There is currently a lot of heat on the market and in the news, and this article might be controversial.

Most people think negatively and wrongly about debt, and reading the press would let you believe that in the best of all possible worlds, people, companies and governments should be debt free. Wrong!

Debt is, up to a point, good, not bad.

At the private level, most people who buy property in their lifetime will have to borrow money (debt!) because they don’t want to wait another 10-15 years until they have the capital to buy their dream property in cash. So good news! You can now live, say, in a nice and comfortable house with your beloved ones, and your new home will provide quality time to you, your family and your friends for many years to come.

In recent years, the cost of financing for this type of debt has been low in developed countries, typically in the range of 3.5%-5% per annum interest.  A low cost, high value investment.  And usually fairly low risk for banks (well, except stupid banks providing 100% financing with variable interest rates c.f. the USA).

So what do you complain about? Private individuals who don’t like debt either have a cost of capital lower than the cost of debt (for example, their expected rate of return is 1%-2% i.e. money sleeping on a savings account, whereas the cost of debt that they face is 4%), or they feel very unsecure about their medium to long-term financial situation (e.g. liquidity issues, risk of being unemployed).  But again, you should not think this way.  Not only should you have higher expectation on your financial investments (go for 5%-8%, not 2%!).  But you should not get paralysed by risk; from the moment you were born, your life has been as risk, and as far as your finances are concerned, as long as your manage your risks, things will be OK in the end.

At the corporate level, debt is also good, because it is cheaper than equity and can be raised in a more flexible manner. With the money raised by debt, a company can finance its investment in new product innovation as well as expansion in new markets. So in most cases it does not make sense for a company to bet debt free. Unless its access to debt is very expensive (the cost of debt is high), or its shareholders expectations are very low (its cost of equity is low, i.e. family business where profit might be somewhat secondary, at least in the short-term).

At the government level, the same applies: debt is good! Governments use debt to finance expenses and investments that makes sense now rather than later.  They use debt money to invest in the well-being of their citizens.  No doubt that some stupid expenditure will be made along the way, but overall, a lot of money will be spent in a wise manner as well.

So what is so scary about debt?  The only thing scary is when you cannot repay your debt (interest, principle) as planned i.e. you have a liquidity or refinancing issue.  When this happens, then you are in default:

• If this happens to a private individual on its house financing, then typically your house will revert to the bank, which will sell / auction it to recover (some of) its principle.
• If this happens to a company, typically the debt holders will become the new owners of the business and might continue to run it, or liquidate it to recover the stake that they have initially invested.
• If this happens to a government (e.g. Russia, Argentina), then the government defaults on its debt repayment, and debt holders might only get a portion of their money back.

You should not be scared or doubt the US ability to reimburse their debt.  First, the USA is a wealthy country, rich of natural resources, as well as talented and enterprising people.  Second, about 2/3 of the public debt is owed by the US government to American nationals, and only 1/3 to foreigners (in particular China and Japan).  So even if things went really bad (they won’t), the US government could default on its internal debt only. Think about it as a form of extraordinary tax on the rich (those likely to hold government bonds).  The reality is still that the US public debt is what it is today because successive American governments have not been able to raise tax as they should have in the last 30 years – tax on consumption, for example, is low by international standard.

This would make a lot of American people poorer on paper, and make a lot of people angry, but this would not be the end of the world.  Think about the last 100 years.  The world has gone through worse periods many times over.

S&P’s downgrade of the US government debt from AAA to AA+ will turn out to be a very healthy signal.  Like any private individual or corporation, government cannot increase their debt forever.  In the last 30 years, government debt in countries like the USA, Germany, France, the UK and many others, have only known one way: up. This period is now over.

It was high time that someone sends a strong message that government should stop living above their means and increasing their debts forever. That does not mean that governments should be debt free.  It only means that they should have a balanced budget on average, and use time of economic growth to reduce unreasonably high debt levels accumulated in periods of recession.  Politicians will have to learn to do just that in the future.

So debt is good, as long as you don’t abuse it.