In the world we know as consumers, debt allows us to buy things now and pay for them later, by basically agreeing to pay a lot more for those things than they actually cost. In the world of investing, debt magnifies the profits of other investments.
It’s easy to understand how. If you have an investment in mind that you expect a 10% return from, and you have $100,000 to invest, you expect to make a $10,000 profit. But if you can borrow another $900,000 at 5%, you can make 10% on your initial $100,000 plus 5% on the $900,000. You’ll earn 10% but have to pay 5% to the bank as interest. So your profit will end up being $55,000!
The problem is that debt magnifies profit, but it also magnifies risk. The 5% interest you owe the bank on the $900,000 has to be paid no matter what, and that comes to $45,000. So long as your 10% estimate is accurate, life is good. But if there is a bad year and your rate of return is actually 0%, life is terrible. Had you only been using your own $100,000 you wouldn’t have made anything but you wouldn’t have lost anything. But now, because of the money you borrowed, you are actually in the hole $45,000.
When times are good and profits are strong, there tends to be a pervasive tendency for both borrowers and lenders to discount the risk side of this equation. Since the more money is borrowed, the higher profits will be, investors ask to borrow many, many times over their own actual investment money. Lenders only make money when they are lending it, so there is also a profit motive for them to dismiss risk as unlikely.
Calamity strikes when borrowers leverage their investments so much that when their investments don’t perform as hoped, they end up unable to pay back their loans. When this happens systemically, banks get can lose billions and billions of dollars, which limits their ability to lend, which creates a ripple effect through the entire economy.
This is how the stock market crash in 1929 evolved into a series of bank runs and then into the Great Depression. It is also what has happened to the American economy in 2008, what happened to the Japanese economy in the early 1990’s, and what has led to nearly every major financial bloodletting in modern times, around the entire globe.
In fact, a simple rule that no entity of any kind is allowed to borrow more than a certain multiple of their asset base would prevent, arguably, all future financial meltdowns.