A Disquisition on the Nature of Debt

Daniel Davies over at Crooked Timber:

What is debt? It’s a promise to pay back a specific amount of money at a specific time. Why is it so popular – why do people always seem to end up getting into it? Why, for example, don’t people make more equity investments, buying a share of someone else’s profits and sharing their risks in the way in which Islamic banking is meant to operate?

Basically, because debt has one big advantage, and it’s the same advantage that market economies have over command economics – it’s really really efficient in terms of the amount of information that people need to gather about each other. If you’re lending money under a debt contract, all you need to think about is Do I think this guy is good for the money?, and all the borrower needs to think about is Can I pay this back?. If you’re trying to make an investment and share the risks, all sorts of other questions come into play: How much could this be worth in a really good outcome? What further projects might grow out of this one? What effect will the sharing of the upside and downside have on the way the thing is managed? Am I selling my shares too cheap?.

If you’ve ever watched “Dragons’ Den” (the format was broadcast as “Shark Tank” in theUSA), you’ll note that the real human drama in the series is not really when the entrepreneur is pitching his or her new invention. What people come to watch that show for is the bit where one of the investors makes an offer. The guy has said he wants £200,000 for 10% of his company, and Duncan Bannatyne or equivalent says he’ll give the money, but he wants 40%. And the entrepreneur sweats on the spot. This, in microcosm, is the stuff that gets cut out of the process when you’re dealing with debt rather than equity. David Graeber wrote a whole gigantic book, one of the messages of which was that from an anthropological view, debt contracts denatured exchange relationships and took them out of their context of cultural human interactions, but in my review, I noted that Graeber didn’t seem to appreciate the extent to which this is a collossal time saver. Having a debt relationship with someone means that they don’t really care all that much about your project as long as you pay them back, but that’s a good thing; it makes investing much less intensive in time and effort.

More here.