A Way out of Debt Reliance: Accepting Risk in our Financial System
Rise in income inequality, worsening economic outlook for the younger generations, swelling public debt burden for everyone, these seem to be among the major topics worrying inclusive economists everywhere. This has also given rise to news articles, presidential candidates, and academic publications that preach the failures of capitalism and advocate the need for more socially oriented policies (if not outright socialism). In the second policy brief of the Economics for Inclusive Prosperity series, Anat Admati  very rightly begins her essay with the sentence “A healthy and stable financial system enables efficient resource allocation and risk sharing.” She then goes on to focus on how regulations should be designed and how these would ensure and enable a better distribution of resources—thus focusing on the “efficient resource allocation” part of the quotation above. She then advocates, among other things, along with many other economists who believe in inclusive economics, for less reliance on debt.
Although these points are agreed upon to some extent, it is unlikely that regulations alone can be sufficient. People will always seek to overcome regulations, either directly through lobbying, or by finding loopholes. This does not mean we should ignore regulations, nor doubt their effectiveness in controlling irregular behavior, but one should not be overly optimistic regarding how far regulations bring about a “healthy and stable financial system”. In the best case, regulations can ensure the latter (stability), but not the former (healthy).
As for reliance on debt, it seems inclusive economists are united on this front, convinced that reliance on debt is troubling, and getting rid of it would improve inclusive prosperity. This diagnosis is accurately described by many economists, yet diagnosis and treatment are two very different things, and treatment can only be effective if one can identify how the problem came about in the first place. This policy brief intends to focus on the root of the problem of debt reliance, answering the question very few economists delve into: What is the reason for the existence of so much debt (not just in the more recent low interest years), i.e., the preference of banks (and private investors) for debt? Moreover, how can the problem of reliance on debt actually be solved?
Short answers: The answer to the first question can be summarized as “Risk and Leverage”. The answer to the second: “Risk Sharing”.
The Root of the Debt Problem: Belief in Riskless Gains
Banks opt for debt for most, if not all, of their transactions, whether it be in their assets (private loans, mortgages, etc.) or liabilities (customer deposits). The same can be said for customers with their respective assets and liabilities. Asking either banks or customers to rely less on debt is futile, without first understanding how deeply rooted their perceptions of adequate risk and leverage are.
I can vividly remember how this started for me, as I am sure many readers may share a very similar experience: I had just turned seven years old and both my parents and grandparents decided to gift me envelopes of money, rather than buy me toys as they did many years before. While giving me the envelopes, they explained, “You are old enough to buy what you want now”. I slept that night dreaming of all the toys I could buy with the money, however when morning came, my father took me with him to the local post office (which had a bank as part of its services), and explained to me that it was wiser to save the money I just got. “Putting the money in the bank makes it grow, the bank never loses it, it is guaranteed, and you can buy more things later”. Unwillingly, I agreed, and so got my first savings account. I would later be very excited when the bank statements arrive, seeing how that little interest was added out of nowhere to my minuscule sum of money. It was, indeed as my father had promised, growing!
At such an early age (or even earlier), is usually where the problem starts: We are introduced to the idea of guaranteed riskless gains. I was lending the bank my money, completely ignoring, unaware, and to be honest, not even interested to know what the bank was doing with it or how it was being invested. All I cared about was that I would get my money plus the little interest payment. My belief in riskless gains was born!
One might argue that this was not the intention of neither the bank, nor my father, but instead that I am a victim of oversimplification. I cannot argue as to their intentions, but I can clearly state that the lesson I had learned would remain uncorrected, and was more than sufficient to fuel my saving behavior for years to come.
As the years went by, this idea would flourish into scenarios of an easy life, where I did not need to worry about my money, it was safe, and all the risk was carried by the bank, and the more money I invested, the higher the interest amount would be, it was after all, a percentage of my deposit. In the best case, I could save enough to live off the interest receipts for the rest of my life. No risk sharing was needed, nor inclusion in the banks’ plans, nor worrying how the economy would fare, just guaranteed profits.
This idea is so attractive, that we do not question it after a few good months of reinforcing it through steady interest payments. The longer the interest payments flow in, the stronger our belief becomes. It later grows and expands, from having larger sums in our savings accounts, to engaging in insurance policies that promise to carry all the risk for us (for our cars, our liabilities, and even our lives), so we can enjoy our time and not need to worry. Although this complete risk transfer is very admirable, it removes every bit of inclusiveness in our minds when it comes to financial dealings. Only those (risk-loving) individuals who decide, willingly, to engage in the stock market for want of higher returns, should care about how the financial market is running, but for the rest of us content with our saving accounts, we could not care less about the risk, the management of our funds, nor the financial market risk, no one was interested in showing us the wrongs of our ways.
Recognizing the Downside of Riskless Gains
I only started realizing the downside when a friend decided to found a start-up directly after graduation, and took out a loan to finance her small company. I was involved in a rather informal manner, looking through the accounting books and helping to manage liquidity. At the end of the first year, the company, like many start-ups, ended up making a loss. Here I witnessed how the bank demanded its share of interest payments on the loan, bringing about a question in my mind: How can the bank demand money from such a small start-up before it has even managed to break-even? Does the bank not realize that the interest payments will be more of a burden to the company, pushing the break-even point even further away? The answer came immediately from my seven-year-old self “I don’t care how they manage the money, I want my money plus my interest”. That was when I realized that I might just as well be the customer whose deposit is on the other side of this loan. As a depositor, I was not interested in knowing how the money was managed, I had the luxury of complete risk transfer! But now my friend was the one carrying the entire burden of providing me with the interest payments. I could imagine how this inverted point of view may never dawn upon other depositors, which led me to a had a long philosophical debate with myself, pondering whether this idea of gaining interest on one’s money, regardless what is happening on the other side of the loan, made any sense. I could see the benefit and the harm laid out in the accounting books of the company, and in the interest payments I received on my deposit. I could not reach a conclusion at the time, but the answer came a few months later as I visited my friend once more and we sat preparing her corporate tax returns.
Realizing How Risk Sharing Feels
Since the company was making losses, the government was not demanding any taxes, instead, we could write off the losses for the following years (in case the company ever broke-even). This presented me with a dire contrast to the banking model: The government has also invested in the company by providing us with roads, security, negotiating trade deals, and other services in order for the company to conduct its business. Nevertheless, the government did not demand payments (taxes) if the company did not make any profits! The government was not getting paid this year. I was sure the government was not happy, but it was accepting, and would only demand payments after the company broke-even and profits started to flow.
Now I had two models in front of me, the banking model and the governmental tax model. Each had its pros and cons. But which one was the better model? I decided to search for their origins: The taxation model is discussed and decided upon in democratic parliamentary sessions. What would happen if we proposed a tax code to function like the banks, with the government demanding its share regardless of a company’s (or private person’s) economic performance? There would be a large financial burden on everyone, with many people unable to pay their taxes, ending up jailed or at least heavily debt encumbered, thus it would never pass a democratic vote.
In other words, one could formulate this more technically as the government taking a quasi-equity position in every person and company’s life, sharing the risk of the decisions a person or company takes. The government would then take the effort to be included in their lives, by asking everyone (in the form of one’s tax return) how that year was for them, and demand its taxes only after taking the financial situation into consideration. The government is dealing in an inclusive manner and it is sharing the risk, even though it did not even get a say in what economic activity one chooses to engage in. This model aims at a more just society capable of surviving in both good and bad economic times by ensuring the tax burden is distributed only among those who profited during that year. The system is fair in that every person knows that if they end up losing money due to some economic circumstances, they will not be asked to pay taxes that year. The intuitive nature of this system, its perceived fairness, and its simplicity made it clear to me that among those two models, this “felt” better.
It also highlighted a common contradiction many practice in criticizing entitlement programs with the argument that these people are doing no effort, and expect to be paid at the end of the month, just for qualifying for a specific entitlement program. But this is exactly how riskless gains work, one qualifies for them by having a specific amount of money, namely enough saved beyond one’s expenses. As soon as this amount is reached, one is entitled to interest payments at the end of the month although doing absolutely no effort in the process. The most recent bailouts during financial crisis even taught us that both end up being financed by the taxpayers! The only difference between both is that one is aimed at social welfare and equality, and the other is not.
The banking model (of loans and deposits) does not fulfill a social welfare function, nor does it attempt to, since it does not claim to share the aim of a more just society capable of surviving in both good and bad economic times. A loan is, by design, non-inclusive. It is a debt position, with a win-win situation only for the lender, in the sense that interest payments are obtained in good and bad economic times. The only risk the lender carries is that of borrower default, and even then, legal recourse with guarantees and collateral would come into play, with the lender definitely losing less than the bankrupt borrower (who in our current credit rating system may be penalized for this for many years). Does the lender realize that the interest payments may hasten the occurrence of such default? I refer you to my seven-year-old self again as an answer to this question.
Why is Debt so Prevalent?
So why are loans demanded by borrowers, given their relatively weaker position in the transaction? One answer is that some borrowers have no choice, i.e., cannot find anyone to provide an equity position for their financial needs. This may be blamed on the lenders’ belief that a much easier more guaranteed loan is a better alternative in the sense “why take some risk, when you could alternatively take no risk”, i.e., that belief instilled in our younger years. Believing that there is a less risky option (loans) will reduce the supply of the risky one (equity).
The second answer is “Leverage”. By agreeing to a loan, a borrower who has already broken-even and is making profits, is able to finance further expenses while not allowing the lender a profit-dependent portion of the income, but rather a fixed sum. This ensures that the borrower neither need to share more than he would like, nor does he need allow the lender into the inner workings of his finances, i.e., no need to include the lender in terms of privacy (such as the government demanding tax returns) or in terms of managerial control (such as voting rights). In other words, loans can be useful and suitable for some borrowers, and are therefore still in demand. However, they will never fulfill an inclusive role. They are by design not intended for that purpose. If we are indeed to encourage inclusive prosperity and better allocation of income, loans cannot be the way forward. Loans are meant to isolate the prosperity of both parties, not include them in it: In bad economic times, the lender is able to profit while the borrower loses. In good economic times, the borrower is able to leverage their position yielding exceedingly high profits, leaving the lender with a relatively meager interest payment, even if the high profits were only obtainable using the loaned sum. Inequality and isolated prosperity is associated with complete risk transfer, while inclusive prosperity cannot be disentangled from risk sharing.
Yet, some people equate risk sharing with accepting losses. This is untrue. Risk sharing is in fact the model by which stocks, partnerships and equity positions work, and have led to many a profitable year. The prevalence of debt is therefore not because of its superiority in terms of profits (it is not), but in its sense of secure payments and its similarity to what we learned as children. If we were to unlearn this idea, and accept the simple notion of “no pain, no gain”, even in our financial dealings, the prevalence of debt would be significantly reduced since it would be countered by an enormous supply of equity providers. One need only look at the growing trends of crowdfunding in startups and other forms of direct banking that have appeared since banks were plagued by one crisis or scandal after the other.
It is however important here to highlight that banks are in no way the culprits here, nor do I claim that the financial system can survive without the functions of banks. In fact, I argue the contrary: Banks should be more active in the financial system, but more in equity than in debt. They should accept deposits in the form of equity, and give out financing in the form of equity. Not only would this solve the problem of ensuring banks have enough equity to cover their risk. Capital requirements would not be as relevant if the bank is not obliging itself to repay guaranteed interest payments to depositors. This, however, requires depositors to accept such a deposit form in the first place.
In such a world, banks would become even more competitive, since a depositor would be choosing among banks for their management, and not for their interest rates (which are set by the Federal Reserve and only vary within a specified range).
Reducing the Reliance on Debt
Having answered the first question regarding why debt is so prevalent, I know address the recurring recommendation of inclusive economists for the reduction of debt. Here one may rightly ask: How can we achieve this reduction in practice, and is such a reduction realistic, or idealistic?
Some may argue that the preference for engaging in loans (rather than equity positions) comes from the preference for security of returns without needing to be included in the financial details of how our money is being managed, i.e., a preference for risk (and effort) aversion. However, I argue here to an emphasis between our nature in being “risk averse”, and our nurture to being “riskless”. To illustrate the difference between both, one need only visit the countryside farmers and observe how they lead their lives. Farmers will prepare and fertilize the soil, plant the seeds, then may decide to wait for rain (slightly more risk), or take things into their own hands and water the soil (risk aversion).
They are however, never guaranteed a harvest. The risks vary: bad weather, disease, and even price fluctuations that may not lead to a break-even, even with a good harvest. Yet, this is how farmers have lived for years. They have developed their methods, found ways to reduce their risks, or even share the risks in farmer cooperatives, yet they know and accept that their harvest (and eventually their lives) will never be riskless, nor effortless, and thus it is no longer a goal for them. They are risk averse, and will remain so, but they know that riskless is not a natural position to be in. I learned this during one project in my bachelor studies, where I had to conduct a questionnaire with some farmers in a tiny village outside the reach of banks. When I explained to them the idea of an interest-yielding deposit with the same words my father used “Putting the money in the bank makes it grow…it is guaranteed” and asked whether they would be interested in such products being provided by a bank in their village. None of the 25 farmers I interviewed could accept the offer since they did not believe such an option could exist, with one of the older farmers clearly explaining to me “Youngman, I have been working this land for over 50 years now, and I know if something is too good to be true, it is not”. At the time, I thought those farmers were just too outdated and out of reach of civilization to understand how far we have come (and exactly that is what I wrote in my report at the time). Now however, I support the farmer’s argument that the idea of riskless gains is not natural, but those of us who have lived in the vicinity of banks have grown so used to it, that we accept it blindly. In fact, we accept riskless returns and teach, not only our young children, but even our students in finance classes to compare the returns on a risky asset to the riskless alternative (so-called risk premium), and base investment decisions upon that.
Accepting Risk in our Financial System
Thus, the most important step in reducing debt is to increase the supply of alternative equity financing. This, being well known and not such a breakthrough in itself, is much easier said than done, since it requires a paradigm change in the way we raise our children, teach finance and the way we ourselves think of financing. I do have to highlight here the fact that the capital provider is the one in control; in this case the bank depositor or the lender in general. If the bank were not pressured to meet obligatory interest payments to its depositors, it would not need to demand the interest payments on its loans regardless of market conditions. Therefore, it remains in the hands of the depositor to change the nurture of riskless returns to the more natural risk sharing approach. People accept this idea in the case of actively managed mutual funds: we invest our money, and pay someone to manage the fund, knowing very well that this implies full risk-sharing, just without the actual burden of managing the investment ourselves (due to our limited time, or knowledge of market workings).
Examples of Risk Sharing
One need only look back at Japan’s post-war rise to see how revising the ideas of riskless profits gave rise to one of the largest post-war economies. With the Japanese central bank’s zero-interest policy, the idea of riskless profits was eliminated. No seven-year-old Japanese child would be promised “your money will grow…guaranteed”, but rather would have been told “it won’t grow if you don’t take some risk and put in some effort”. One cannot claim that absolutely no debt was involved in the economic resurgence of Japan. Rather I emphasize the idea of risk-sharing, whether through taxes or through equity investments. Profits were only possible if risk was taken. Moreover, the zero interest rate meant that any investment being analyzed would result in a positive risk premium (because there was no riskless alternative). This lowered the opportunity cost for engaging in productive activities, ensuring that Japanese capital would go directly to even the least profitable ideas, as long as it generated just enough profits, while at the same time creating jobs and economic welfare. The result 70 years later is one of the largest economies in the world, with “lower levels of inequality than almost every other developed country”.
On the other hand, when one looks at the 2007-2009 financial crisis, one can see how significant the burden of debt was on homeowners. With the banks unable to offer flexibility, and demanding mortgage payments on promptly, more pressure was put on the borrowers, forcing them into more debt to cover the payments, or financial delinquency, both of which are not a win for the bank, but a significant loss for the borrower.
If we could imagine mortgages of an equity nature, in such a hypothetical world, the banks would have told the homeowners “we understand what you are going through, this is a crisis, we can wait it out, you do not need to be evicted, and we understand that we cannot demand interest payments in such a rough time”. Unfortunately, the banks were not at liberty to do so, whether because they did not want to delay the profits for their stockholders, or because their depositors were themselves not offering the bank such flexibility.
Financial economists have discussed in details the causes of the financial crisis, how it could have been avoided, and what regulations would have reduced the negative effects. However, none of these discussions or regulations would have improved the situation for homeowners who were evicted. If the banks were better regulated or sub-prime lending were prohibited, then fewer people would have had the chance to apply for a home, thus once again, the people who have the least money are the ones who suffer, i.e., we are not reaching any income equality improvements.
Instead, if mortgages were more of an equity nature (with risk sharing), they would be seen more like stocks that seized to pay dividends for a period, and even witnessed a fall in price. As we know with stocks, one must look at the fundamentals to recognize if the company is just passing through a rough time, it would be more prudent to wait it out and hope the company will be able to get back on its feet. This would be in the interests of all parties aiming for inclusive prosperity for all involved. We can never rule out that there exist those who are in a hurry to get their profits immediately, regardless of what is happening in the economy (my seven-year-old self included).
A healthy and stable financial system through increased risk sharing and less reliance on debt is a prerequisite for inclusive prosperity, yet how these two could be practically achieved, has eluded policymakers. This policy brief focuses on the root of the problem of debt reliance, addressing the preference of capital holders for debt rather than equity, and provided recommendations on how this core problem could be addressed by focusing on the core beliefs instilled in our children and youth as well as by utilizing risk sharing equity products and discouraging financially riskless gains that are presented without highlighting their non-financial drawbacks.
We need to teach our children that money does not in fact grow on trees (or in this case, at the bank), but can only yield returns if the underlying investment also performs well (risk-sharing). We need to teach our students that a risk premium is an unfair comparison, like comparing apples and oranges, since a riskless asset does not lead to inclusive prosperity, but rather to more inequality, financial isolation, and a debt burden for the borrower. Finally, we must all care about where we put our investments, just as the farmer always carries the risk of a bad harvest. Returns and risk cannot be disentangled from one another, neither can inclusive prosperity and risk sharing. The aim of riskless gains in our later years by investing our wealth in bonds without needing to worry about how the economy and the financial markets develop, is no longer a sustainable model.
Finally, we all need to understand that our economies are now so globalized, that we will all have a stake in keeping the economy growing and caring about the financial performance of companies that in turn create jobs, and not simply be indifferent to how many people get fired, how many homes get repossessed or how many companies declare bankruptcy, as long as our interest payments are being credited to our deposits.
This policy brief does not naïvely claim that moving to risk sharing will solve income inequality, since one cannot share financial risk without first having capital to begin with. Instead, the intention here was to provide a way out of debt reliance. Nevertheless, by revisiting how we believe money grows, we can reduce preferences of capital holders to use debt instead of equity. They must be encouraged to engage further with entrepreneurs, whether directly or indirectly by paying managers to conduct the required financial inclusion for them. The capital providers will still be sharing the risk, and therefore will not be putting undue financial burdens on borrowers. This may eventually lead to income equality improvements in the long run.
 Anat R. Admati (2019) https://econfip.org/policy-brief/towards-a-better-financial-system/#
 Nor possibly even an autocratic one evidenced by the fact that no country I know of applies an income tax code, which levies income taxes regardless whether one indeed gains any income.
 Yuriko Koike (2015) https://www.weforum.org/agenda/2015/03/why-inequality-is-different-in-japan/