Saturday, July 9, 2011

Debt relief fallacy

Every few months, a friend forwards me a story titled “Hoe ekonomie werk” (or “How economics works”). Typically the post comes with a comment like; “Something here seems wrong, but I can’t say what. Can you ?”. Most definitely I can. It is a complete bucket of cow dung. However, it is a very well garnished and disguised bucket of poo, which is why my otherwise smart friends are repeatedly taken in by it or struggle to put their finger on just why it bothers them. This is why it keeps coming back.

It is a pretty short story, so here is the original in Afrikaans with my direct and literal translation into English below it, including grammatical oddities as far as I could manage to translate them.

"Dis Augustus in 'n dorpie in die klein karoo. Dis droog, warm en die dorpie lyk verlate. Dit is 'n moeilike tyd, almal is in die skuld en leef op krediet. Skielik daag daar 'n ryk toeris op. Hy stap die enigste hotel binne en sit 'n R100 noot op die ontvangstoonbank neer en gaan met die trappe op om 'n kamer te gaan kies. Die hotelbaas vat die R100 noot en haas hom na die slagter om sy skuld te gaan betaal. Die slagter neem die noot en gaan betaal sy skuld by die varkboer. Die boer haas hom om met dieselfde noot sy skuld by sy verskaffer te vereffen. DiƩ hardloop gou en maak sy rekening skoon by die dorp se prostituut, wat in die moeilike tye selfs haar dienste op krediet aanbied. Die vrou van die nag haas haar om haar rekening by die hotelbaas te betaal, waar sy gewoonlik 'n kamer huur om haar werk te doen. Die hotelbaas vat die R100 en plaas dit terug op die toonbank. Net toe kom die ryk toeris terug, neem die noot omdat hy nie met een van die kamers tevrede is nie, en verlaat die dorp. Niemand het enigiets verdien nie, maar die hele dorp is nou sonder skuld!"

"It is August in a small town in the Little Karoo. It is dry, hot and the town seems abandoned. Times are hard, everyone is in debt and lives on credit. Suddenly a rich tourist arrives. He walks into the only hotel and places a R100 note on the reception counter and walks up the stairs to choose a room. The hotel boss takes the R100 note and rushes to the butcher to pay his debt. The butcher takes the note and goes to pay his debt with the pig farmer. The farmer rushes with the same note to settle his debt with his supplier. He goes to clear his account with the town prostitute, who offers her services on credit in these hard times. The lady of the night rushes to pay her bill at the hotel where she usually rents a room in which to do her job. The hotel boss takes the R100 and places it back on the counter. Just then, the tourist comes back, takes the note because he is not satisfied with any of the rooms, and leaves town. Nobody earned anything, but the whole town is now without debt."

The story suggests that there is a simple solution to all our economic woes and seems to imply that the solution is an infusion of money from outside. It sounds like an argument for foreign aid or maybe like what Bono has in mind with eliminating 3rd world debts.

What I suspect bothers my friends, is that - if prosperity could be increased this easily - why is it not being done ? How do you translate this to a real economy and what prevents us from doing it ? Of course, you can’t and this is not a solution at all. The story is based on so many fallacies and erroneous assumptions that I have been brooding for months over where to start.

1. Debt is not only a burden, otherwise people would not engage in it. Debt is a way of getting today what you would only have been able to get at a point in the future by diligent saving. The price you pay for bringing that purchase to the present from the future is interest. The benefit gained from having something now rather than later must be greater than the interest paid to do it, otherwise you would rather wait for the future to arrive. Assuming that people will be better off without debt misses the simple fact that debt is typically a good thing. Micro loans which helped millions of people in Bangladesh out of poverty and won Yunus a Nobel Prize is just one example. Only when you over-extend yourself – where you get now what you would never have been able to save for and buy in the future – is debt a bad thing. Settling your debts – something of value – is hardly a way to resolve economic strife.

2. There are two sides to debt. The guy extending the credit must trust that you have the ability to pay him back in the future (i.e. that some amount of saving on your part would have generated enough funds to purchase the item plus the interest needed to bring it to the present from the future). If there is any doubt in the mind of the creditor, he would either not lend out his money or increase the interest rate in order to compensate for the risk. This means, when times are tough, people may want to borrow more… but there is a natural check on this from the creditor side, both in higher interest rates and tougher lending criteria. He would be more reluctant to lend out money in hard times, since repayment is then at greater risk. How this town got to such a situation is thus a mystery.

3. People’s preferences are not always to only repay their debt or ever to repay all of their debts. It could be that the butcher is not particularly worried about his debt with the farmer. When the R100 lands on his table, he might decide to pay only R5 out of his R100 total debt. In fact, he might flash his cash around a bit to convince the farmer that he is good for an even greater loan and - having made a token payment of R5 - could walk away with pre-existing debt of R95, new stock for R80 paid in cash and additional stock of R55 bought on new credit, bringing his total debt to R150 and choosing to spend the remaining R20 with the prostitute. The farmer, having just received R5 payment on debt owed to him, having made R80 in cash sales and extending R55 of additional debt, now has R85 to burn. If he does the same thing to his supplier and so on around the circle, everyone will end up deeper in debt and under the illusion that they are better off because of all the stuff they purchased. Offset the purchases with their increased debt, and they are no better off at all.

4. New money inflates and distorts (1). Prices are the market signals which convey the message of how much and in what order of priority people want to get or dispose of things. When new money comes into the system, it distorts these signals. In the example above, the farmer gets the impression that there is suddenly a great demand for his product. He invests in an expansion of his business and raises his prices… just to find later that it was a mal-investment based on demand which does not really exist. Everyone else gets the same misleading signal from the additional money sloshing around, so at some point in the future they find themselves faced with high or rising prices and stock which is not selling. The initial good feeling is called a bubble and the result is a crash… dropping prices, businesses failing and stuff being produced which nobody can afford.

5. This sto
ry cannot be scaled up. Surely the biggest problem with this story is that it cannot be translated to the real world. This kind of abstract model building towards a wrong answer has a name in economics; the “Ricardian Vice”, after economist David Ricardo. Sometimes models can be very useful – Ricardo also gave us the concept of comparative advantage, which lead to greater free trade. However, it is often quite wrong, as in this case. In a real economy, who would be the rich tourist ? A reserve bank or foreign country can increase the money supply or provide financial aid, but how will it extract that money again ? The fact that the rich tourist leaves with his money at the end of the story is a rather crucial bit, as implied by the previous point.

6. Real economies are not closed systems. Once the tourist puts down his money, someone might purchase goods from someone outside of the system. If the prostitute sends R50 of her R100 back to her family in Absurdistan, it is gone from local circulation. Also, in a real economy, the tourist must get his money from somewhere. As a foreigner, he must have sold stuff to the town in the past in order to get the currency they use and which he is now bringing in. Implying that he is from elsewhere in the same currency zone, simply changes him from foreign aid (tourist) to the central reserve bank (hotel owner). So rather than a tourist bringing in R100, the hotelier might print R100 and then burn it when it arrives back on his counter. In one case the R100 is simply old value returning to its origin and in the other it is new money which inflates and distorts. In both cases it is like to flow away at least partly.

7. People don’t all have the same amount of debt. If the hotel owner owed R100, it is highly unlikely that the butcher would also happen to owe exactly R100. Assume the butcher owes the farmer only R10 and can keep the other R90 handed to him by the hotel owner. Now, even if the farmer owes the supplier R100, he only has R10 to pay it with. Let’s assume everyone else still owes R100 and that the farmer hands over the full R10 given to him by the butcher. Now the R10 circles around and ends up on the hotel counter. So the hotel boss will need to fork out R90 from somewhere to refund the tourist his R100. The only person who has that kind of money is the butcher, so a loan is probable. In this case, the butcher is debt free, everyone else has their debt reduced from R100 to R90 and the hotel boss is back to his original R100 problem. In real life, fragmentation is even greater than this, so any reduction of debt which may result will be small compared to the money inserted.

There are probably more problems with this story and I will add them as they arise… in the meantime, it is clear that this story is a load of crackpot, whack-headedness, which could have some rather devastating effects like inflation, bubbles and mal-investment. It is wishful thinking with an evil edge. This is why I feel it is important to spend over 2000 words refuting a silly little 200 word brain-fart. Please keep on distributing this story. Spread it around. But please include a link to this response to it. Who knows how much trouble needs to be undone in its travels around cyber-space.

Footnotes: [1] The word inflation originally referred to an inflation of the money supply, not a sustained rise in price levels. The latter has become the popular, though flawed, definition and is the one meant here.