Debt Effects

Suppose we borrow an amount equal to 10% of our income every year. And suppose we pay off 10% of our debt every year. What does our economy look like?

Assume the interest rate is always 5%.
Assume we start with zero debt.
Assume our income is $10,000 per year, always.
Assume our standard of living is equal to our income plus what we borrow minus the debt service we pay.

Assume we start work at age 16 and drop dead at 80.

I put all that crap in a spreadsheet.

Graph #1

We start at age 16 with zero debt. We borrow a thousand every year, and pay back 10% of what we owe. Our debt accumulates. But when it gets to $10,000, we're paying back a thousand every year, same as we borrow. So our debt stabilizes at that level, the $10,000 level.

In the real world our borrowing varies from year to year. Prices and, hopefully, incomes go up. Interest rates change. And terms of repayment change. In the real world accumulated debt differs from what this graph shows. But the graph shows the kind of thing that would happen if prices and incomes and borrowing and interest rates and terms of repayment weren't all changing. What happens in the real world looks like what the graph shows, but twisted and distorted by the facts of life.

One of the biggest distortions life creates is that in the real world our reliance on credit grows over time. If we start out borrowing an average of a hundred dollars a year, as in 1956, we can end up fifty years later borrowing forty-four hundred dollars a year. But that's what happens when economists and policymakers think that a constantly rising debt goes "hand in hand with improvements in economic well-being".

I can't believe they had the nerve to say that "hand in hand" thing.

Graph #2

With income of $10,000 and $1000 borrowed, we can spend $11,000 the first year. We started with no debt, so debt service that first year is zero. In later years, debt service takes some of our money, and our standard of living falls.

After 10 years or so, the debt service payment goes above $1000 a year. That's more than the thousand we borrow each year. So our standard of living goes below our $10,000 income level.

Our Standard of Living continues to drop thereafter, but more slowly. As we saw above, our accumulated debt eventually levels off. As our debt stops rising, our debt service stops rising, so our standard of living stops falling. Why does it level off $500 below our income level? Looks like it's due to the cost of interest. In my spreadsheet for this simulation, the interest portion of the debt service payment gradually approaches the $500 level. The numbers fit.


On the Standard of Living graph, the blue line runs above our $10,000 income for a while, and below it thereafter. In the spreadsheet calculation, the difference from the $10,000 level is due only to our borrowing (which pushes the blue line up) and to debt service costs (which drag it down). For those first 10 years or so when the blue line is above 10,000, we're ahead of the game. But after those early years, the Standard of Living goes below our income level and our creditors are ahead of the game.

That's a bit of a simplification. Creditors can have bad days, too. But you get the idea: We're ahead of the game in the early years, and behind the game thereafter.

The Standard of Living graph indicates our standing for each year separately. It doesn't add last year's number to this year's. For each year it shows how that year's borrowing and that year's debt service payment tally with that year's income.

In life, we may take things a year at a time, or a day at a time, but if we're ahead every year for ten years or so, things seem pretty good. And if we're behind every year, without ever a good one, things can seem pretty bad. So I want to look at the cumulative effect of being ahead of the game or behind it due to the effects of borrowing and loan repayment on income.

Graph #3

On the earlier graph, the Standard of Living graph, we start at $11,000, a thousand dollars above our income level. Over the next ten years the blue line gradually falls and eventually gets down to our income level. That year, there is no gain.

On this graph, the Cumulative Gain or Loss graph, the blue line starts at the $1000 level because our standard of living was $1000 above our income level. Over the next ten years the blue line rises as we add in gains from later years, but it rises more and more slowly because each year's gain is less than the one the year before. After 10 years the cumulative gain reaches a maximum, just below the 5000 level on the graph. At the maximum, the line is just about flat, because the gain from borrowing has just about dissipated, and our Standard of Living is just about equal to our income.

In the years thereafter, our debt service is more than the $1000 we borrow each year. As a result, our Standard of Living runs below our $10,000 income level. We're behind the game, and each year is a loss. When you take those annual losses and add them to our Cumulative Gain or Loss graph, what you get is a shockingly large cumulative loss.

And yes, I checked that $100 number, $100 per year per capita borrowing in 1956.