ideas-econ-debt

is debt better or worse than equity?

debt is simpler than equity. debt is more arms-length whereas equity is more alignment of interests. taking on equity requires giving up some control, taking on debt doesn't. equity is permanent, debt is temporary. but debt can lead to debt-slavery, equity cannot.

probably because of the debt-slavery problem, Islam apparently forbids debt (well, at least debt with interest, but when there is a nonzero chance of default, this is the only non-money-losing kind of loan), but allows equity.

in my opinion, both debt and equity have a place. in founding pietrust, i realize that if you have a vision you don't want to give up control until you can be sure that that vision will persist. so in this situation, debt would be preferable to equity.

so how to have debt without slavery? some people like the idea of periodic debt jubilees, but i don't see how that could square with modern finance, e.g. how could a company sell a bond if next year was a jubilee year?

some ideas:

• forced exponetial decay of interest rates over time. eventually, every debt's interest rate goes to zero. the government sets a maximal half-life. note that the interest rate can still be floating, w/r/t a government-published interest rate, as long as the additional portion of the interest decays (e.g. it's the real rate which must decay, not the nominal). this can be seen as a more flexible form of jubilee -- there is not a certain point in time when all debts expire, and the principal of debts doesn't expire, but each particular debt has a half-life.
• bankruptcy is a good innovation. it should be more freely allowed -- the recent legislation making it harder to declare bankruptcy is a bad idea. no class of debt (e.g. government educational debt) should be excluded from bankruptcy (except perhaps stuff like court judgements, fraud, etc).
• the government should encourage zero (real) interest rate loans. all government loans should be zero (real rate) rate. All nonprofit loans should be zero real rate. For example, education loans should be zero real rate. Whenever the government guarantees the credit of an entity, it should insist on a zero real rate loan (but then how would the loaner get paid? hmm... mb not the best idea as such..).
• debt that is convertable into equity at the option of the debtor
• a more standardized 'bail-in' process by which a debtor can declare bankruptcy at which point existing debt is converted into equity in a well-defined manner without going to court. (combine this with the extreme form of the recommendation that bankruptcy should be more freely allowed, which in the extreme means at will, and you get the previous bullet point: e.g. bail-in upon bankrupsty converges to bail-in at will).
• combining the previous two, introduce a new form of bankruptcy; bail-in bankruptcy. Declaring bail-in bankruptcy affects all of your debts and gives each creditor a choice; reduce the interest rate to 0% real rate (you still have to pay down the principal on the agreed schedule, however), or convert the debt into equity according to previously specified agreements. It is a standardized process that does not require going to court and can be freely done at any time (although it is still very publically recorded and kills your credit rating, although not as much as true bankruptcy, in which you are released from paying off some of the principal.
• temporary equity, that is, equity that, after time, is "callable" by which i mean converted into debt at the option of the fundraiser. again, instead of making the call time a sharp cliff, make the par value at which the equity can be called a geometric decay.
• the most common hack: a statuatory limit on the interest rate
• define 'debt slavery' and outlaw it directly. For example: if a person's interest payments would be more than X% of their income, then they don't have to make interest payments above X% (and this non-payment is simply erased, it is not added to the principal). This is sort of like a less-extreme version of bankruptcy, because the debtor still must pay interest and the principal debt is not erased.
• Another view on temporary equity and outlawing debt slavery: imagine a disadvantaged person living in a world of capital-intensive technological advancement. Due to the capital-intensive technological advancement in the world at large, the time value of money is very high, hence interest rates are high. Due to person's disadvantagment (perhaps they don't understand technology and don't have well-placed contacts), they are not able to achieve the going rate of return. Such a person, if they take out a loan large relative to their net worth, will probably end up in debt slavery, as they will not be able to make a return on equity higher than the loan's interest rate. Bankruptcy is one solution, but it's a rather abrupt (binary, discrete, discontinuous) one. Another more continuous (smooth) solution is to make the interest rate relative to the debtor's rate of return, rather than the creditor's. The reason that this may be thought of as a smoother analog of bankruptcy is that, if the loan's interest rate (the creditor's ROE) is higher than the debtor's ROE for a long enough duration and the loan is sufficiently large, bankruptcy will certainly occur. So this solution can be thought of as doing the bankruptcy in little bits rather than all at once. Now, tying the interest to the debtor's ROE rather than the creditor's means it's equity. But the problem with perpetual equity is a loss of freedom. So, make the equity callable, e.g. temporary; as long as the debtor faithfully pays a certain percent of their income, a certain proportion of the debt is discharged (or in this case, a certain proportion of the equity is repurchased).

Note a common thread in all of these: limiting the effect of the exchange in the far future. under these proposals, in the far future, each entity retains more ways to profitably control its own destiny.

• Note that the argument for temporary (callable) equity can be made in terms of perpetual freedom: debt carries the possibility of perpetual non-freedom (reduced to bankruptcy) for the debtor if the debtor's ROE is lower than expected; perpetual equity is a form of non-freedom itself; callable equity is only temporary non-freedom (which is unavoidable anyway if you wish to have an economy in which people can take a job, e.g. sell their time).

some historical and intercultural context

In some ancient societies, debt was permitted but interest rates were regulated. In some, interest rates were unregulated. In some, debt was forbidden (see http://en.wikipedia.org/wiki/Usury ).

It seems clear that debt with interest is the sort of thing that some people (and some entire cultures) find extremely upsetting, and consider unethical. However, some other cultures also consider interracial marriage to be terribly unethical, and i think it is clearly ethical, therefore, the fact that a bunch of cultures consider something to be terribly unethical should not be a sufficient argument not to do that thing. However, it does suggest that we look into and understand the issue at stake so as to make sure there is not, indeed, something objectionable.

The arguments against interest rates, or against high interest rates, seem to me to be of three kinds:

a) Debt with interest leads to monetary gain without work, and this money is tranferred from the debtor, so it is an unjust redistribution of wealth.

b) Debt with interest leads to 'debt slavery', e.g. to a persistent power imbalance which is unfair to debtors and suboptimal for the community.

c) "In a partnership or joint venture where money is lent, the creditor only provides the capital yet is guaranteed a fixed amount of profit. The debtor, however, puts in time and effort, but is made to bear the risk of loss." -- http://en.wikipedia.org/wiki/Usury

(are there other arguments that I'm missing?)

The proposals earlier on this page essentially address (b) by limiting/hacking the concept of debt to try to allow its beneficial properties while making debt slavery less common.

I don't find (c) convincing in the modern Western system where bankruptcy is permitted -- the creditor takes on a very real risk of loss in the event of the bankruptcy of the debtor (especially if the debtor is a corporation rather than a person, in which case bankruptcy has less personal cost, and is 'just business'). Maybe this made more sense in the old days with debtor's prisons (or in the modern era in the special case of debts exempted from bankruptcy, such as U.S. Federal educational loans -- an exemption that i emphatically do not support).

If you buy a sufficiently strong form of (a), then you essentially must outlaw all lending at interest on principal (after allowing an interest rate pegged to inflation to protect the real value of the principal). This leads to portions of [self:notes-econ-islamicBanking] .

There are other restriction observed by Islamic banking besides these. According to Wikipedia, Islamic banking may not provide money for things that Islam forbids, including alcohol, pork, gambling, gossip, or pornography. It also forbids 'Gharar', which seems to mean a certain form of uncertainty, and 'Maysir', which seems to mean gambling. The prohibition on Gharar seems to forbid conventional insurance and leads to a replacement in Islamic banking with another form in which risk is only pooled between risk-takers, and is never transferred to a speculator. Suffice to say, one could believe in (a) without accepting the need for all of the restrictions in Islamic banking.

One concept in Islamic banking is Musharaka, which seems equivalent to what I call 'temporary equity', above. The lender-equivalent purchases equity in a company (the debtor-equivalent). There is a repayment agreement by which the debtor-equivalent is entitled to repurchase the equity at a certain rate. In the mortage form, called Musharaka al-Mutanaqisa, the lender-equivalent and the debtor-equivalent form a joint venture to purchase the property, and then it proceeds as in Musharaka, except with the additional understanding that if the debtor-equivalent stops paying, the property will be foreclosed and sold, and the venture will be dissolved (with the debtor-equivalent getting their share of the proceeds from the sale).