Dealing with debt, a moral hazard

Have you ever seen Wile E. Coyote in the “Road Runner” cartoons when he routinely runs off a cliff, hangs suspended in midair until he looks down - and only then, according to cartoon laws of physics, does he drop?

Such a caricature may be used to illustrate what economists call the Minsky moment. That is when, after a period of time when people have forgotten the hazards of accumulating too much debt, they casually allow debt to accrue to unmanageable levels.

When people belatedly realize that their debt load is too heavy, borrowing does not immediately come to a halt. But soon after, their finances collapse, and in a sense, they drop out of sight

So today, Korean household credit card overuse is what is keeping some country risk managers from getting a sound night’s sleep. As was recently reported, current South Korean household debt is now in the ballpark of $600 billion. One may wonder if the Koreans are using plastic with a “Who? Me worry?” MAD-like attitude - and whether after a dozen or so years, Koreans have largely forgotten the trauma of the IMF crisis

But don’t get me wrong. In normal economic situations, debt is a healthy way for people with too much cash to be able to park their money in a productive way by allowing other people to use those funds while repaying the lender with interest.

Yet debt can be what economists call a “moral hazard” - when one party takes out a loan and places the risk on the lender or others of possible non-repayment. It helps to note that in the circles of 18th-century mathematicians, “moral” meant “subjective” in evaluating decision-making. A hundred years later in the insurance industry, the term routinely achieved its negative nuance that remains with us to this day

In any case, Seoul seems to contradict all the doom and gloom reports about the economy. Visitors to Korea are often struck by the vibrant commercial activity that is happening busily about us. But upon closer examination, virtually all transactions - no matter how small - are being paid by credit cards. All of this is possible due to Korean card issuers’ subjective or “moral” risk policies.

We should remember that it was the IMF crisis that motivated the Korean government to promote credit card use to stimulate spending while providing retail paper trails to increase taxes. And to make this scheme really work, merchants have been required to accept credit cards for even smaller transactions than would normally be accepted in other countries.

Given all of this, Korean families routinely use four to five cards per adult to make all kinds of purchases while using cash sparingly. In doing so, Korean families have an inflated sort of wealth that can be used for fashion accessories for young people to paying for after-school cram schooling for the students, etc. The important point is that all of these transactions are helping to keep this economy humming - even if it all may seem like a giant Ponzi scheme.

And it really could be a Ponzi scheme, unless the following takes place. First, the economy must continue to grow. And second, borrowing and accrued debt must be moderate, relative to that growth.

Currently the Korean economy is reckoned to be growing at 3.3 percent, with next year projected to be as high as 3.8 percent. Meanwhile, household incomes on average have been growing at about 4 percent, with household debt accruing a bit more than 5 percent. Normally, a partial offset to debt is inflation that cheapens accumulated borrowing.

The problem is when inflation rate fails to adequately depreciate debt. From what we gather from the news media, South Korea is facing a 14-year low of only 1.18 percent annual average consumer price index inflation.

Nonetheless, credit card borrowing continues, with many Korean card users routinely passing debt around from one card to another to yet another.

I have a Korean friend who has lived better than his siblings while consistently earning the least. How? He and his wife have become experts in moving debt from one card to another and to yet another - often a new - credit card. He plans to pay it off with an early retirement bonus and severance pay. After that, I’m not so sure, but he has always been crafty in coming up with something, such as getting money out of his sons, one of whom has become a physician.

Unfortunately, not all Korean families spawn doctors, lawyers and highly successful business people. Many may well be chasing that metaphysical roadrunner bird of higher lifestyles without realizing that they have run off a cliff.

Like Wile E. Coyote, even Koreans cannot withstand the pull of gravity. Yes, Koreans are famous for managing their economy and their households in a remarkably overleveraged fashion. But sooner or later if the money is not paid off, the borrowers must drop, leaving the risk takers holding the debt.

In isolation, these events are anecdotal, but in aggregate, we could have a real problem on our hands - particularly if a major international economic crisis once again visits this market, pushing many credit card users off of the cliff. Following the recent close call, when the U.S. Congress threatened to not raise the debt ceiling and thereby cause an unexpected global financial crisis, today many financial professionals still have good cause for concern.

*The author is president of Soft Landing Consulting, a sales-focused business development firm, and senior adviser to the IPG Legal group.

by Tom Coyner