In his recent post, Ray Dalio [investor and hedge fund manage] shared his thoughts on debt and equity.
He says the following:
What I mean by that is that debts have to be paid above all else. For example, if you own a house (i.e., you have “equity” ownership) and you can’t make the mortgage payments, the house will be sold or taken away. In other words, the creditor will get paid ahead of the owner of the house. As a result, when your income is less than your expenses and your assets are less than your liabilities (i.e., debts), you are on the way to having to sell your assets.
Unlike what most people intuitively think, there isn’t a fixed amount of money and credit in existence. Money and credit can easily be created by central banks. People, companies, nonprofit organizations, and governments like it when central banks make a lot of money and credit because it gives them more spending power.
When the money and credit are spent, it makes most goods, services, and investment assets go up in price. It also creates debt that has to be repaid, which requires people, companies, nonprofit organizations, and governments to eventually spend less than they earn, which is difficult and painful. That is why money, credit, debt, and economic activity are inherently cyclical.
In the credit-creation phase, demand for goods, services, and investment assets and the production of them are both strong, and in the debt-repayment phase, both are weak.
In a perfect world, ceteris paribus, using debt to build wealth makes perfect sense. The advice is to always, or rather risk, other people’s money instead of your own. The interest on the loan repayment is tax deductible.
But we don’t live in a perfect world, things happen.
Some people decide to land some planes in twin towers in a foreign country and boom, markets tank, interest rates increases, suddenly your income is compromised and you are unable to pay your debts.
Covid-19 is another proof. People lost their jobs, and subsequently lost their houses.
Country X wants to build an airport. They take a loan from country Y. Life happens, and Country X is unable to repay the loan to Country Y. Country Y takes over and owns the airport in Country X. Trevor Noah digs deeper into this scenario: Why China is in Africa
Debt eats equity.
The lessons is straightforward, we don’t live in a perfect world, relying on people’s things is not good, they will wake up one day and decide they want their things back and you will be left in the lurch.
You are better off owning things than relying on someone else’s things.
In my African Sepedi proverb we say: mphemphe ya tswenya, motho o kgona ke sa gagwe. Loosely translated: always asking/borrowing things is burdensome, you are better off having your own things.
Off-course Ray Dalio has put it in a sophisticated financial language. If one cannot service their debts, their assets will be sold or taken away.
“Debt eats equity” my quote of the year.