Tuesday, May 20, 2014

Another Man's Asset

We know that a household can become over-indebted. The consequence of this over-indebtness - when it becomes apparent - is that the household loses its ability to take on new debt, and is asked instead to start paying back the existing debt. The household needs to lower its living standards, as it was financing those standards with debt in addition to income.

We also know that a whole nation can get over-indebted, through some combination of private and public debt it owes to foreigners. In this case, the general living standards of the population fall. In the absence of foreign aid (e.g. in form of fairly-priced loans), there's no other option than "austerity". (All this is of course a simplification, but one can't write about the economy without simplifying, especially if one has a point to make. So I hope you don't get too tangled in details I have omitted.)

What I write above about a nation must also be true when it comes to any group of nations (that doesn't consist of all the nations in the world), like the European Union.

But if one asks about the possibility of global over-indebtness, one usually gets to hear that it's not possible because "one man's debt is another man's asset". This point is often stressed by mentioning that for the whole world to get over-indebted, there would need to be an extraterrestrial creditor.

I ask myself a question: Can't a central bank be seen as an extraterrestrial creditor, in the sense that money coming from central banks comes from outside the economy and money going into central banks leaves the economy?

And another question: Can't commercial banks be seen as an extraterrestrial creditors, in the sense that the money they create out of nothing when they extend a loan (see my previous post) comes from outside the economy and money paid to the bank in the form of a repayment of a loan is destroyed from the economy?

I will come back to the first question in my future posts, but now I will dive a little deeper into the role of commercial banks as creditors (as holders of assets).

Two main types of "another man's assets"

I will put this very simply: If I have lent you cash I happened to have in my pocket when we last time met, and you have promised to pay it back later, I have an asset, an I.O.U. from you (I'm creditor and you are debtor). When I handed you the cash (an asset itself), it was replaced on my side by the I.O.U. and my wealth in form of assets remains the same as it was before the loan (assuming now that you pay me back). When the day comes that you repay me, I get back the cash and the I.O.U. as an asset ceases to exist. Your debt was my asset. Now my asset is the cash again. Just before you repaid me, you had an asset (the cash) and a corresponding liability (the I.O.U. you gave me). After you repaid me, you don't have that asset but you neither have the liability.

Let's call the I.O.U. the creditor held "another man's asset Type 1".

It should be obvious by now (especially if you read my previous post) that the situation is not as clear cut when we talk about commercial banks as creditors. Loans to households and businesses form the main part of the assets a typical commercial bank holds. These loans can be seen as assets in that they generate income for the bank in the form of interest payments. But these loans can't be seen as assets in that they don't represent any real wealth, as they are not a "store of value". The bank can lose this asset in a blink - sometimes against its own will - through (early) repayment of the loan. The money paid back to the bank is "destroyed", as it was created "out of nothing" by the bank when the loan was granted - so there is no cash that would replace the loan as an asset like there was in the first example (Type 1). Additionally, a non-bank lender can often sell the asset (loan) to someone else and keep the proceeds from the sale. A bank can sell a loan (through securitization) but doesn't get to keep the proceeds from the sale. The money is again "destroyed".

Let's call the loan the commercial bank had made "another man's asset Type 2".

I have heard many times how one man's debt is another man's asset. I have never heard which type of asset (Type 1 or Type 2) it is, although the difference between these two types must be substantial as Type 1 represents wealth while Type 2 doesn't represent wealth?

I can now see why many banks offer "Asset & Wealth Management" services. One man's debt may reflect another man's wealth?

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