jmherbenerIf some people have higher time preferences and others lower time preferences and they are willing to engage in mutually advantageous lending and borrowing, the the market is “healthy” if the trades are made and “unhealthy” if the government prevents the trades from being made. Whether or not those with higher time preferences are wise to take on the debt is not a question that can be answered by economics reasoning alone.
At best, economics can explain the distinction between sustainable indebtedness and unsustainable indebtedness. In the unhampered market, the lenders will assess the likelihood of the borrowers to pay back their loans. They will lose if they overestimate the willingness and ability of the borrowers to pay back and they will gain if they accurately estimate. Thus, indebtedness is regulated in the market by the same profits and losses that regulate the production and exchange of anything. As I cited in a previous post, the average American household is much more indebted today than a hundred years ago. But, the bulk of that debt is sustainable because the average American household hold more assets. There is nothing unsustainable about a young person borrowing to buy a house and using his future earnings to pay for it.
Unsustainable indebtedness comes about when the Federal Reserve engages in monetary inflation and credit expansion. Some of the creation of credit is extended to borrowers who have neither the willingness nor the ability to pay back their loans. Banks are willing to do this because Fannie Mae and Freddie Mac created massive secondary markets for these sub-prime mortgages. The banks would earn the fees to write mortgages they knew would not be paid back and then sell them to Fannie and Freddie. The Fed is the source of unsustainable indebtedness in our economy, both private and governmental.