Debt and Pay - There Has to be a Balance

16/08/2012 10:57 BST | Updated 15/10/2012 10:12 BST

The increase in private debt in the last twenty to thirty years has led many people to become concerned about the future of the economy. The argument that a high level of personal debt would create economic problems has gained support due to the recent turmoil in the financial markets. The biggest problem with large private sector deficits arise from the inability of the workforce to repay the outstanding debts they have accrued. For the workforce to be able to make the repayments their income has to be a sufficient amount to make the full instalment of the loan agreement.

There are two factors that have made the debt and pay balance uncorrelated. The first is the high level of outstanding debt, which generated through the expansion of credit created by low interest rates set by the Bank of England. The Monetary Policy Committee (MPC), who set the interest rate have aimed to hit a two percent inflation target since the introduction of Monetarism in the late 1970's and early 1980's. The inflation target has been set as a priority over the size of the private sector debt level, which has subsequently risen to record levels.

The high level of debt and the impact it has on the long term economy has been neglected over the last twenty to thirty years. This has been due to the emphasis put on the rate of inflation, taking precedence over all other economic targets. The other factor that has led to a disparity in the debt and pay balance is the low level of income. Since the recession hit the rate of income has fallen making the ability of the workforce to pay off the existing debt obligation harder, if not impossible. As income diminishes the expected repayment does not fall in tangent. The same amount of money has to be paid back at each instalment regardless of the debtor's income.

When the economy contracts and the money supply falls, the ability to pay back the owed debt declines and in many cases fails. I have my suspicions that all of the efforts made by Central Banks and Governments to 'stimulate' the economy have been to address the issue of the inability to repay private sector debt, rather than to make the economy grow, which they claim is their real agenda. One method of making the repayments more affordable is to lower the interest rate, which has been done to an extreme degree as any further cuts would make the interest rate negative.

The other method has been to increase the aggregate money supply of the economy through debasing the currency by Quantitative Easing (QE), this has been done extensively. These two solutions pose a couple of problems. The first problem is it is just a further expansion of credit, which will have to be repaid in the future kicking the can down the road, making the economic problems worse in the long run. The second problem is whether the money is getting to the people who owe the outstanding debt. If it is not they will not be able to pay the expected instalments and the situation will not be resolved, even if the money supply is expanded.

Both of the current attempts to increase the money supply to either 'stimulate' the economy or enable debt repayment, which is what I suspect they are really aiming to achieve, will most likely create inflation later on in the business cycle. However if equilibrium is not made between debt and pay the instalments will not be made and the debts will default. Therefore a solution has to be found to increase money supply and make the debt repayments viable in the future. One suggestion I have made in the past is rent controls to free up some of the income of the debtors to help them pay off outstanding debt.

The system would be similar to reductions in the interest rate for homeowners with a mortgage linked to the base rate. When the interest rates fall the monthly debt instalments fall. If rental costs were capped to a percentage of income it would have a similar effect of reducing the cost of living for the workforce that an interest rate cut would, allowing them to pay off existing debts. The percentage of income paid in rent could be altered on a monthly basis and will allow for the repayment of debt without creating further debts or inflation later on in the business cycle. If you would like to read more about this proposed suggestion you can here.

The landlords would lose out in this suggestion. However I have often wondered why they have been able to charge the rents they did in the first place. The rental costs have been linked to the rate of mortgage payments and property values, which were artificially pushed up for years by the low interest rates maintained by the Central Banks. It therefore begs the question as to whether the high rents were ever justified, as they were propped up by centrally planned intervention which would not have occurred if the Central Banks pursued a different policy.

This not only makes me think the cost of renting is too high now, but that the charges landlords have been making should never have been allowed. When I originally made this proposition arguments were made that the rent payments would be inflexible for the properties bought with an outstanding mortgage, which would be subsequently rented out. These so called 'Buy to let' properties, which often have to make mortgage payments with the rental income, could suffer. However I think that this type of product is immoral. To me it appears that the bank has decided that someone can borrow money to buy a property and rent it out to someone else who pays the mortgage for them.

I don't think that this type of agreement should be allowed. It is basically the bank saying that one person can have free money to take advantage of someone else who is less fortunate. The only thing that differentiates the landlord from the tenant is the fact that the bank allowed the landlord to borrow money. It is like giving one person free money at the expense of someone else because they have a better credit rating. In China if someone wants to buy a second property they have to put forward a fifty percent deposit, in cash, before doing so. This acts as a deterrent to debt fuelled property empires, which will likely cause the economy enormous damage in the future.

I therefore think that it would only be fair that the people who should take the brunt of the economic pain to allow debt repayments to be made should be landlords. Even if it means they have their property repossessed as a consequence. The landlord will likely have another property to live in or they would not be able to rent the property in contention out to someone else. If they lose the property they only lose income and potentially investment capital depending on the value of the property when it is sold. The tenant on the other hand would be out on the street if they could not make the rent payments or have to default on their outstanding debt, if their income falls.