Two Faces Of Debt

Two faces Of Debt

Two
	Faces
		of
			Debt
Federal Reserve Bank of Chicago

This booklet is the fifth revision of "Debt -- Jeckyl and Hyde," originally published by the Federal Reserve Bank of Chicago in the November 1953 issue of its monthly review, Business Conditions. The original article was written by Dorothy M. Nichols. The latest revision was written by Anne Marie L. Gonczy and Timothy P. Schilling.

First revision: October 1963

Second revision: February 1968

Third revision: October 1972

Fourth revision: August 1978

Fifth revision: September 1992

Two Faces of Debt

No one likes to be in debt. Yet debt often allows people to raise their living standards and increase their productive capacities. Debt entails risks and future obligations, but can also provide a means of generating future income.

Everyone, at some time or another, has seen the disastrous consequences of excessive accumulation of debt by a person or business. Conversely, growth and prosperity have flourished at times when overall indebtedness was rising rapidly, and some economic slowdowns have coincided with periods of debt reduction. Thus, debt appears to be both good and bad -- a paradox that has challenged philosophers for centuries. This booklet examines debt in the American economy and the composition and distribution of debt between major groups of debtors and creditors. While the review points out some risks that can be associated with an over-reliance on debt, it shows the vital role debt can play in channeling savings into productive investment.

Debt is Credit

People who borrow are often looked upon as lacking thrift and a sense of responsibility. But people with good credit ratings are viewed with respect -- often even with envy. Yet, the transaction is the same -- to obtain credit is to incur debt. Recognizing this identity is the first step toward understanding debt and its function in our economy. The next step is recognizing the different forms of debt. And the final step is understanding the uses of debt.

Everyone knows what debt is when he or she owes it, but people sometimes forget that most of the financial assets they try to accumulate are the debts of others. A brief summary of the things that make up the total debt of the economy calls attention to some of the less familiar forms of debt and suggests the relationship between debt and economic activity. The principal forms of debt are shown in the following table, grouped according to the economic sectors owing them. The types of debt owed by each sector reflect differences in both borrowers' credit needs and conditions under which lenders are willing to supply funds. One important difference in debts is their maturity -- the length of time before the debt must be repaid. This varies from "on demand" to several decades. Other characteristics that vary with the types of debt are the collateral a borrower offers, if any, the contractual arrangement for payment of interest and principal, and the negotiability of the debt instrument itself.

There are also other types of claims that have some of the characteristics of debt. A business needing funds, for example, can obtain them either by issuing shares of stock or by borrowing. Both the purchaser of the stock and the lender are suppliers of funds. But a stock certificate represents an ownership interest (equity), while the notes and bonds are a form of debt. Both are claims against the income and assets of the business, but under our legal system, the debt has a prior claim, providing protection to creditors (lenders) and limiting their risk, both up and down, while owners (stockholders) share all the risks of success or failure.

The concept of debt used here includes the money-type liabilities of the government and financial institutions -- currency, deposits, and share accounts. These instruments differ from other debt in some respects. Some, for example, are used in everyday transactions. However, their inclusion is appropriate for the purpose here -- to present a comprehensive view of all financial claims that all units of all sectors can be called upon to meet, either on demand or in accordance with contractual agreements.

. . . to households

Most people are familiar with home mortgages, installment contracts, charge accounts, personal loans, and credit cards. Some kinds of debt, like home mortgages, are typically long-lived, with repayment schedules that span most of a person's active working years. Others, like charge accounts, are meant to fall due so soon that the use of credit instead of cash involves little more than convenience.

Credit . . . is the only enduring testimony to man's confidence in man.

James Blish

Credit is a system whereby a person who can't pay gets another person who can't pay to guarantee that he can pay.

Charles Dickens

People differ in the extent to which they use credit. Some seldom borrow, while others use credit any time they make a large purchase. An important reason for the widespread use of consumer installment and mortgage credit is that a family's needs usually peak while the family's income is still relatively low. Essentially, young families are able and willing to borrow because they expect higher income in the future. Thus, by using credit, they can obtain the use of expensive goods (homes, cars, appliances) rather than renting them or first saving all the funds required to purchase them. Additionally, the use of credit may facilitate the purchase of a good or service (education, for example) that will enhance future income and the ability to pay off the debt.

Purchases can be made, of course, by drawing on savings, which are financial assets accumulated earlier. Significantly, a person with savings is most apt to qualify for credit. As Ogden Nash put it:

One rule which woe betides the banker

who fails to heed it,

Never lend money to anybody

unless they don't need it.

The point is that indebtedness may increase, not because borrowers live beyond their means, but because they would rather borrow than give up earning assets for purchases that cannot be paid for completely from current income.

Types of Debt Owed, by Sector [back] (billions of dollars)
Households		Businesses		Governments		Financial Institutions		Rest of World

-- Loans, securities, and other payables --
Mortgages	2,934	Farm mortgages	84	Savings bonds	126	Bonds	515	Bonds	120
Consumer credit	809	Other mortgages	976	Other federal securities	3,786	Pension fund reserves	1, 961	Business investment	611
Other borrowing	265	Bonds	1,089	State and local securities	849	Insurance reserves	813	Borrowing from banks	35
		Trade Payables	759	Pension fund and insurance reserves	1,014	Borrowing from Federal Reserve and Home Loan banks	120	Commercial paper	75
		Taxes Payables	58	Other payables	102	Borrowing on securities	380	Other borrowing	105
		Borrowing from banks	741			Commercial paper	366
		Commercial paper	117			Mutual fund shares	579
		Finance company loans	309			Other liabilities	465
		Foreign loans and investment	549
		Other borrowing	155


-- Money-type liabilities --
				Currency in circulation	254	Commercial bank deposits	2,291	Foreign currency	113
				Deposits at Federal Reserve banks, vault cash, and other	155	Savings institution deposits	1,251
						Money market mutual funds	498

. . . to businesses

Entrepreneurs and managers are probably more aware of debt than consumers, because most businesses make use of credit in one form or another. Debts of businesses include bonds, notes, and commercial paper issued by corporations, mortgages on land and buildings, other bank loans, and trade payables. Companies, like individuals, often go into debt to buy long-lived goods. Some business assets, such as factories and office buildings, are so costly that many companies would lose years of profits if they waited until they could save enough to buy them outright. Business investment in such assets is particularly important because it is a key ingredient of growth, both for the firm and the economy in general.

Businesses also borrow a great deal of money for short periods. Much of this short-term credit is used to fill gaps between the time businesses pay production expenses and the time they receive payment for sales of their products. A farmer, for example, who borrows to buy feeder cattle typically repays the debt months later, after the fattened livestock are shipped to market. Likewise, a retailer will borrow to purchase inventory knowing that it may take weeks or months to sell the inventory, and even longer to receive payment from customers. The motivation behind business decisions to go into debt is the desire to earn profits. Business people will willingly add to their debts only if they expect the extra income earned through the use of borrowed funds to more than cover the total borrowing costs. Whether businesses borrow to finance specific expenditures or to provide working capital, the deciding factor is the prospect for increased earnings.

. . . to governments

If you'd know the value of money, go and borrow some.

Benjamin Franklin

Neither a borrower nor a lender be.

William Shakespeare

With governments, borrowing is a different proposition. Governments, whether federal, state, or local, largely determine their own incomes -- through their power to tax. And unlike private businesses, governments do not borrow and spend to generate profits, but rather to provide public services.

Most borrowing by the federal government is used to bridge gaps between tax collections and total expenditures, rather than to finance specific services or projects. State and local governments often borrow to finance construction of specific projects (highways, schools, bridges, etc.) that would be difficult to pay for out of current income. Among the federal government's debt obligations are the familiar savings bonds -- issued with relatively long maturities but redeemable on demand -- and many marketable securities maturing in periods generally ranging from a few weeks to 30 years. The Treasury also issues special nonmarketable securities to some of its own agencies and trust funds, to state and local governments, and to foreign governments and central banks. Government-sponsored agencies also issue debt to support home financing, student loans, and other purposes.

In addition to issuing securities, the federal government, through the Federal Reserve System, issues noninterest-bearing debt -- currency or paper money. Currency is so widely accepted as a medium of exchange that most people do not think of it as a debt. Technically, however, Federal Reserve notes are liabilities. Also, all governments "owe" the reserves held in their various retirement and insurance funds.

. . . to financial institutions

Financial institutions may also be considered debtors. The major types of organizations in this category are depository institutions (commercial and savings banks, savings and loans, and credit unions), life insurance companies, finance companies, money market and other mutual funds, and pension funds. Apart from the role of depository institutions in providing checking account services, these organizations act largely as intermediaries -- accepting funds from savers and lending them to borrowers.

While most depositors probably never think of their deposits in banks as bankers' debts, one can be sure that bankers do. Banks in effect "borrow" deposits from their customers with the promise to return them either on demand or after a specified period. Likewise, savings and loan associations, life insurance companies and other financial institutions receive funds from their share-owners and policyholders with the promise to return them on request or under fixed contractual conditions. Generally, a financial institution "goes into debt" at the initiative of its creditors (customers whose accounts it holds). But when commercial banks and savings institutions issue certificates of deposit, which have fixed maturities, they "borrow" deposit funds in much the same way other corporations acquire funds through the sale of securities.

Financial institutions pay interest on certain types of liabilities, such as time deposits and insurance reserves. Since the early 1980s, depository institutions have been able to pay interest on some checking accounts, although they still cannot pay interest on demand deposits.

. . . and to the rest of the world

As international trade has expanded, businesses and governments in other countries have become increasingly indebted to institutions in this country. A portion of the debt owed by foreign entities is incurred because of trade activities. The balance primarily represents long-term investment abroad. Funds are obtained through the issuance of bonds and commercial paper, through loans from banks and other lenders, or through direct investment abroad by domestic businesses.

He that lends, gives.

George Herbert

No man's credit is as good as his money.

Ed Howe

Debts are Assets

While debt is a claim on the assets and earnings of those in debt, it is also part of the assets of their creditors. Just as there must be a buyer for every seller, for every debt incurred there is someone else who acquires a financial asset of equal amount. For example, a debt such as a savings bond, a deposit account, or a corporate bond is as much an asset to the owner as a stock certificate or title to real estate. In the case of commercial banks and most other financial institutions, almost all assets consist of debt instruments -- promissory notes, bonds, and mortgages -- evidencing that some business, government, or person has borrowed from them. In fact, many of these institutions are prohibited from investing in equities in any sizable amount.

Why are most people willing to hold the debts of others as assets? Or more to the point, why and how do we save? People choose to hold currency and checking accounts to facilitate spending. But they are reluctant to hold more than needed for transactions because currency and some checking accounts are nonearning assets while those checking accounts that are interest-bearing typically earn less than other debt assets. These other types of debt offer a convenient way of storing savings (funds that are not needed for immediate spending) while earning returns in the form of interest.

The many forms of debt owed by different types of borrowers provide a wide choice of outlets for funds that can be loaned. Lenders make their selections based on the types of financial assets that best suit their needs and, to a large extent, that reflect the length of time they are willing to forego use of their funds and the degree of risk they are willing to accept.

A lender who plans to use the funds for a vacation cruise within a year, for example, is more likely to purchase an asset such as a short-term Treasury bill or a certificate of deposit maturing within a year than to lend the funds for a 30-year mortgage. A longer-term debt asset might be acceptable, however, if it is one that can be sold easily, enabling the holder to get cash for the asset, if needed, before the maturity date. But, it is important to recognize that the price at which a long-term security could be sold might be considerably above or below the initial purchase price, introducing an added element of risk to the lender's investment. The ease of converting an asset into cash without loss is referred to as its liquidity.

In addition to differing in terms of maturity and liquidity, debts differ in their risk of default and in the extent to which they are secured by collateral -- i.e., assets pledged by a borrower that the lender would acquire in the case of nonpayment. Lenders will tend to assume greater risks for higher rates of interest. Generally, the smaller the risk of nonpayment, the greater the collateral, and/or the greater the liquidity of the debt, the lower the interest rate. This reflects the premium savers place on keeping their funds safe, liquid, and conveniently available.

Borrowers compete for the use of funds by offering financial instruments with different terms (interest rates, security, and schedules of payment) and maturities (length of payment period) that may be attractive to lenders. Although the number and types of debt instruments have expanded rapidly in recent years, the financing options to different types of borrowers vary greatly. While a corporation may be in a position to decide whether to sell long-term bonds, borrow from banks on a series of short-term notes, or issue commercial paper, most home buyers do not have as wide a choice. Generally, they must obtain mortgage loans. If mortgage terms are more stringent than desired, a buyer may not be able to obtain as much credit as he or she wants and may have to accept a relatively short-term loan with higher payments than expected. However, the increasing number of mortgage options available (shorter maturities, balloon payments, adjustable mortgage rates, prepaid points) has made mortgage financing more accessible. Still, if none of these alternatives are viable, the consumer may have to consider renting instead.

Although most borrowers have some choice in the terms they offer lenders for the use of funds, the federal government is unique in its appeal to the whole range of lenders. Because of the huge volume of its borrowing, the ease with which its debt can be traded, and its superior credit rating, the government can exercise considerable choice in the terms it offers and accepts. A major task of public debt management is tailoring government securities to fit the needs of all types of lenders -- individuals, depository institutions, pension and trust funds, and businesses -- that have funds available for different periods and have different earning and liquidity requirements.

Given its ability to offer attractive terms to all lenders, the federal government plays a particularly significant role in the debt market vis-à-vis the other borrowers with which it competes. Like any borrower, when the federal government enters the debt market to obtain new credit, the increased demand has the potential to raise the price of credit, i.e., the general level of interest rates. Because the federal government is generally willing to pay whatever rate is necessary to attract the funds it needs, and because its debt is very safe and liquid, lenders typically meet the government's needs or demand for credit. Other borrowers, however, generally must offer even more attractive terms if they want to attract credit. When borrowing by government comprises only a small portion of the total new debt desired, its impact on interest rates is generally small. However, as the governmental portion of total borrowing increases, the potential impact on interest rates also increases, and private borrowers are forced to offer even higher rates if they wish to obtain credit. Concerns have sometimes been raised that a large volume of federal borrowing "crowds out" other borrowing because private borrowers are unable to offer terms attractive enough to obtain all the credit they desire.

While government debt can be attractive to all lenders, debts of the major types of financial institutions -- especially commercial banks and savings institutions -- are particularly well suited to the requirements of small savers. These institutions generally stand ready to repay funds left with them, in exact dollar amounts and immediately upon request. To be able to meet such demands, they must invest part of their funds in assets that can be readily sold at fairly stable prices. This usually means high-grade debt obligations of individuals, governments, and businesses.

While prudent investment policies provide the prime safeguard for funds entrusted to these institutions, further protection is given by distributing loans and investments over a wide range of borrowers and maintaining an equity cushion in the form of capital and reserves for use in absorbing losses on any debt defaults.

Furthermore, because of the vital function these institutions perform as custodians of the public's money and savings, they are subject to supervision and support by various regulatory agencies, including the Federal Reserve. Regulatory supervision of operations helps to ensure that depository institutions operate safely and soundly. In addition, some government agencies insure a large part of the deposit and share liabilities of these institutions. Insurance and guarantee programs are also provided for some types of loans that these and other financial institutions make. The ability to borrow from Federal Reserve banks and Federal Home Loan banks can also be of great importance to many depository institutions because it can provide a needed cushion during times of financial duress.

The following chart shows the distribution of debt among major sectors of our domestic economy and their net interaction with foreign borrowers and investors. The units within each sector that owe and own debt are not identical, but many businesses and individuals are included in both groups. A business, for example, often borrows to grant credit to customers. Most people wear two hats -- one as owners and another as owers of debt. Anyone with a mortgage on his or her home and possessing a savings account or savings bond occupies such a dual position.

Debt in the Balance Sheet of the Economy
Owned by			Owed by
Households	9,475	4,008	Households
Businesses	2,499	4,837	Businesses
Governments	3,382	6,286	Governments
Financial Institutions	8,674	9,239	Financial Institutions
Rest of World	1,399	1,059	Rest of World
Total	25,429	25,429	Total

All figures are in billions of dollars. Estimates are for Yearend, 1990

At every stage in the growth of . . . debt it has been seriously asserted by wise men that bankruptcy and ruin were at hand. Yet still the debt went on growing; and still bankruptcy and ruin were as remote as ever . . . .

Thomas Macauley

Who goeth a borrowing goeth a sorrowing.

Benjamin Franklin

Although many consider going into debt the antithesis of thrift, without debt many of the thrifty -- and especially small savers -- would be hard pressed to find profitable outlets for their savings. Moreover, unless these funds were spent by somebody, future income and savings would tend to decline. A basic axiom of economics is that each dollar spent by one person is a dollar of income for another. Any amount of unused, unspent income (savings not invested) must ultimately reduce future income by at least that amount, and probably more since money changes hands many times while in the economy.

In addition, debt traditionally provides the capital needed for long-term growth. Through prudent use of debt, firms, individuals and governments can reap the benefits of technological and infra-structure improvements, without first having to save the funds or raise taxes significantly in a single year.

Debts in Sector Balance Sheets

Total debt owed must equal total debt owned, but this equality does not apply for any individual or group. Some individuals and businesses owe more than others owe them, while in other cases, debt assets owned are larger than debts owed.

The gross and net debt positions of the five major sectors of the economy are shown in the following 5 charts. These "debt balance sheets" show the estimated amounts of debt owned and owed by each sector. These outstanding debts are arranged in subgroups indicating the sector from which debt assets or liabilities originated. This cross-classification by debtor-creditor group and the net debt position of each group are summarized in the following table.

In total, debts owned and debts owed between units within the same sector are, of course, equal. Credits by one business to another are both assets and liabilities to the business sector as a whole, although the owners and owers are different business units. The balance sheets show two major debtor groups -- business and government. The net debtor position of business is primarily due to the fact that most business assets are held in the form of plant, equipment, and inventories rather than financial assets. The net debtor position of government reflects two factors:

Most claims on government are in the form of debt because most public bodies cannot raise funds by issuing shares of stock.

Governments, unlike individuals and businesses, have no choice but to borrow to bridge the gap between current receipts and expenditures because they do not (and, because of statutory limitations, generally cannot) save in anticipation of future requirements.

Despite their net debtor position, government units usually have favorable credit ratings. Interest rates on Treasury securities are lower than on private debt, evidencing investor confidence in the federal government's ability to pay debts as they come due. The low interest rates on debts issued by state and local governments reflect the exempt status of interest on these securities with respect to federal, and often state, income tax.

By far, the largest net creditor group is the household sector. In the mid-1980s, the rest of the world moved from a net debtor to a net creditor position, but still accounts for only a very small portion of the total net credit supplied in the U.S. economy.

Reflecting their role as financial intermediaries between savers and borrowers, banks and other financial institutions both own and owe a huge volume of debt and occupy a slight net debtor position. Commercial banks have been an important element in the economic life of most western countries for centuries. Over the past 50 years, savings institutions (savings and loans, savings banks, and credit unions) have also become an important part of the financial sector. And pension funds, which have benefited from the widespread adoption of pension plans and increased contributions by employers and employees, offer further opportunities to accumulate savings. Overall, the liabilities of financial institutions (which are assets to the account holders) have risen dramatically.

Debt Assets and Liabilities by Sector [back] (billions of dollars)
		Households	Businesses	Governments	Financial Institutions	Rest of World

Households
Own -- 9,475	Owed by:	267	313	2,419	6,435	41
Owe -- 4,008	Owed to:	267	141	1,267	2,333	0
Net -- 5,467
Businesses
Own -- 2,499	Owed by:	141	706	151	835	666
Owe -- 4,837	Owed to:	313	706	472	2608	738
Net -- 2,338
Governments
Own -- 3,382	Owed by:	1,267	472	955	526	162
Owe -- 6,286	Owed to:	2,419	151	955	2,285	476
Net -- 2,904
Financial Institutions
Own -- 8,674	Owed by:	2,333	2,608	2,285	1,258	190
Owe -- 9,239	Owed to:	6,435	835	526	1,258	185
Net -- 565
Rest of World
Own -- 1,399	Owed by:	0	738	476	185	-
Owe -- 1,059	Owed to:	41	666	162	190	-
Net -- 340

Notes: Estimates based on Federal Reserve Flow of Funds data for yearend, 1990. Nonprofit institutions and personal trusts are included with households. Only non-financial businesses are included in businesses. The Federal Reserve, federally sponsored credit agencies, federallyrelated mortgage pools, and state and local government employee retirement funds are included with governments. Financial institutions here include depository institutions (commercial banks, savings and loan associations, savings banks, credit unions), finance companies, money market and other mutual funds, real estate investment trusts, securities brokers and dealers, and issuers of securitized credit obligations. Rest of world includes debt owed to and provided by U.S. holders only.

Households -- the economy's largest lender group -- own well over one-third of the total debt assets outstanding. Much of the household-owned debt is highly liquid, being in the form of currency, checking and savings accounts at banks and savings institutions, and shares in money market mutual funds. Another significant portion is held in reserves in pension and insurance funds. Most household obligations, however, are fixed, long-term debts -- principally residential mortgages. The strong net creditor position of households is reflected in their net worth, which also encompasses a huge aggregate of fixed assets and durable goods.

Debt in the Household Balance Sheet [back]
Debt Households Own				Debt Households Owe