If a company or an individual borrows money to buy assets, we say that person or company is leveraging. Leveraging means you are putting more money into the asset than you have. You could buy, if you have $100 to invest you could buy $100 of stocks, or you could buy $200 of stocks and borrow $100. That makes you in a riskier situation, but also both up and down. So if you bought $100 worth of stocks and you're lucky and it doubles in value to $200, you've made $100. But if you leveraged and the stock doubles in value, your portfolio goes from 200 minus 100 to 400 minus 100, or $300. So you double your profits. But on the other side of it is if the stock falls in value. Suppose you bought it unleveraged. You bought $100 worth of stock and it falls in value by 50%, then you are down to $50, you've lost 50. But if you leveraged and you borrowed $200 worth of stock and borrowed $100, then if it falls by 50% you're wiped out. So leveraging increases risks. People look at how leveraged economies are and wonder about the chaos that might ensue in a market correction. For example, China is widely described as a highly leveraged country, it's gotten worse after the financial crisis. There was a Wall Street Journal article just the other day pointing out that corporate debt, borrowing by corporations in China. It is 160% of GDP in China. Whereas in the US, it's only 70%. So that means the Chinese economy is leveraged. And it could do very well as a leveraged economy, but it's more vulnerable and this is a concern. So debt leads to bankruptcy. If you have no debt, you normally don't go bankrupt because bankruptcy occurs when your creditors are after you for non-payment and normally, you would just pay them if you had the money. It's just when you don't have the money that you are in trouble. Now I think a very important, I keep coming back to Irving Fisher. As I say, I'm a little bit biased because he's a Yale person but I never even met the guy and I don't know if I would like him. He's kind of a quirky guy. He would invite students over for dinner at his house, and he would tell them at dinner, you have to chew each bite 100 times before you swallow. Because he thought that was health. Anyone do that? [LAUGH] Be careful to chew your food well? It must have been a little bit odd having dinner with Irving Fisher. But he was a brilliant economist and he wrote an article in 1933, in Econometrica, called the Debt-Deflation Model of Great Depressions. In 1933, prices were falling at a rapid rate because of the depression. We had huge deflation. And he thought maybe that's why we are having the depression, and here's his train of thought as he describes it there. Normally people who borrow money are the optimists, right? They're borrowing, they're leveraging. They think the stock market will go up or some other market will go up and they want to get it. And they're willing to take risks. So you have the risk-taking optimists on one side and then you have the naysayers. They are people who are pessimistic and risk-averse and they don't want to take chances as the lenders. So, what happens when there's a huge deflation and consumer price index goes down? Well, that magnifies the real value of the debt, right? If you owe $100 and the consumer price index falls by 25%, your debt has gone up to about 133, it's gone up a lot. So what ends up happening in a deflation is that the debtors get beaten down. The optimists have less wealth in real terms and the pessimists have more because now the $100 that they loaned is worth a lot more. So he thought this has to be important. You know that people are different. Some people are natural optimist, and some people are just, not necessarily that they're just pessimistic, but they just don't want to get into that. They're not entrepreneurial. I don't mean that disparagingly. They're just a different personality. Maybe they're artistic or something else. But then in a depression, wealth gets distributed towards them so in a weighted sense they get more votes now. So you've now rewarded the pessimists and the world is being run by the pessimists. So no wonder we're in a depression in 1933. Now the recent crisis, that is of 2008/9. That's no quite so recent anymore, but it's still with us. Did not bring much deflation, not like 1933. But what it did do is it produced lower consumer prices than people expected. because inflation often practically disappeared, and there was some deflation at times. So that means that irrelative to expectations, wealth had been distributed, redistributed from those who borrowed money to those who lent money. So it's still true and it may be important factor to consider. This brings up a question that I've already alluded to. Why isn't debt indexed to inflation? Well it isn't. This is the puzzling thing about human nature, people just don't get it. And it happens again and again that we have major shifts in the price level and it redistributes debt value between debtors and creditors. People just don't get it, I think they're afraid of index numbers, this calculations, the consumer price index, there's some calculation, you want my debt to be tied to a formula. So anyway I've already alluded to the fact that I think we should create an indexed unit of account like they have in Chile or Mexico or some other countries. So that it would be easier for people to contemplate indexation, but they dont, this is the real world. So any time we see unexpected behaviour of consumer prices it has real effects on the economy. John Geanakoplos here at Yale has written a number of papers on what he calls the Leverage Cycle. And pointing out that leverage has varied quite a bit through time, notably recently in the United States in 2006, just before the financial crisis. Leverage became extremely high, particularly in the housing market. Banks were allowing people to borrow, typically something like 97% of the value of the house, to borrow a house. So this leverage, you think anyone who takes a risky investment and borrows 97% of the money, that's really a daring thing to do. But everyone was doing that. Anyone who was in that stage of the lifecycle where you'd buy a house, it's funny how people value, I don't think that people are consistent at all in their thinking about risk. A view developed in 2006 that the housing prices are going up, I said before 2006. Housing prices are going up so fast you can make a lot of money by, in fact you could make a huge amount of money, percentage-wise, by just buying a house. If you bought a house in 2000, home prices went up, well, I don't know, I should have this memorized, but let's say they went up 50% after that, you make 50% on your investment, it's pretty good. But if you borrow 97% of the money, it's just astronomical what you could make. People got excited about leverage because they also had the perception that home prices don't fall. I know this was out there, people had this idea. Why do they think that home prices don't fall? Just the Law of Economics, house prices never fall? But we know the law is wrong because in 1933 they were falling rapidly and so, I guess that's beyond people's memories. So, people got kind of an optimistic bias just before the financial crisis. And the economy leveraged itself up. It isn't the government that did it. The government if anything, was leaning against that with regulations. So anyway, so that's the end of my thoughts. So is debt immoral? I tend not to think of it at all as immoral. We talked about the Irving Fisher diagram. How the ability to borrow and lend raises utility. I think that at various times in life you need money, the extreme case is you need money for illness, you're sick, you're going to die, you need expensive treatment. Of course you borrow the money. So lenders are not evil. Even if they lend, we talked about this, even if they lend for your honeymoon, for a vacation. That's not evil, either. You may know, psychologically, your fiancee needs that if you want the marriage to succeed. And that's just something you have to do. It's not crazy, it's not self-indulgent. So I think debt is a good thing, but not always well-managed.