Tuesday, January 17, 2012

Debt and Economic Structure

In my post today, I am going to talk about the principles of structural debt reliance in an economy. It is (I hope) going to illustrate, in principle only, why so-called austerity causes a downwards spiral in an economy, and why denying the need for reductions in government borrowing are a fallacy. It is deliberately simplistic, but I hope that it will nevertheless make the point.

In order to illustrate the point, I will use a notional company that makes office 'widgets'. I choose this type of company as its products have broad applications (as all organisations use office supplies to some extent). We will imagine that our notional company makes 1000 widgets per week, and is a private company. At the starting point of the example, the government is borrowing money, but not excessively. Our widget company is supplying many organisations with their products, and they are a company in reasonable shape. Amongst their many customers are various government organisations, and these organisations purchase on average 200 widgets per week.

The widget company actually likes to supply these government organisations, as they have one particular advantage, and that is that they are government organisations. From this flow many benefits to our widget supplier. They pay on time, and most importantly, they seem to pose no credit risk. This in turn has benefits in, for example, raising finance, as the credit provided to the government is seen as rock solid. Overall, the widget company likes to supply to the government, and even hires a sales specialist who has knowledge of government procurement to help build this area of the business. Our widget maker starts to notice the growth of their business with government organisations, with government spending increasing over time. The money being spent by the government is increasingly funded through borrowing, not through taxation.

Our widget maker sees government sales creeping progressively upwards, moving steadily from 200 widgets a week, up to 300. At the same time, there are steady increases in sales from the other purchasers of widgets. With the ongoing growth in the business, our widget maker makes some new hires, and invests in new plant. The demand for their widgets is growing steadily, and they are struggling to meet the new demand for 1200 widgets per week, and will soon be turning down orders unless they invest. On current growth rates, they feel confident to invest in capacity for 1500 widgets per week. In order to grow their business, they visit their bank, and have a persuasive story of steady growth, reliable customers, and a growing stream of revenue with which to repay the loan for the new capacity. The loan is granted, and our widget company invests in expansion. All the while government borrowing is steadily increasing and the overall size of debt growing.

All is going well for our widget company, and then there appear to be tremors in financial markets. For many years, government debt has been growing, and concerns are starting to be raised about the degree of borrowing by the government. Words such as crisis start being used, and yields on government debt are rising. Raising new debt is becoming more difficult and expensive. There is talk of government cutting borrowing, and cutting services. Our widget maker is concerned, but not that concerned until the cuts to government expenditure start to be implemented. The number of widgets sold to government departments stops growing, and then starts to decline. The government sales specialist explains that the cuts by the government are limiting the spending of departments on new widgets, and that some of the government organisations are disappearing entirely.

Sales to government organisations start to fall back to the original 200 per week. It is a blow, but it is not that big a blow that our widget manufacturer cannot survive. After all, it was not just the orders from the government that were growing, but also the sales to businesses. They may have over-invested in new capacity, and repaying the financing of that capacity will be more difficult but not impossible. Time moves forwards, and the cuts of the government are starting to bite. Our widget maker once again becomes concerned. Whilst the government widget purchases have stabilised at the original 200 per week, the company notes declines in orders from some private customers. Also, some of his private customers are becoming tardy in paying their bills, and this is hitting cash-flow. The company is finding that sales overall are falling back towards the 1000 widgets per week, and they need at least 1100 sales per week to cover their cost of finance.

They are in trouble, and their cash flow is starting to be a problem for meeting their bills. They are themselves making late payments. They do not understand what is going on. After all, they had a diversified customer base, and were not reliant only on the growth in government orders to finance their expansion. However, they were unaware that many of their customers, just like themselves, were also supplying the government and like themselves grew (in part) through growth in government orders. And then there were the companies that supplied the companies that were supplying the government. And then there were the companies that supplied the companies that supplied the companies that supplied the government. In each case, they all see a deterioration in their revenue as government cuts bite, and each sees a negative impact upon their business.

The companies that are direct suppliers to the government are hit hardest. They are the ones now being tardy with paying their invoices. This tardiness impacts down the supply chain, with some companies not being paid for their products and services as companies start to fail. Our widget maker is now in trouble and is one of those companies. Their own suppliers are complaining about late payments, and are starting to restrict any new credit to the widget supplier. As credit from suppliers starts to disappear, and with now negative cash flow, our widget supplier is going bust. When the inevitable happens, the workers are laid off, and the bank takes a hit to its balance sheet. The liquidators sell off what remains of the plant and anything that might have value for creditors. The laid off workers look for new work, but with so many companies laying off workers, new work is difficult to find.

The laid off workers are unemployed, and they therefore tighten their belts. There is no money available for many things they had enjoyed before. For example, they would regularly go out to restaurants, but this is now completely unaffordable. It is notable that, whilst many restaurants are still in business, many restaurants are also going bust. It is not just restaurants, but other businesses that are closing the doors, such as shops, and hair dressers. And the shopfitters, and the wholesalers are also being hit. Yes, some businesses are still doing well, but the numbers of bankruptcies over a multitude of sectors are steadily rising. Even where businesses survive, they are often downsizing. Unemployment is climbing fast.

At this point I will stop. It is clear that this is a self-reinforcing downwards spiral. The managers of our widget business were, in all regards, perfectly competent business people and  managed their company in a sensible and responsible way. The market gave them positive signals, and they responded. As business people, they did everything right.

Our widget maker was directly exposed to government cuts, but was also indirectly exposed. As the borrowed money flows through an economy, the structure of the economy shifts to the consumption of that money. In some cases, as in the case of our widget maker, the shift in structure is readily apparent. In other cases, the shift in the structure of the economy is less apparent. For example, the small sandwich shop near the widget maker's factory that is doing good business as a result of the increase in the labour force in the widget maker. For example, extra staff may have been taken on to service the increase in business from the widget factory.

When we imagine the many interlinked ways that an economy restructures to service the debt founded consumption, it does not come as a surprise when we see countries such as Greece slide into a downwards spiral as government cuts borrowing and expenditure. It is the only possible outcome. There are those that propose the opposite course of action, which is to increase borrowing and expenditure, but the logic of this is that the economy will simply structure more deeply into servicing the debt based consumption. It will, undoubtedly, delay the problems, but only at the cost of more pain when the ability to accumulate yet more debt finally comes to an end.

Even if only holding debt accumulation at the current rate, the problem remains that the debt is accumulating, but the structure of the economy will remain the same; it means that the problem of a debt based structure is left unchallenged. One day, the economy must restructure away from the debt accumulation as infinite debt accumulation is not possible. There will always come a point at which the debt burden becomes too much, or where markets finally perceive that it is unsustainable.

When an economy structures around debt accumulation there is no painless fix. It is simply unreal to imagine that a restructuring away from debt accumulation might be undertaken without the period of the downwards self-reinforcing spiral. It absolutely must happen. The only question is to ask how much of the economy is rooted in debt consumption, how fast and deep the cuts will be. There are, of course, some things a government might do during this painful period, such as retraining, and other ideas to try to ameliorate the pain. However, there is no avoiding that the painful restructuring is the only way that the economy can move back onto a sustainable path.

4 comments:

  1. I think you have hit the nail on the head. The economy grows in the initial phase of debt accumulation, however as time moves on the the weight of carrying an ever increasing level of debt (i.e. repayments) becomes a strain. Each £ created as debt has a diminishing effect on GDP, to the point where new debt is actually destructive. Interest rates are at zero, central banks and pumping credit like its Christmas, and everywhere we see the things we need to live skyrocket in price (energy, food etc). You have reached and crossed the Debt Saturation point for a debt based economic model.

    http://economicedge.blogspot.com/2010/03/most-important-chart-of-century.html

    The model is eating itself. I think you used the term cancerous before. Couldn't be more apt in my opinion.

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  2. Thank you for providing such a simple picture of what is going on in the 'real' economy. For me, it is too easy to lose sight of these fundamental inter-company and governmental relationships. I wish the BBC or ITV would do a half hour documentary based on your illustration above - just so that the public can understand what is happening and what all the fuss is about.

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  3. Hokay, time for an Idiot Boy question. Is the world as a whole borrowing, or lending, or exactly in balance?
    As a follow-up, even if there is an exact balance between borrowing and lending, is there any sufficient mechanism for geographic rebalancing of production and consumption, or will economies of scale and government intervention guarantee that an imbalance continues?

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  4. The 'Idiot Boy' question that anonymous asks is intriguing - I'd simply taken it for granted that the world as a whole had to be exactly in balance, but maybe not? What say you on this Cynicus?

    Today's Telegraph (http://www.telegraph.co.uk/finance/comment/ambroseevans_pritchard/9031478/America-overcomes-the-debt-crisis-as-Britain-sinks-deeper-into-the-swamp.html)points out that Britain is a gigantic debtor, but is yet a creditor of other major debtors such as Spain. If this all unwinds then how does the final balance between our debtors and creditors play out - does anyone know - are we maybe better or worse off than we think?

    We hear a great deal about the debtors (UK, US, Greece, Spain, Portugal, Ireland etc.) in all this sorry affair, but very little about the creditors. Presumably the creditors are those who end up owning the world, but who are they - BRIC countries, transnational corporations, incredibly wealthy individuals? And how will they act when this all unwinds?

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