Friday, October 24, 2008

To owe or not to owe

There is no doubt that the economic crisis in the US will get worse and thousands more will lose their jobs. As I indicated in an article a few weeks ago, the original bailout plan fashioned by Congress would not have had any effect on the credit or equity market because it did not address the underlying problem, but rather sought to deal with wiping the blood from the wound rather than putting a stop to the bleeding. It wasn't until after the statement that interbank loans would be guaranteed that some hope of credit came back to the market, thanks to the solution proffered by the Europeans.

In my own view it was not even necessary to commit any funds to the crisis, as all that was needed was to bring back confidence to the system. The amount of funds offered in any bailout plan will have no effect if a market loses confidence, because markets survive by the will of behaviour rather than any amount of funds or government intervention. The best role for a government is to support the natural laws of the market rather than intervene too much, as we have come to realise from our own experiences.

The effect of debt
The other consideration coming out of the current US crisis is the matter of debt. This is an effect we know only too well in Jamaica, as during the second half of the 1990s we began a path to racking up a level of debt that would eventually condemn us to the serious economic challenges we face today. I guess we can always boast that the great US followed our own strategy of living beyond our means and take some pride in the fact that we are in the company of the US.

As I have always said, the absolute level of debt is not an issue. So whether we owe $100 million or $1 trillion is irrelevant. What matters is the marginal return on each dollar of debt compared to the marginal cost. As long as the marginal earnings from each additional dollar we borrow is greater than the marginal cost, then it is okay. As soon as the cost of the debt becomes greater than the return from each dollar of debt, then it becomes an issue. So when debt is used for consumption rather than production it is always going to have a higher cost than the return, as maybe the only return one gets from consuming borrowed money is an increase in the numbers of "hangers on".

So what happened to Jamaica was that we borrowed money to support a lifestyle that we did not earn. In other words, even though we owe a lot of money which our grandchildren will continue to pay, we look good owing the money. Some of my friends argue with me that Jamaica is more developed than other countries in the region as we have better-looking cars, more cellphones and technology penetration, better-looking roads, and better houses. While this may be true, I don't think this alone is a measure of development.

This has been illustrated by what happened in the US also. And I have no sympathy really for anyone who by reason of their excesses find themselves in serious financial difficulties. Jamaica itself has earned the right to the economic difficulties we find ourselves in. No one put a gun to our heads and forced us to borrow the money and waste it on consumption and activities that cost us rather than provide us with a return greater than the cost of the funds borrowed. We made that decision on our own. The problem is that even those who had no part in the decision are suffering. Similarly no one forced the US consumers to find themselves in a position where the savings rate was negative. And while they were enjoying the fruits of poorly managed debt (the latest car, big house, etc) they never sought to share it with those who were being prudent. So why then when the chickens come home to roost do we hear of the difficulties being faced? Just as they were enjoying the previous excesses, then they should similarly enjoy the results of the excesses.

World crisis
Because of the excesses of the US economy over the years, the world is now faced with an economic crisis that will get much worse and which we will not be able to recover from for years to come. The basic principle of what happened is that the US consumer was living on debt with no real income to support the debt. So they would borrow money to buy a house and even while owing on the house then they would borrow money on the equity in the house for personal spending. Because everyone was doing it the market price of houses escalated beyond the real value, based on expectation, and seeing more equity in the house the consumer borrowed even more for consumption. The money that was borrowed on the basis of the artificially growing equity was not used for investment but rather consumption, which had no returns attached to it.

So when the prices of houses started to fall because of a fall-off in demand, the money borrowed based on the equity became a problem because the equity in the house had fallen off significantly. So the "poor" consumer ended up with a debt far exceeding the value of the asset, and what is more, because the market value of the asset was being driven by unreal expectations, then it will not for the foreseeable future come back to the peak value on which debt was borrowed.

This created not only an issue for the consumer but also the bank that lent them the money as the asset values on the balance sheet now started to decline, and the liabilities were increasing as loans grow based on the rate of interest. Now multiply this effect by millions of people and we have the current global financial crisis. The problem now is that we will not in a very long time recover the wealth lost, which will continue to lead to cutbacks in companies and personal consumption. The result is similar to a balloon that is quickly losing air and so gets out of control.

In Jamaica we did the same thing by borrowing money to postpone the medicine of market adjustments. We borrowed to control inflation, the exchange rate, and buy more cellphones and cars, building a few stadiums along the way. In other words we took part in the same excesses as the US consumer. But it was okay to do so as long as the world economy was growing as it meant that more wealth was being created and we could always get more money to borrow to support our "champagne" lifestyle even with our "soft drink" income. Our desire for the farcical development meant that we were always willing to borrow money to spend on consumption, as even though we owed a lot of money we looked good while doing so.

What has happened to Jamaica now is that the curtain has been closed on the grand global partying. The final act has been played and we find ourselves as actors out of work. We can no longer get money from foreign investments and debt as easily as we used to and even if we do it will cost us more. This will no doubt lead to us having to cut back on our national standard of living as the US consumer has to do. The difference between Jamaica and the US is that unlike them we have no reserves to help to cushion the effect of the crisis. So when one calls on government to intervene financially it seems as if there is a failure to understand that even in the good times the money that we were spending was never ours, and as a country we had no savings.

The only thing we can do as a country is cut back on our lifestyles and change fundamentally our production relationships. Of course another problem is that the economy is 70 per cent services, and without real production there will be little money to buy any services. Even as we move forward with this dilemma we will be tempted to borrow even more to ease the pain. The question will surface again, "To owe or not to owe". The answer has always been, and continues to be, only as long as the marginal revenue is greater than the marginal cost, and we ignore this at our own peril.


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