Wednesday, March 14, 2012

Can Borrowing create Wealth?

Most countries in the developed world are trying to cross a debt high wire. Today, their ability to balance on the wire is essential to the financial stability of the world. How did all these countries get into such precarious positions? Largely, the blame can be assigned to borrowing. Such an obvious assertion does not explain much.

We need to go further back and understand why each country began borrowing. Unfortunately, the answer is simply, because there were lenders willing to loan money. No country evaluated their capacity to repay the loans. Political leaders depended on the lenders to evaluate their country's capacity to repay the loans. This task was done about as competently as the risk evaluations of subprime bonds. In fact, there is a parallel between subprime borrowers and Finance Minister borrowing. Both assumed the willingness of a lender to give them money implied they must have the capacity to repay the loan. In both cases this was a flawed assumption. The lender was not evaluating their capabilities, but only the quality of the collateral in the case of subprime borrowers and the implicit gurantees of repayment in the case of sovereign borrowers. Each evaluation only scratched the surface of what needed to be evaluated.

Risk Managers of subprime lenders did not look at the stability of the entire market. Their focus was only on the specific property.  Risk Managers of Sovereign lenders did not look at the competing demands of tax revenues, but only whether a "guarantee" was implied. No one probed into whether the guarantee could be fulfilled. The Global Debt Crisis is largely a result of sloppy lazy work by all sides.

Even so, the negative consequences of this laziness might have been avoided if the borrowers and lenders had made loans that made sense. What is a loan that makes sense? It is a loan that generates sufficient revenue to repay the principle and interest. What kind of loan is that? The simplest example is a toll road that will generate enough income to repay principle and interest. Very few public expenditures meet this standard.

Let's review some of the more common public expenditures that get countries in trouble. All defense borrowing is of this type, but there are others. Surprisingly many of the most egregious examples are the funding of education. Most of the developing countries in the Middle East are using funds from their oil rich brethren to educate their populous. Admirable, but once educated these graduates cannot find jobs. Consequently, the poor countries hire many of them in "make work positions" funded with precious tax revenues insufficient to pay their salaries and meet the principle and interest payments for the colleges and universities funded with borrowed funds. This is a classic example of loading the camel before having a market destination to travel to. Development of the private sector must proceed the education of the employee.

In N Theory the requirement of being able to repay a loan is the Finance Rule. Failure to consider the Finance Rule when making a borrowing or lending decision ends in a Debt Crisis. Escaping from a Debt Crisis after the fact is extremely difficult as we are learning. Every country should make the Finance Rule part of their governing documents.

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