Not So Outlandish
One of the chief complaints from commenters so far is that economic growth would come to a grinding halt. That's true, at first. But once the financial system completely deleverages, it would resume to a normal, sustainable level. Borrowing wouldn't be allowed, but investment could still occur. Equity would be perfectly legal -- and is far more preferable.
Start-ups would instead have to rely solely on equity investment rather than debt. Imagine if, instead of an interest expense, all companies just had a dividend payment to worry about. Remember: there would be no tax benefit to debt anymore, so why wouldn't equity be preferable to debt?
The credit markets wouldn't be entirely eliminated -- even without debt. Rents and leases would grow. They would take the place of some mortgages and loans. When people actually save their money over time, they can pay in full for homes, cars, and other items if they choose. No one's way of life would change that drastically, except that they wouldn't be tens or hundreds of thousands of dollars in debt: they would have to actually save money before they buy something.
A Healthier Economy
What about homeownership? What about college? How would all of this ever be paid for? Some of part of all of these big credit-driven purchases would shrink. But that's not necessarily a bad thing.
Homeownership obviously got way out of hand, as more people purchased homes than could remotely afford them. And as mentioned, these people won't be on the streets -- they'll just rent instead. Besides, buying a home is highly overrated.
For education, the same could be said of college. It could easily be argued that too many people go to college today. Is a Bachelor's degree in Anthropology from a little private university no one has ever heard of that costs $35,000 per year really economically preferable to an Associate's degree in nursing from a community college that cost a tiny fraction of the price? You would also see parents starting to care more about saving for their children's college, because student loans are no longer an option. I think the prospect of young adults questioning whether college is worth it and starting their lives debt free sounds pretty good.
But in general, what you'll also see is asset prices relative to wages decline. If fewer people could afford education and houses, then their prices would have to drop as demand declines -- and they should. Frankly, economic equality will probably increase. Profits at the high end of the spectrum will have to be lower in order to sell products, but salaries for the masses won't come down as much. Too much consumer credit actually leads to greater inequality, since the lower- and middle-income consumers feel they have more purchasing power than their actual income dictates. Credit keeps the masses ignorant and blissful.
It Will Never, Ever Happen
But rest assured, as intriguing (or awful, depending on your perspective) an idea as this is, it will never, ever happen. It's about as politically poisonous as you could begin to imagine. The transition period would be absolutely dreadful. Imagine a heroin addict going through withdrawal. Now imagine 300 million of them going through it at the same time.It wouldn't be pretty. Our society is far too addicted to credit to ever humor the idea of ending it entirely. Indeed, we'll be lucky to deleverage enough as a nation to merely avoid collapse in the decades to come, much the less coexist healthily with credit.
A few people who read the idea commented on the oddity that it would come from me, given my background in investment banking -- specifically in credit markets. This is worth a story. When I first learned about securitization, I understood its benefits. But I also quietly played devil's advocate with myself, wondering -- what's the point? Why sell debt-driven cash flows to investors? Why wouldn't the bank just keep the loans to themselves and reap the profit? Other than the cynical view that the bank didn't want bad loans, securitization increases credit, since the bank gets more funding to make more loans to additional people. It would then securitize the loans again, ad infinitum.
At some point, you have to wonder whether all this money is real. And, indeed, that's precisely what happened and helped to create a huge bubble, which caused the world economy to shake on -- and almost spin off -- its axis. The problem with leverage is that it grows and grows and grows, because everybody loves it. The lenders are happy to get fees and interest income, while the borrowers like the products they can enjoy now and worry about paying for later. It's instant gratification at its finest.
But it's bound to fail. It's a nice fantasy to think that we will keep debt in check, on the personal or government level, but it's like a hard drug user saying he has the habit under control. Credit is just too delicious and hypnotizing a force to use in moderation, which is why I suggest humoring the idea of eliminating it entirely. Even though it will never happen, at least it could start a dialogue about weaning ourselves off our credit lines.