Consumer credit loans seem benign enough except for cases where people dig themselves into a hole by using credit card debt to finance everyday expenses until things take a turn for the better. Mortgages and refinance loans can also be a problem when people bet on their home’s value increasing dramatically, and student loans often seem to place an unrealistic burden on people at the outset of their career.  There are better ways to enable home ownership and education. [see Mortgage Loans]

Using interest-bearing loans to finance business ventures can cause much bigger problems than consumer loans. Hyman Minsky concluded that the use of debt in corporate finance was a major factor in making capitalism inherently unstable. [see The Financial Instability Hypothesis ] He distinguished between three different kinds of debt financing: hedge finance, speculative finance and Ponzi finance. 

Hedge finance is betting that revenues will grow sufficiently to pay off the loan completely. Speculative finance is betting that revenues can be counted on to cover just the interest payments and that the loan can be refinanced when it comes due. When a business bets that a new loan can be used to pay both the principal and the accrued interest on an existing loan, Minsky calls it “Ponzi” finance. The use of speculative and Ponzi financing for business eventually leads to pressure to increase prices so that there is sufficient revenue to service the debt. Minsky sees this pressure as a major cause of inflation. 

Reliance on debt refinancing of this sort reached epic proportions in the last half of the 20th century. When Continental Illinois bank failed in 1984, its operations required it to borrow $8 billion every day. Its rescue by the Federal Reserve gave rise to the expression “too big to fail.” Obviously there was more involved in this catastrophe than simple loans. The root of the problem was a small bank in Oklahoma which made a series of questionable loans to oil wildcatters and sold the loans “upstream” to major banks such as Continental Illinois and Chase Manhattan. The problem is not just the ability to make a loan, however questionable, but the ability to sell the loan as an asset to someone who may know nothing about the viability of the underlying venture. A similar dynamic was at the heart of the financial crisis of 2007 when questionable mortgages were packaged as securities and sold to institutions that knew nothing about the original borrowers.

Usury may be morally questionable and debt financing of risky ventures may cause instability in the economy, but it is financial markets that cause catastrophes to spread like wildfire around the globe. [see Financialization]

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