Thursday, July 30, 2009

Financial Mismatch At The Interface (2 of 4)

It is generally accepted that when a developing economy reaches a certain level of complexity, it experiences an economic crisis as we saw happen to several countries in Latin America and Asia during the last part of the Twentieth Century. And the reason why such crises happen has been attributed to the view that when the economy begins to advance, the developing nations tend to live beyond their means even as a large portion of the population does not share in the fruits of the progress but lives in poverty.

It is also generally accepted that the economic crisis through which the whole world is now struggling began with the fact that cheap goods and cheaper services were made available to the consumers of the advanced economies by the working poor of the emerging ones and that cheap credit was extended to the rich nations by the leaders of the poor ones. And the question is whether or not the two economic crises were due to one and the same set of causes. If the answer is yes, the next question to ask is whether or not the causes are also behind the cyclical booms and busts that hit the developed economies every so often.

To answer these questions we begin with a simple definition of what makes a market. We say there is a market when at least two individuals conduct a transaction where something is exchanged for another. The transaction can be a barter where goods or services are exchanged for other goods or services. Or the transaction can be a more sophisticated commercial exchange where goods or services are exchanged for a commonly accepted currency that can later be exchanged for other goods or services with someone else somewhere else.

We must also note that anyone who participates in an economic system is both a buyer and a seller. In fact, the individuals who work for an enterprise sell their labor for currency which they later use to buy goods and services. And the enterprises sell their goods or services for currency which they later use to buy labor as well as other goods and services. The important point here is that for any of these transactions to take place, the participating entities must communicate and must reach out to each other in some fashion which means they interface.

It is safe to say that inside even the smallest of jurisdictions, numerous interfaces take place every day among the various entities. But we can group these entities into one of two classifications. One group is called the supply side and it comprises the makers and sellers of goods or services. And the other group is called the demand side and it comprises the consumers of those goods and services. The utility in making this classification is that we can now visualize a single interfacing window where the transactions take place between the supply side of the economy and the demand side.

So then, how can this set-up go wrong and cause crises when implemented in the developing nations? The answer is that the problem begins at the interface and spreads from there. What often happens is that the institutions that grant the loans to the developing nations stipulate that the latter must export the goods or services they intend to produce so as to earn enough in the currencies of the developed economies to pay back the loans. What results is not a two-sided equation with a single interface linking the two parties but a three-sided contraption with two interfaces tying together the three parties in what often becomes a difficult relationship. The difficulty arises not because there exists the intention to take colonialism back to the poor nations but that the lenders want to make sure the loans they gave out will be paid in full with interest as agreed upon.

In this set-up, things develop in such a way that instead of having a labor force being paid enough to buy and to consume the products and services it makes, we have a labor force that produces goods and services for export. Where there used to be a system calibrating the work done with the wages paid so as to balance the two sides of the equation, there is now a contraption where the workers are expected to produce but their role as consumers is supplanted by the wealthy foreigners who gave out the loans.

In short, the twosome has become a threesome and where there used to be one interface for bargain and for the exchange of ideas between the workers and their employers, there is now a second interface linking the employers with their foreign bankrollers who are also their customers, advisors and counselors. And it does not take too much imagination to figure out which advice and which counsel the employers will take more often.

But that is not all because there is here a hidden fault line that is a time bomb. As long as the business owners have a foreign market where they can sell their goods and services at a relatively high price, they will not reduce their prices to match the purchasing power of the local population. Nor will they pay their workers higher wages to make them afford the goods and services they produce. And what contributes in part to the making of such decisions is that the business owners discover they still do not make enough money to live the extravagant life they crave and pay back the loans they took from the foreign entities. Instead, they discover that it is the foreign middlemen who make most of the profit on the goods and services they produce in their enterprises using the cheap labor of their poor countrymen.

Only then do the nouveau riche of the developing countries realize they have two problems on their hand; one problem having to do with a disgruntled work force at home and one problem having to do with anxious lenders abroad. So what do they do? They aggravate the situation even more by spiriting what money they can lay their hands on outside the country and stash it in secret accounts far away from home. This done, they prepare themselves to take flight at a moment’s notice when the day of reckoning comes knocking at their door.

This type of scenario played itself out more often in Latin America than in Asia but something close happened there too. And shortly after these scenarios were played out in some Asian countries such as the Philippines, it so happened that mainland China was ready to show itself as the emerging industrial power with the muscle to turn the table. What the leaders of China did was use their country’s interface with the developed world to conduct a different kind of bargain with their counterparts there.

What came out of this encounter was that instead of creating a loop where products and services went from China to the developed world in exchange for payments going in China’s direction, the Chinese managers of the economy asked their wealthy customers to keep the money, consider it a loan and pay interest on it. In doing this, the Chinese made it so that their customers never became their bankrollers, advisors or counselors. And the consequence has been that the crises which used to hit the developing countries now hit the developed ones instead. And we are living the aftermath of this reversal.

And so, to answer the earlier question, yes, there are similarities between the causes that usually trigger the crises in the developing countries and those that triggered the world crisis we are facing today. What remains to be verified is the question relating to the periodic booms and busts that plague the developed economies: Do the similarities extend to them as well? Again, we must look at the interface between the supply side and the demand side of the equation to see what kind of relationship exists there.

To help us in this regard, we first visualize a society living in a primitive economy based on barter alone as it used to be eons ago. Everyone produces something, some of which they keep and some they exchange for other things with their neighbors. The more that a family or a clan produces, the more they get to consume or to exchange for other things. But if for some reason one clan produces less than they will need during the upcoming season, they will make do with less. In a society like this all that is produced by the members is consumed by them which is what keeps the two sides of the equation in balance and prevents a mismatch from developing at the interface.

Fast forward to a complex society in modern times where consumerism is rampant and most of what is produced is sold on credit; from a house to a pair of socks, from a car tune-up to a family vacation; from a toy to a college education. Of course, the consumers pay for the privilege of receiving something now and paying later. This is to say that credit has its cost. How expensive the cost will be depends on the interest rate and the duration of the loan. But on average, the consumers get to dish out more than twice the price of a residential unit before they pay for it in full, at least twice the price of a car before they get to own it, and one and a half times the price of everything they charge to their lines of credit.

But despite these mind boggling arrangements, the system functions more or less well most of the time except for the inconvenience of having to put up with a mild form of boom and bust once in a while. However, things can develop in such a way as to turn the mild boom and bust into its more exaggerated form known as the bubble. Looking at what transpires in such cases will shed light on the mechanism by which all forms of boom and bust happen.

To see this, imagine a set of twins who are separated at birth and who grow up with neither of them knowing he has a twin brother. They do the same kind of work, marry the same kind of girls and buy the same kind of homes at the opposite ends of the same town. One day, chance brings them together and they realize who they are. They discuss their lives and discover how closely paralleled they have been except for one thing; one twin has no money and the other has a million dollars in the bank. How did this happen?

The story of the twins is told in part 3 of the series.