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Effects of Debt

Debt gives people and organizations a chance to do things that they otherwise would not be able or allowed to owing to financial constraints. Generally it has been noticed that people in industrialized nations use it to purchase houses, cars and many other things that are otherwise too expensive to buy in exchange for cash on hand. Institutions also use debt in many ways to leverage the investment made in their private equity. This leverage, which is the proportion of debt to equity, is considered important in determining the risk involved in making an investment - the more debt per equity, the riskier the business.

Debt in general is a sign that a society is optimistic and that it believes in its future earning capacity, though arguably also that it lacks a strong work ethic although the money must be repaid, and perhaps also that it is postponing the solution to present problems. For instance, it may temporarily compensate a fall in revenues that is perceived as short term by an increase in debt.

The excesses in debt accumulation in certain societies have been blamed for worsening economic problems. For example, prior to the onset of the Great Depression, the debt to Gross Domestic Product ratio was very high in economies around the world. Economic agents were hence heavily indebted and this excess in debt which was equivalent to excessive expectations on future returns, and was subsequently accompanied by asset bubbles on the stock markets. However, by the time the expectations corrected, the deflation and credit crunch followed. Deflation effectively made debt more expansive and, as Fisher has explained, this reinforced deflation again, since, in order to reduce their debt level, economic agents reduced their consumption and therefore investment. This reduction in demand reduced business activity and caused further unemployment. In a more direct sense, more bankruptcies also followed due both to increased debt cost caused by deflation and due to the reduced demand.

It is possible for some organizations to enter into alternative types of borrowing and repayment arrangements which have a lesser likelihood of resulting in bankruptcy. For instance, companies can sometimes convert debt that they owe into equity within themselves. In such cases, the creditor hopes to regain something equivalent to the debt and interest in the form of dividends and capital gains made by the borrower. The repayments are therefore proportional to what the borrower earns and so can not in themselves lead to bankruptcy. Once the debt is converted in this way, it is no longer deemed a debt.