Representational image. PHOTO: REUTERS
KARACHI: Economics is a social science where millions of factors interact to produce results.
Due to the intricacies and interdependencies of this huge magnitude of factors, understanding and predicting economic variables has always been a challenge for the professional economists. But one approach has always paid dividends and that is going against conventional wisdom.
What most people do may not be beneficial and the path trodden by a few produces phenomenal results. This intuition is in line with the law of diminishing marginal utility - in my view the most powerful law in economics.
Among the pearls of conventional wisdom, the most ingrained is the philosophy of saving money. In eastern cultures, children are indoctrinated with the merits of savings over consumption and debt is always considered bad and troublesome.
Due to this indoctrination, children develop an innate aversion to debt and a childish fondness for savings. This attitude deserves practical investigation.
Savings refers to the activity of storing money for future use or investment – benefits of which to be reaped in future. Debt, on the other hand, refers to borrowing money today for buying any asset or financing accumulated assets.
The idea behind savings is that the money saved grows over time. On the other hand, borrowers have to pay extra cost for the debt they have incurred.
The problem with savings primarily arises when savings are made in the form of money. This is due to the fact that money loses its value over time due to inflation and printing of money by central banks.
Robert Kiyosaki – the author of bestseller “Rich Dad Poor Dad” – has always vehemently despised savings in the form of money as money loses value and at the same time he has always been a great proponent of debt affinity for this purpose.
Let’s go through a practical example to illustrate this point.
Let’s assume someone bought an apartment five years ago in Karachi for Rs4.5 million. This apartment was financed up to 90% through a bank loan. Over a five-year period, the value of the asset increased up to Rs12.5 million.
With average 10% interest rate, the interest paid on a Rs4-million loan over the five-year period would max out at Rs2 million whereas capital gain booked on the asset is around Rs8 million.
On the other hand, some naive saver must have deposited Rs4 million at the same time and he would have made less than Rs2 million over the same period.
Hence, the borrowers won big time!
Another big advantage of debt is that in certain situations ie for companies, the interest is tax deductible, which means it reduces tax liability for the borrower as well.
The primary reason for this disparity and counter-intuitive practical and extremely real example is the money printing frenzy of the central banks. As more and more money is printed ie money supply is increased, the currency loses value. As for everything if the supply is increased, the value nosedives.
Rupee-savers face one more challenge and that challenge is in the form of the axe of devaluation which hangs over their heads. In the last two years, the rupee lost 40% of its value, which means the rupee savers lost 40% of their savings.
Had they bought a Toyota Corolla two years ago with that saved money, they would have been better off.
It is not to be suggested that debt is always good. There are forms of bad debt. Credit card, in my view, is the worst form of debt as the assets generally bought from credit cards do not last long and do not create long-term value. However, mortgages and debt for the purpose of investment in business are generally good forms of debt.
Hence, the debt brings its own challenges as well. But if we play with it carefully, we can generate real financial value for ourselves.
This is the reason why the really rich people are always dipping in debt from toe to hair. It shields them from inflation, protects them from devaluation and depreciation of the currency and saves a lot of money in the form of tax. It also helps them accumulate valuable assets in the long term.
The writer teaches economics
Published in The Express Tribune, January 20th, 2020.
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