Economics 19: an equity economy
by George Hatjoullis
The purpose of this blog is to explore the possibility of moving to a global economy in which there is only equity financing. In the process, the nature of debt and what it brings to the modern economy might become more apparent. It is a hypothetical exercise but with real significance. Sharia financing does not involve debt. Modern financial crises involve debt and, as I hope will become apparent, cannot occur without debt. Leverage is everywhere implicated in financial crises and cannot exist without debt. So let us assume a global ban on new debt contracts. Existing contracts are to be honoured but cannot be renewed or rolled over though perpetual debt contracts are to be allowed to continue. What institutional changes are required? How will the global economy fare in the transition? What would be the characteristics of an all equity financed economy in a steady state?
The difference between debt and equity is in contractual obligation. Debt involves a contractual obligation but equity does not. This may sound surprising but it is the essence. However, equity will invariably involve a contractual claim, otherwise it would not be rational to make the equity available. If a friend asks for some money that he will repay with interest, this is a debt. If he is unemployed and offers half of his first years salary once he gets a job, this is equity. Many financing relationships have a blend of equity and debt but the acid test in disaggregating the two is through ‘obligation’ and ‘claim’. In our hypothetical brave new world only claims are permitted once existing obligations mature.
The first consideration for major institutional reform would be banking. Modern banking is based almost entirely on debt. Money is nothing more than the obligation of a bank. Money is created when a bank makes a loan. It creates a deposit and makes it available to the borrower. Money has been created. The borrower has a contractual obligation to repay. Individuals that receive payments and salaries deposit them with a bank. This is a loan to the bank and the bank has a contractual obligation to honour the deposit. In a world without debt the banking system, as currently construed, would cease to exist. This raises the question of the nature of money in a non-debt system, the stock of money and the payments system. The central bank would need to take over the payments system directly. This would not be a major challenge and indeed would ensure stability. The challenge is in varying the stock of money and in particular expanding the stock of money.
The transition period would see a steady contraction of bank balance sheets. The stock of money, which is just bank liabilities, would contract. New mortgages would not be available and property sales would be on a cash only basis. House prices would collapse. The same phenomenon would become evident throughout the system and a major deflation ensue. Means of payment would become very valuable and command a larger and larger price in terms of goods and services. The central bank would still control the creation of notes and coins but being unable to lend, could only make more cash available in exchange for goods and services. There would be a huge windfall to the central bank in the form of seigniorage. The central bank would make seigniorage available to the state which would be helpful as the state, being unable to borrow, would be running balanced budgets. The state could only spend what it raised in taxes. Indeed during the transition it would need to raise more than current spending in order to pay down debt and interest. The initial and transition impact of banning debt would thus be a huge negative economic shock.
The high price of money (in terms of goods and services) would encourage several developments. First, private monies would emerge and prosper (e.g. Bitcoin). Second (and partly as a consequence of the growth of private money) the velocity of circulation of the fiat (i.e. central bank) money stock would increase dramatically. The velocity of circulation is the number of times a unit of currency changes hands in a specific unit of time. Thirdly, economic agents would resort to equity based financing arrangements. These factors would mitigate the cost of transition, in terms of below potential GDP. It is the new equity based financing arrangements that is of most interest.
Individuals would no longer be able to borrow to bring forward consumption or purchase durable goods. They would need to save up and buy spot or enter some variation of a rental agreement assuming the goods provider was happy to provide such an arrangement. The most important example of such rental agreements is for a residential property. In the blog, Personal Finance 8: residential property, I deconstructed the residential purchase into a buy-to-let-to-yourself exercise. You still pay rent but you pay it to yourself and have a leveraged investment in the property. In our brave new world you cannot have a leveraged property (or any other asset) investment. There are no mortgages. During the transition period house prices would come under enormous downward pressure. The volume of sales would drop and only forced sellers would be evident. How then would residential property be financed? One possible development would be through Residential Equity Pools (REPs). Instead of using your £30k as a deposit on a mortgage financed purchase, you invest in shares of a REP. The REPs use pooled equity funds to purchase property and let it. As an investor you might also acquire priority as a tenant. You have an equity investment in property and pay rent, as before, but the investment is not leveraged. However, you do receive a dividend from the pool, based on rental income. You are no longer-buy-to-let-to-yourself, just buy-to-let without leverage and paying rent to the REP.
A key change in the equity economy is evidently the loss of leverage. This would have a big downward impact on the price level during the transition though the price level would settle on a steady state once the transition is complete. In a non-debt world price stability would be a normal feature of the economic environment. Speculative bubbles are still possible but would not have systemic implications. The only money committed to speculation could be equity. It would only be possible to lose what you have. It is not possible to lose more than you have. It is through losing more than we have that financial problems spread through the system infecting others to whom you have a contractual obligation. Losing debt as a means of finance means losing price instability and risk of systemic financial crises. So what is the downside and why does debt exist?
Many people have become wealthy (at least on paper) through property. However, this wealth is largely the consequence of leverage through mortgages. If I own a £100k flat with a 70% mortgage and it goes up by 10% then my net worth (or equity) is now £40k. If I own £30k of shares in a REP and house prices go up by 10% my net worth is £33k. I can get rich with leverage but I can also lose more than £30k. My REP investment loss potential is limited to £30k but my wealth growth will be slower. My investment in the REP is also an investment in the management of the REP. My influence is slight and I am dependent upon the professional integrity of the management. If I own my property it is all down to me and I have complete control. The opportunity to leverage gains (and losses) and retain control or influence over the asset or enterprise are the key attractions of debt. The loss of the opportunity to leverage gains seems a price worth paying for the greater stability but the issue of control is more controversial. Entrepreneurs may balk at enterprise if control is diluted. In practice there are devices for getting around this concern.