Debt

What It Means

Debt is money owed by one person, company, or institution to another person, company, or institution. Those who borrow money are called borrowers or debtors, and those who loan money are called lenders or creditors.

In the modern world debt is very common, and it is a central part of the world economy. Borrowers can use loans to finance purchases and projects that they could not otherwise afford, and lenders can generate income by charging interest (a fee for the use of borrowed money) on loans. These activities account for a large portion of the total economic activity in most modern countries. Without debt and the purchases and income it generates, modern economies would be only a fraction of their current size.

Consumers commonly go into debt in order to purchase large items, such as automobiles and homes. Another common form of consumer borrowing is the use of credit cards, which allow individuals to make purchases (of smaller items than homes and cars) and to pay for them at a later point in time. Companies borrow money for a variety of reasons, including to build or purchase new factories and equipment, to hire new workers, to buy inventory and other materials, and to pay for unexpected expenses. Likewise people starting a new business must often borrow money to cover their initial expenses. Governments also routinely borrow money to finance schools, highways, hospitals, and other public projects, and they borrow especially large amounts of money to go to war.

When Did It Begin

The phenomenon of debt dates back to at least the earliest civilizations. As early as 3000 bc , loans were used to facilitate economic activity in ancient Mesopotamia (which now lies in Iraq, Syria, and Turkey). While creditors charged interest in these early times, this practice was widely condemned by religious figures as diverse as Buddha, Jesus, and Mohammed. Interest collecting and money lending were considered immoral by many prominent spiritual leaders, philosophers, and members of the general public from ancient times through the Middle Ages (which lasted from about 500 to about 1500).

Furthermore, prior to the twentieth century most societies dealt very harshly with debtors. In ancient Greece, Rome, and Israel, among other early civilizations, debtors who could not pay what they owed were sold into slavery, though Israeli custom required the freeing of such slaves every 50 years. The feudal system of the Middle Ages (in which aristocrats, or those belonging to a small privileged class with inherited land and wealth, ruled over all the people who lived on their land) generally treated debtors more leniently. This was true only because all men were required to serve their rulers in the military and could not be spared for the purposes of punishment. As the Middle Ages came to an end and capitalist economies (in which individuals could own property and conduct business with some amount of freedom from feudal or government control) began to develop, harsh treatment again became the norm for debtors. Until the nineteenth century people who could not pay their debts were generally sent to prison.

Even though debtors’ prisons were phased out in Europe and the United States in the mid-nineteenth century, most people continued to frown on the practice of going into debt except to purchase the most necessary items. Debt was considered irresponsible and even immoral, an attempt to acquire things one could not afford to buy by honest means. Only essential investments, such as a farmer’s purchase of seeds or a company’s construction of new factories, were seen as legitimate reasons for borrowing money.

Throughout history governments have borrowed money in order to conduct wars. Only in the aftermath of the Great Depression (the severe financial crisis that afflicted the world economy in the 1930s), however, did government debt during peacetime became routine. National governments found that they could stimulate their ailing economies by spending money (often on public projects and on aid to the unemployed, the poor, and the elderly), and this was seen as beneficial even if the money had to be borrowed. Since that time public opinion of government debt has fluctuated, but governments have continued to borrow money for peacetime needs and with the intent of managing the economy, as well as for the waging of war.

More Detailed Information

By the end of the twentieth century, debt had long since been accepted as a natural part of economic life, and borrowing and lending accounted for an enormous part of the economy in all developed countries. It had become common for the amount of debt (including the debts incurred by individuals, companies, and government at the local, state, and national levels) in a developed nation to add up to more than three times the total value of all goods and services produced by the country’s economy.

Several conditions are necessary to support an economic system in which debt plays such a big role. First, the members of such a society must be likely to repay what they owe. A credit system in which most people try to avoid payment is unsustainable. Second, there must be a sophisticated legal system that emphasizes the protection of private property. A debt is a loan of one person’s or organization’s private property to another person or organization; if debts are to be reliably collected, laws must be able to defend creditors’ property rights. Third, the society’s money must maintain its value. When a country’s currency is unstable (that is, when its money tends to lose or gain value erratically as a result of rising or falling prices), then a creditor cannot count on the value of the money he or she will eventually be repaid.

Most debt is transacted not by borrowers and lenders in direct contact with one another but by intermediaries, such as banks. Banks take in money from depositors and lend it out to borrowers. Depositors are paid interest by the bank for the use of their money, and the bank charges borrowers a somewhat higher rate of interest. The difference between these rates of interest is one of the key sources of any bank’s profits.

Debt is often based on created money: figures on paper (or in computer systems) rather than hard cash. Banks do not hand over actual coins and bills to borrowers. Instead, they give borrowers a checkbook with the amount of the loan recorded as a balance (the amount of money available) in a checking account. People can write checks or withdraw money that is subtracted from these balances, but a bank does not have actual currency on hand equal to the full value of all its bank accounts. Banks make loans, instead, in proportion to a small amount of currency that they are required by law to keep on hand. If, for example, Community Bank has $10,000 in currency, it might need to keep only $1,000 in reserve and can lend out the rest. The borrowers then take the money and place it in a bank account, which can then be lent out to other borrowers. This process continues, and the initial $10,000 in currency allows Community Bank to make loans equal to 10 times that much money. Community Bank thus literally creates 90 percent of the money in its accounts out of thin air.

This form of money, which exists only as numbers in banks’ computer systems, accounts for much of the total money supply in a country at any given time. In 2006, for instance, there was about $800 billion in physical cash in the United States. If the money supply had been calculated to include not just cash but also checking, savings, and other forms of bank accounts (all of which represent money owed by banks to account holders or by borrowers to banks), however, it would have amounted to more than $7 trillion. Debt, therefore, is one of the chief sources of the nation’s money supply. Its importance to the economy can hardly be overstated. Not only does debt fuel business ventures, make possible large purchases, and allow for the construction of highways and the fighting of wars, but it also provides much of the basic material (money) for the entire economy.

Recent Trends

The modern world relies on debt for increased prosperity, but this does not mean that debt does not at the same time threaten prosperity. At the end of the twentieth century and the beginning of the twenty-first century, one form of debt was particularly worrisome to many Americans: credit card debt. Whereas going into debt to buy a house is usually seen as a reasonable way of making a purchase that cannot be made otherwise, credit card debt often results from irresponsible spending on smaller items. In exchange for instant gratification, many Americans sentenced themselves to seemingly never-ending financial burdens and, in some cases, the threat of bankruptcy (an inability to pay debts, which can lead to the seizure of property and other valuable resources).

As of 2007 around 144 million Americans had at least one major credit card, and the average American family had eight different cards. Of the 144 million cardholders only 55 million regularly paid the full balance (the total amount owed) of their credit card bills every month. Nearly 90 million Americans, then, owed not just the amount of their balances to credit card companies but were also paying interest and fees that were often very high. People with poor credit histories (a record of late and missed payments), for instance, might be charged a yearly interest rate of around 30 percent, and the average balance for those who maintained a balance from month to month was estimated at $13,000. Thirty percent interest on a balance of $13,000 would amount to an additional charge of $3,900 a year, not counting additional fees commonly assessed by card companies. Of the 90 million people who habitually failed to pay their monthly balances, approximately 35 million made only the minimum payment of 2 percent of the total balance each month, which amplified the effect of interest and fees and extended the amount of time they would likely remain in debt.