragile.

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