Wednesday, December 1, 2010

Global Debt Crisis

By Dr. Suhaib Riaz.

Strategists currently have a watchful eye on the massive macroeconomic changes unfolding, including the European debt crises (Ireland, with Portugal, Spain and more to come), currency instability and other related problems. Strategic decisions will reflect the impact of these macroeconomic changes in many ways – witness Nissan’s recent decision to restructure its production and support functions to dollar-linked economies such as US and China to avoid currency volatility.

The Global Financial Crisis is quickly becoming referred to as the Global “Debt” Crisis, which is long overdue. I first wrote about the importance of scrutinizing debt practices underlying the crisis here and here (.pdf), presented it here, and recently again brought it up here (with co-authors).

Economist Hyman Minsky first proposed the detailed link between debt and economic cycles. Debt increases during boom periods up to a tipping point where returns from inflated assets can no longer service debt. While this view is now enjoying some revival, what is missing is a recognition of the role of social legitimizing mechanisms through which a debt-induced boom period comes about. The practice of debt has acquired a halo, or what institutional theorists call “social legitimacy”, through the aggregate (yet time-bound) success of business organizations, consumers, and indeed sovereign governments that rely on debt practices. Till the crisis hit us, there was an increasing perception that debt practices are sound in a fundamental and time-invariant manner. Debt was fixed in the public imagination as a taken-for-granted practice associated with economic success. However, this logic is flawed – or at best is only temporarily acceptable during boom periods. Sooner or later, debt comes calling in substantive terms.

Three historically unique developments, all connected with debt practices, require particular investigation due to their dominant role in the current crisis. Though often considered separately, their combined impact deserves more attention. The first is the lax financial regulation on a new and large set of leverage tools, such as derivatives. The second is the historically large concentration of power in a few players in the financial industry, many of which are key nodes in networks of debt. The final aspect is the increasingly global nature of the networks of debt. Recent news on how the US Federal Reserve bailed out European Banks, including Barclays and UBS, shows how these aspects tie-in across the globe. Put together, these three factors act toward increasing the scale but decreasing the frequency of debt-based crises, as larger contagions of business, consumer and government constituents across the globe are created to save smaller contagions (witness Europe's bailout plans for Greece and Ireland; the United States’ government bailout of banks and industry, etc.). These contagions are but grandiose efforts to cloud the substantive problems of debt through continuing to legitimize and thereby preserve existing debt practices. However, no matter how large the contagion, it cannot avoid substantive problems forever and only serves to increase the severity of a crisis when it actually unfolds. 

These substantive problems are what will likely lead to further government bankruptcies in Europe, and perhaps even to the abandonment of the Euro, in the worst-case scenario. Though this sounds far-fetched today, one thing we have learned during this crisis is "if anything can go wrong, it will" - the worst-case has often been the one that unfolded.

The legitimacy and ideological support provided to debt practices across a wide network of industry, regulators, governments, professionals, business schools, and more, deserves investigation in these times. However, in an environment marked by political handwringing and lack of political will, such deeper exploration of economic practices and questioning their socially constructed legitimacy is not easy. Yet, that alone makes it incumbent upon thought leaders to do so.

1 comment:

Ryan Clancy said... my first though. This is very well communicated and spells out clearly the issues faced ahead.

In my opinion, one of the issues is society's unwillingness to face austerity measures today, to save tomorrow. My point is that the general public generally endorses the idea of stimulus plans, reduced interest rates, and other synthetic strategies. However, this encourages further borrowing. What will be devastating is the impact on the financial markets when interest rates rise to natural rate. The potential result; decreased demand for shares (stock market crash), substantial and unstainable increases in the cost of servicing our debt, and major defaults on our loans.

If anyone has any further discussion to add, I am excited to hear further opinion.

Post a Comment