A Greek tragedy
Greece is a country rich in history and culture that is peopled by a warm and friendly race. It is a must-visit nation for any tourist. Is it an important country, though? Not really. In European terms its economy is an insignificant rounding off error, contributing merely two per cent to Europe’s GDP (gross domestic product, a representation of national income). And yet, Greece is threatening to begin a financial domino cycle of chaos in Europe.
Similarly, a small number of American investment bankers, numbering not more than a few tens of thousands, brought the entire world to its knees a few years back with their weapons of mass financial destruction. What’s going on?
Any discussion on this topic gets lost in complex terminologies and acronyms. Credit default swaps. Mortgage backed securities. Derivatives. Sovereign credit ratings. What in god’s name do these scary words mean? Actually, they’re not important. What is important is to understand what’s at the root of these problems.
At its core the problem can be expressed in one simple word: debt. But what is debt? Simply put, it is a loan from a bank to an individual, company or a country (there are other types of loans but they’re not important in the context of this article, so let’s ignore them). The debtor individual, company or country must repay the loan. If they don’t, the bank loses money. If too many debtors renege on their loan, the bank will go bankrupt. And remember, the bank does not have too much of its own money to lose. The money it loses belongs to its depositors. So if a bank goes bankrupt, many hard-working depositors find that their savings have suddenly disappeared. If the bank is large enough, it may cause such massive money losses that this may lead to an economic free fall. That is why the Western governments moved heaven and earth to save their big banks in the economic crisis of 2007. That is also why the actual moneybag in Europe, Germany, will be forced to do all it can to protect its irresponsible Mediterranean neighbours, because of the possible danger to its own banking system.
So if debt is so risky, why have it at all? Why don’t we just have a debt-free world and we can all live happily ever after? No financial crisis. No economic chaos. It sounds good, right? Not so fast.
We cannot do that because debt also does a lot of good, as it is one of the fundamental creators of money. Debt is the lifeblood of the modern global economy. It is debt that has allowed us to create economies large enough to give unprecedented lifestyles to large masses of people. Today’s middle classes enjoy the kind of comforts that were reserved for nobility a few centuries ago. It is debt that has allowed the creation of enough wealth to achieve this.
Debt, therefore, is like a steroid. To a young, virile and fast-growing person steroids can serve as catalysts that help add bulk and muscle rapidly. As you grow older though, you need to be careful. An overdose of steroids can lead to a sticky end. At the same time, if your body has got used to a steady and safe level of steroids and you suddenly withdraw them, you could experience severe withdrawal symptoms.
Debt is similar. An emerging economy (like India) can have its debt levels increasing rapidly without posing a serious problem. This is because its income is also growing fast enough to enable it to repay that debt. Of course, we should keep in mind that an overdose is risky. However, if you are a mature economy like Greece or America, you need to be careful about how much debt you incur. Because your income is not going to grow fast enough.
Were these countries careful? Nope. Greece’s debt to GDP ratio is nearing 200 per cent. This is too high for any country, more so for Greece as its income as a country has been actually declining. During the American financial crisis of 2007, the American consumers had gorged on debt. Many took two or three loans against their houses and spent it all on appliances and holidays. Banks, careless of risk, were giving loans to anyone — even people who clearly had no ability to repay. Mull on this weird type of loan that was proffered: Ninja loans. Ninja means No Income, No Job, No Assets. They would find such “Ninjas” and give them loans. Would you expect such people to default? Do birds fly? But the irresponsible American banks didn’t care. In the short term they showed good growth and profits. The CEOs took obscene bonuses. And the long term was someone else’s problem!
When the party stops, and an individual (American consumer) or a country (Greece) is not able to pay back their loan, it is the banks who offered these loans that go bankrupt. In the case of Greece, for example, large European banks have lent it money. So if Greece defaults on its debts, these banks will lose a lot of money. And is that only the bank’s problem? Not really. It is also the problem of the depositors of the bank who will find that their savings have suddenly disappeared. Therefore, as such banks go bankrupt, money disappears and the entire economy suffers. So if anyone defaults on their loan, it becomes a problem for everyone — even those who had not taken any loan in the first place. Will Europe be hit by the overdose of debt in Greece and the near overdose in Ireland, Portugal, Italy and Spain? Yes, the pain has already begun. Will that hurt India? Yes, partially. We should be prepared for some more bad news.
Amish is the bestselling author of The Immortals of Meluha and The Secret of the Nagas www.twitter.com/amisht