[MUSIC] Generally, in developed economies, sociologists and economists point to the fact that collective social values look to have shifted from thrift to extravagance, from living within our means to living beyond them and from attitudes that used to encourage saving to those that promote spending. New norms that were otherwise, inconceivable or at least never mentioned in public have gradually been embraced. Take for example, the remarkable news conference call by the leader of the wealthiest and also the biggest data nation in the world back in 2006. With the recession looming, President George W Bush asked Americans to simply, quote, go shopping more, unquote. At the time, I thought this was not only hilarious, but also a little bit crazy. Previous generations, after all were taught to tighten their belts during hard times and work harder not to go outspend each other at Walmart. Bush may have wanted to stimulate economic growth through spending, but I think he had this backwards. Just like other economists who followed his logic by routinely connecting consumer spending and economic growth as if the former is the cause, and not the result of the laggard. In other words, as we saw in course three on value, economic growth is derived from investments in assets, in education and in ideas. It does not come from consumption per se, nor does it come from spending on dead end, make work projects, which we can see in the bizarre spectacle of Chinese ghost cities that have resulted in a colossal failure to urbanize new areas. The important point is that our attitudes towards spending and debt are most often shaped and affected by what we hear, and see around us instead of by economic facts, and truths. In other words, by social norms more than by sound financial incentives. This is especially true about borrowing money, because that subject is still typically taboo. We rarely discuss and analyze debt comfortably out at the open with experts. Instead, we get little bits and pieces of information from potentially unreliable sources and then jump to our own conclusions. Even in the privacy of our own homes, it isn't uncommon for families to have a lot of difficulty navigating money matters, which can become a source of resentment tension and negative energy. There is yet another aspect about that that makes it so tempting. Remember, our discussions about the time value of money in course one on decisions? That was when we demonstrated how financial markets serve, as time machines that translate future values into present values today through changing levels of interest rate. Remember, the elegant formula for value is equal to the future cash flows divided by the interest rate? This illustrates something called the wealth effect. The wealth effect means that future cash flows become more valuable today, because they're being discounted at lower interest rates. Moreover, in markets, we saw the value of a stock today is based on discounting the future dividends it will produce. And in the subsequent course in value, we demonstrated that the value of a project today is derived from discounting its future cash flows. Generally, this holds for all future cash flows of any asset, whose present value increases when lower interests are used to discount them. This is very important for our conversation about debt. Because when present values increase, you can borrow more. In other words, if the value of your business or your home or for that matter your retirement portfolio goes up because of low interest rates, lenders will be prepared to allow you to borrow even more money against the value of those assets. The financial system in essence converts future income into values observed today, which affects investment, consumption and borrowing decisions that are themselves influenced by interest rates. If you consider today's record low interest rates, do you think we have borrowed enough or we have borrowed too much? If we borrow too little from the future cash flows, we risk of not realizing our full economic potential, which has its own set of consequences. These can mean becoming uncompetitive and unproductive, which would lower our living standards or say, we are in Greece or in another region where severe austerity measures have been imposed on us. Meaning, significant cuts in the government spending have occurred. In this kind of situation, borrowing is generally avoided, which may seem wise at the surface level. But without borrowing to put cash into the economic system, cuts can end up strangling the economy, because there's just not enough money to move around. The cash flow is simply inadequate. History has proven that this is often a recipe for strikes, for civil unrest and political turbulence, none of which puts people to work or none of which which creates more revenue. Or for that matter, solidifies the economic situation. On the other hand, we know that if we borrow too much, our indebtedness will create all kinds of pressures and risks. If we borrow to excess, so that we over-invest and create too much output, then there isn't enough demand for the goods and services that are over-produced. We get what seems to be happening today, which is slow or zero growth. This is also called a deflationary environment. If we have too much supply for the amount of demand, eventually, the output shrinks leading to zero or no growth opportunities and that results in economic stagnation. A classic example of deflation in a major economy is Japan, which has so called lost 20 years since its asset prices collapsed in 1991. The collapse in 1991 triggered a drop in GDP, falling wages and stagnant price levels. Japan is still struggling its way back to its 1991 levels since. Borrowing against assets that are overvalued or mispriced by the market is a dangerous side effect of too much borrowing. Say, your savings are held in funds comprised of overvalued bonds and stocks. When the markets correct and assign lower values to these securities, but your debt remains fixed, the likelihood of default dramatically increases and people relying on scheduled repayments are at risk of getting poor very quickly. A famous example of this is what we know as the housing bubble. In a super hot real estate market, the values of houses rise beyond the real values of both properties. When home owners borrow against those inflated values, meaning, they take out a mortgage to purchase an overvalued home and then the real estate market later corrects, we end up with people owing more of their homes than their homes are actually worth such as a mortgage of $500,000 on a home that is now worth say, $300,000. The term for this situation is an underwater mortgage. And often, people in this situation will just walk away from their homes. Generally, views and attitudes of individuals, institutions and governments shape the difficult question of how much debt any sector can sustain. Every time a lender strikes a deal with a borrower, there is a signal that feeds into a wider level of awareness of similar decisions, which leads to a new normal. Over the past two decades, we have shifted to a new normal of accepting more and more debt. In other words, most financial decisions that involve borrowing are not called rational calculations that are guided by logic. Rather our disposition towards borrowing reflects the norms, the financial fashion of the day. These norms are shaped by competing choices where it's easy to lose sight of the big picture and this loosing sight happens in a negative ways in all sectors of the economy. For example, I'm willing to bet that many of us spend more time trying to save a few dollars on purchasing an online ticket or on groceries for that matter. Transactions are relatively lesser than important than we do, understanding our mortgages and finding the right mortgage for our needs. A move that could save us tens of thousands of dollars over the lifetime of the mortgage. This and similar examples of hyper consumerism financed through debt. Speak to the erosion of a culture that once resisted debt. So, let's now ask the hardest questions to answer. How much debt is too much debt? How do we know where to draw the line? And how do debt levels in one sector of the economy affect the health of other sectors? As we consider these questions throughout the course, we'll focus on the borrowing behavior of households, then on the behavior of key companies and institutions. And then when we get that part sorted out, we'll tackle the most debt tempted part of our society, our government. We can fix that. We'll have made the ultimate financial correction and maybe we'll help our societies resist temptation a bit better than our friend Oscar Wilde could.
