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November 27, 2011

Global Debt Crisis

We know that the world's financial situation is not too good and that it is affecting everybody's lives. The financial media  have not stopped talking about the crisis in the world economy.

For the average person, most of it is too difficult to comprehend. There is nothing that you and I can do about it, either.

The recent Business Insider carries an article which quotes hedge fund manager Kyle Bass. I think this analogy is worth sharing:

Capitalism without bankruptcy is like Catholicism without hell.

In the article, Henry Blodget, a well-known Wall Street analyst, attempts to explain the world debt crisis and points out a fair solution. Written in plain English, it is definitely worth a few minutes of  your attention.

2 comments:

Anonymous said...

For anyone who cannot understand the present financial crisis of the whole western world:

A Modern Fable
-----------------------
Mary is the proprietor of a bar in Dublin . She realises that virtually all of her customers are unemployed alcoholics and, as such, can no longer afford to patronise her bar. To solve this problem, she comes up with new marketing plan that allows her customers to drink now, but pay later. She keeps track of the drinks consumed on a ledger (thereby granting the customers loans).

Word gets around about Mary’s “drink now, pay later” marketing strategy and, as a result, increasing numbers of customers flood into Mary’s bar. Soon she has the largest sales volume for any bar in Dublin .
By providing her customers’ freedom from immediate payment demands, Mary gets no resistance when, at regular intervals, she substantially increases her prices for wine and beer, the most consumed beverages.
Consequently, Mary’s gross sales volume increases massively. A young and dynamic vice-president at the local bank recognises that these customer debts constitute valuable future assets and increases Mary’s borrowing limit. He sees no reason for any undue concern, since he has the debts of the unemployed alcoholics as collateral.

At the bank’s corporate headquarters, expert traders figure a way to make huge commissions, and transform these customer loans into Drinkbonds and Alkibonds. These securities are then bundled and traded on international security markets. Naïve investors don’t really understand that the securities being sold to them as ‘AAA’ secured bonds are really the debts of unemployed alcoholics. Nevertheless, the bond prices continuously climb, and the securities soon become the hottest-selling items for some of the nation’s leading brokerage houses.

One day, even though the bond prices are still climbing, a risk manager at the original local bank decides that the time has come to demand payment on the debts incurred by the drinkers at Mary’s bar. He so informs Mary. Mary then demands payment from her alcoholic patrons, but being unemployed alcoholics they cannot pay back their drinking debts. Since Mary cannot fulfil her loan obligations she is forced into bankruptcy. The bar closes and the eleven employees lose their jobs.

Overnight, Drinkbonds and Alkibonds drop in price by 90%. The collapsed bond asset value destroys the bank’s liquidity and prevents it from issuing new loans, thus freezing credit and economic activity in the community. The suppliers of Mary’s bar had granted her generous payment extensions and had invested their firms’ pension funds in the various Bond securities. They find they are now faced with having to write-off her bad debt and with losing over 90% of the presumed value of the bonds. Her wine supplier also claims bankruptcy, closing the doors on a family business that had endured for three generations, her beer supplier is taken over by a competitor, who immediately closes the local plant and lays off 150 workers.

Fortunately though, the bank, the brokerage houses and their respective executives are saved and bailed out by a multi-billion euro no-strings-attached cash infusion from their cronies in government. The funds required for this bailout are obtained by new taxes levied on employed, middle-class, non-drinkers who have never been in Mary’s bar.

Now, do you understand economics in 2011?

ak3 said...

The Henry Blodget article referenced in the blog is simple and well written and lays out the problem and the solution; both of which are simple. The obvious reason that the solution is not being followed is because of the political system in all the concerned countries. Politicians know the solution but they cannot offer themselves as the sacrificial lambs in this drama. Whoever forces the borrower and lender down the path of real austerity and real write-downs, respectively, will himself be joining the list of unemployed! As such, it is the correct decision from the politicians perspective to "kick the can down the road" with half-measures.

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