Is Debt Always Bad?

We have seen from last week's discussion how Greece is suffering from its massive debt, and from that it is very easy to assume that debt, both public and private, is alway bad... but is it?

The answer is no. Borrowing money and being in debt in the short run increases your capital and gives you the opportunity to invest in something you may not be able to afford at that moment. This is important for decision makers so that they don't have to wait until they have sufficient money and delay their investment plans. It also increases their responsiveness to the changes in the economy so that they can make their investments in a period of time where the economy is doing well.

To determine whether a debt is good or bad we must consider the balance between the risk and the return of the investment. If the risk (reflected through the interest rate) is high and the return (or net gain from the investment) is low, then overall the investment is not worthwhile and the debt is considered bad. In other words, there is no point to be in debt. On the contrary, if the risk is low and the return is high, then this is a good investment and it makes sense to be in debt in the short term. The balance between risk and return shows how easily is the debt repayable and thus is a good indication whether the investment is worthy or not.

This is why a student loan is usually considered a good debt. Education provides a valuable asset that is very useful in the future, therefore high return. The interest rate for student loans are usually very low, therefore low risk.  The same goes to real estate loans.

The key is to not to borrow excessively and be in more debt than you can afford to. Governments and individuals must evaluate and judge whether their decisions to be in debt will bring long term benefits and whether the debt will be repayable. If it is a "yes", go ahead and borrow; if it is a "no", don't bother because it is not worth your while.

The Problem with Greece

Things are not looking good in Greece.

Many of you will have heard from the news about Greece's massive debt crisis. In 2011, the debt has accumulated to 356 billion euros, which is equivalent to 165.1% of it's total GDP, and is forecasted to be around 181.2% of its GDP by the end of 2012. The economic situation in Greece is made worse by the global financial crisis in 2008, which resulted in Greece facing negative economic growth for three years in a row, going into its fourth year.

          

Source: IMF World Economic Outlook

As economists it is important we ask ourselves this question: why is Greece in its position right now?

Over the years, Greece had a serious issue of overspending and "was living beyond its means" (BBC). When Greece decided to join the eurozone in 2002 and started to use the euro as its official currency, it made borrowing much more easier and public spending went to a new all time high. This was the start of its "debt funded spending spree", when the government spent excessively with money they don't have.

A good example of this is the 2004 Olympic games in Athens. It is hard to deny that it was a truly spectacular event and I remember myself staying at home watching live coverages all day long. However, little did I know about the overspending and the negative impact it had on Greece's economy back then. The initial budget for the whole event was 4.5 billion euros, but in the end they spent a total of 9 billion euros - double of what they had expected to spend in the first place! 

Here is a graph showing the level of Greece's public debt, as a percentage of total GDP, from 2004 to 2010:

Source: http://www.indexmundi.com/g/g.aspx?v=143&c=gr&l=en

The percentage debt actually decreased from 2004 to 2007, but do remember that it is still very high (around 100% of GDP). The economy started to do badly in 2007, and as a consequence the government received  less tax revenue from the working population. Tax evasions were also very common. In the end the government cannot cover the budget deficit and it "spiraled out of control".

This made Greece impossible to defend themselves from the global financial crisis in 2008, which widened the deficit even more. As a result, the debt levels continue to rise to a level that Greece was incapable of paying off its debt and ultimately had to ask the EU for financial assistance. Now after the second bailout (130 billion euros) there are yet no signs of recovery, and Greece still faces a couple of tough decisions ahead.