Debts

The difference between simple barter and the modern, international, financialised economy

Modern life wouldn’t be possible without debts. Imagine:

• Employees being paid in silver coins every day for that day’s work, and then paying with silver coins in shops.

• People having to save 100% of the price of a house before being able to buy it, instead of being able to move in after paying a 10% deposit and paying the rest while living there.

• An oil tanker having to carry a tonne of gold half-way round the world to exchange for oil.

Debts make a complex global economy workable—as long as people can generally be relied on to keep their promises.

What is a debt?

A debt is just a promise to give something to, or perform a service for, someone in the future. The person making the promise (the one who owes something) is called the debtor, and the person to whom it has been promised (the one who is owed something) is called the creditor.

A debt is created when the debtor makes the promise, and it stops existing (it is discharged) when the creditor agrees (or is forced to accept) that the debt is no longer owed. Normally this is when the debtor has paid the creditor what was promised, but there are other possibilities (e.g. the debtor going through bankruptcy).

A good way to picture how debts are created is to imagine a piece of paper perforated across the middle, with the top half green and the bottom half pink, like this:

Perforated paper used to create a new debt

To create a debt, the new debtor (Alice in the picture below) first writes what’s been promised on both halves of the paper:

Alice preparing to create a debt of one apple

Finally, the debtor tears along the perforation, keeps the pink half, and gives the green half to the new creditor, Bob. This actually creates the debt:

Alice keeps the pink half, and gives the green half to Bob

The pink half is called a liability. I usually call the green half a debt asset¹.

The simplest outcome is if neither Alice nor Bob passes on their half of the debt paper to someone else, and at some point in the future, Alice gives Bob an apple (not shown). When she does this, the debt is no longer owed, so Alice and Bob both throw away their halves of the debt paper, as we see below:

When the debt is no longer owed, both halves of the paper are thrown in the bin

That’s basically how debts work. A debtor promises to give something to (or perform a service for) a creditor in the future, and later on, usually after the debtor has kept their promise, the creditor agrees that the debt no longer exists.

You might be surprised to know that debts are the only thing besides barter that we need to understand in order to make sense of a world economy with multiple currencies, international trade and sophisticated financial markets. And most people intuitively understand debts already, so I’m convinced that most people can understand economics.

“Contingent” Debts

For completeness, I’ll mention “contingent” debts too. It sounds like it might be complicated, but you almost certainly understand the idea already. You can think of a contingent debt as a debt with a question mark hovering over it. Depending on what happens in the world, one of two things can happen. Either it turns into a normal debt, or it just disappears.

A good example is insurance. If you buy a year’s car insurance, it creates a contingent debt. If your car gets damaged during the year, the insurer now owes you a repair (or some money to get it repaired or replaced yourself). But if it doesn’t get damaged, the contingent debt just disappears at the end of the year and the insurer doesn’t owe you anything.

For anyone interested in more obscure topics, you can also think of copyrights and patents as contingent debts: if someone makes an illegal copy, the state imposes a new debt on the copier which is owed to the copyright or patent holder. Some financial derivatives, such as call and put options, are contingent debts too.

The fact that contingent debts always become something simpler means that most of the time we don’t even need to think about them. We just need to understand the effects of what they can turn into.

Debts and the One Lesson

The One Lesson of economics shows how an economy in which people create and use debts can be almost as simple to understand as a barter economy, which people generally understand intuitively already. And because the money we use nowadays is a debt (owed by a bank to the holder), we can safely ignore the claims of some economists that an economy with modern money is so different from a barter economy that most people can’t easily understand it. I’d go so far as to say that the One Lesson will let you understand economics better than a huge number of economists. Stick around and you’ll see!

1. Some people call it an IOU.