The risks of being a lender

Here in Canada we are going into RRSP marketing season. RRSP stands for Registered Retirement Savings Plan.  If you put savings into one of these plans you don’t have to pay income tax on it.  It is taxed when withdrawn, presumably when your income is less and you pay a lower tax rate.

This might be a good time to think out what happens when you make a bank deposit or give somebody a loan.

Money is a tool, or a lubricant,  to facilitate the exchange of goods and services.  It gives one purchasing power.  When you have money you can use it to purchase goods or the labor of another person or persons.

When you hand over some of your money to another person (or institution) you are transferring that purchasing power.  When you give it to a financial intermediary, i.e. a bank, that institution passes on your purchasing power, probably along with that of other people.  This gives the final borrower a larger amount of purchasing power and the ability to undertake  larger projects than any ne person could do by himself.

All this is done in the expectation that the final borrower will make enough profit to repay the loan with interest.

The industry which promotes this process likes to promise depositors fantastic returns.  However, there are two things that can go wrong.

First the final borrower may go bankrupt or not make as much money as planned or not enough to cover principle, interest and commissions.  In this case the original owner of the purchasing power will take a “haircut”.

The second problem is inflation.  A depositor may get his/her money and interest back but if there has been inflation the purchasing power of that money will be proportionately less.

During the years of prosperity with everything going up these problems have not been serious.  As we go into recession things may be different.

What about loans to government in the form of bond purchases? The same thing applies except that governments don’t expect to make profits on their spending.  If their huge borrowings are to ever be repaid it will have to be out of taxation and user fees or reduced by inflation.

During the hyperinflation in Europe following the first world war a lot of holders of government bonds lost their savings.  It appears the current holders of Greek government bonds are going to take a substantial “haircut”.

I still think the best investment these days is a market garden.

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2 Responses

  1. Hey Art!

    Can you please explain market garden?

  2. A market gardner sells his product, mosly fruit and vegetables, directly to his /her customers either from the farm gate or at farmers markets

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