Debt Be Not Proud*

Rob Arnott
October 19, 2010

Debt Be Not Proud

* With apologies to John Donne: “Debt be not proud, though some have called thee / Mighty and dreadful, for thou art not so / For those, whom thou think’st, thou dost overthrow / Die not, poor debt, nor yet canst thou kill me.

We live in a world profoundly addicted to debt-financed consumption.

For most of us, our first car and our first home were financed with debt. We borrowed with intent to repay, and most of us did just that. We were, of course, no richer because we’d just borrowed to buy a house or a car: We had a new asset, exactly offset by a new liability. Our expected future consumption was reduced, not advanced, by this borrowing. While we were realigning our lifestyle to improve the subjective mix (with a nice house and a car), our lifestyle was improved in some ways and reduced in others (fewer restaurants and holidays), with no objective net difference.

Today, many people, companies and countries borrow to fund current consumption, with no evident intent to repay. As it comes due, our debt is something we intend to replace with new (and often larger) debt. We’re not just borrowing from Peter to pay Paul; we’re borrowing a bit more from Peter, to pay Paul … and to finance additional consumption with the difference. How naive of us, as young adults, to have once thought we might never have to pay back the principal!

Greece recently hit a wall, and had to break a lot of promises to its citizens, notably the retirees and prospective retirees from government employment. Iceland’s banks hit their wall a couple of years ago. Many people who were late buyers during the U.S. housing bubble hit a wall and are in default. Italy, Spain, Portugal, Ireland, Illinois, California and New Jersey are all fast-careening toward their respective walls.

The nature of that wall is generally the same: We cannot find a lender willing to lend us more, to pay off our old debts, and so those debts truly come due. Our choice, in each case, is either to reduce our consumption, in order to pay down that debt, or default.

Of course, with each default, the failed borrower suffers damage, not least being a string of broken promises to trusting stakeholders. But the lenders suffer reciprocal damage. While debt is extinguished for some, so too are assets for others. It is in this fashion that wealth is destroyed in a financial crisis.

Is the U.S. the lead junkie in a world addicted to debt-financed consumption? Are we careening toward perhaps the biggest array of sovereign defaults in world history? Time will tell, but the sheer magnitude of global sovereign debt is not reassuring.

Why Are Bond Indexes Capitalization Weighted?
Bond investors are lenders. As creditors, why should we deliberately choose to lend more to those who are most deeply in debt?

Bond indexes are mostly capitalization weighted. Consider Table 1a. Greek debt is nearly three times the debt of Australia, meaning cap-weighted sovereign bond investors have loaned three times as much money to Greece as to Australia. If Greece has three times the debt service capacity of Australia, this should be fine, because Greece is just as able to service its debt—ceteris paribus—as Australia. But Australia has three times the GDP of Greece. Therefore, on this simple measure, Greece has about nine times as much debt, per dollar of GDP, as Australia. If the yields are similar, as they were a year ago, one might reasonably prefer to own more Australian debt than Greek debt.

Consider an efficient markets perspective. In an efficient market, what does it matter if Greece owes more and is less able to service its debt? If Greek debt is more risky than Australian debt, we should garner exactly the right amount of incremental yield to provide the same risk-adjusted expected return for both countries’ debt. However, we see little evidence of this sort of market efficiency.