I’ve been wondering what would be the best ‘rules’ for debt. For example, during the 90’s depression here in Finland, a lot of people were left with debt that they could never repay. Most of these people had no incentive to work due to the heavy debt. Only recently has the situation improved as the government stepped in to mediate settlements and payment plans (though the intervention is mainly symbolic, since 10 years of unemployment and, more often than not, alcoholism are not easily reversed).
As far as I understand the problem, it was mainly because debt was tied to persons, instead of collaterals etc. And the people found themselves at a dead end when the collaterals had fallen in price and couldn’t cover the debt anymore. The end result, in my view, was very disasterous since the debtors didn’t receive their loan anyway (and the original debtor had probably already sold the loan) and still left a massive section of the populace (in this case, some of the most industrious entrepreneurs) in a hole with no way to climp up.
So how would debt collection be handled in a free economy?
The current situation can only occur under a system of central banks setting artificially low interest rates, whereby the “gap” between savers and debtors is made up by fractional reserve banking, and money is simply created ex nihilo as debt. Thus we have a situation of people heavily in debt, and the concept of “net debt”.
No such thing as perpetual net debt could exist in a free market, as people would only be able to borrow what others save, hence leading to higher interest rates than we see today. In such a situation, savers have an incentive to save, and creditors have a disincentive to borrow, thus eliminating the problem you describe.
If you haven’t already, I recommend you read up on Austrian Business Cycle Theory to see how these artificially low interest rates not only cause consumption booms, but also mal-investments, resulting in the boom-bust cycle.
I suppose that was an enlightend view in its era. A generation earlier the question might have been “Are there no transport colonies?” or “Are there no slave buyers?”
Indentured servitude was another option at various times, I suppose. What kind of useful service one might get out of a subprime speculator deadbeat might be another question.
Under free market conditions the creditor will eventually sell the debt to a collector at a discount. As time goes by and the debt remains unpaid it will get sold repeatedly at lower and lower prices until eventually there is an intersection between debtor’s ability to pay and his desire to clear the debt and end the collection efforts. Both the bankruptcy laws and the laws which regulate how long a bad debt can stay on a credit report have the affect of making debt more expensive for everybody.
Also, there is no need to consider alternatives like servatude or prison. Those options presume that it is some kind of a crime for a creditor to lose. But a loan is just a business venture like any other. And lenders deserve no protections beyond those agreed to in their contracts (ie. forclosure of collateral).
I know the example I described is a creation of central banking. I was mainly interested in what the prevailing view here is on the issue. For example, is the issue purely one of contractual arrangement, so a lender and a debtor could agree that, in the case of a default, only the agreed upon collateral is lost. Or would there be an ‘automatic’ extension of the debt beyond the collateral if the collateral doesn’t cover the debt?
DBratton is essentially correct but he misses one important part of the process. The lender would bundle the delinquent loan into a portfolio of thousands of delinquent loans with similar underwriting and delinquency characteristics. For example, a portfolio might consist of loans that were made to individuals and that were 60 days past due. The loans would all be either unsecured or secured by a similar asset.
The buyer of the portfolio would have statistics indicating what percentage of these loans was eventually paid and how long it took to pay them. In this way, case probability would be converted into class probability (see Human Action for an explanation). The price paid for the portfolio would reflect the fact that some of the loans would never be paid and would discount the remaining loans to account for the number of months that it would take to receive payment. The buyer would then put forth its best efforts to collect as much of the outstanding loan money as possible. It would most likely offer to forgive portions of some of the loans in return for a reduced payment.
This is essentially what J.P. Morgan is doing with the Bear Stearns loan portfolios, although they were given $30 billion by the Fed to fund the process.
You’ve only asked half the question. Even more important is, how would debt creation be handled in a free market.
Without the easy credit enviroment, houses prices would fall dramatically. This would be very beneficial because people would be more likely to own their own home and not have a mortage, and those mortages that existed would be much smaller. Housing prices are constantly held above their natural level and this is used to extract money from people through mortgages.
Goods could(and would) be bought “on credit” without the need for a bank or any lender at all. Today many people pay up front for a car with cash gotten from a bank, then repay a bank slowly. But thats unnecessary, people could pay the manufacturer in installments without any cash changing hands up front.
This is why people who talk about the “demand” for money are completely ignorant. Once the supply has been created people will use it, but there is no “demand” for inflation, if the money supply stopped being continually inflated people there would be no decline in goods exchanged.
Of course, in a free society choosing to not work in order to not have to repay a debt would not be an option. There would be no welfare state to support you in your idleness.
People would be more careful about what what they lend out as well, because they will not have State violence to ensure repayment.