For over a month now, a particular e-mail has been circulating that seeks to
suggest a solution to the global financial crisis. Since I received this e-mail
no less than 10 times myself, it is perhaps safe to assume that many of our
readers have seen it too; for those who have not, here it is in full:
a small town on the south coast of France, the holiday season is in full swing,
but it is raining so there is not too much business taking place. Everyone is
heavily in debt.
Luckily, a rich Russian tourist arrives in the foyer of the small local hotel.
He asks for a room and puts a 100 euro note on the reception counter, takes a
and goes to inspect the room located up the stairs on the third floor.
The hotel owner takes the banknote in a hurry and rushes to his meat supplier
to whom he owes 100 euros.
The butcher takes the money and races to his supplier to pay his debt.
The wholesaler rushes to the farmer to pay 100 euros for pigs he purchased some
The farmer triumphantly gives the 100 euro note to a local prostitute who gave
him her services on credit.
The prostitute quickly goes to the hotel, as she was owing the hotel for her
hourly room used to entertain clients.
At that moment, the rich Russian comes down to reception and informs the hotel
owner that the room is unsatisfactory and takes his 100 euros back and departs.
There was no profit or income. But everyone no longer has any debt and the
small town's people look optimistically towards their future.
Could this be the solution to the global financial crisis?
Debt, velocity and income
This e-mail was presumably generated in Europe, what with its notions of using
the euro and the ideal closed economy that is expounded upon. While in its
logical construction this e-mail falls into the "broken glass pane" line of
questioning (namely is the wanton destruction of useful objects economically
additive or negative) the difference comes about in the seductive notion of
monetary velocity being a solution to a debt crisis.
I for one don't think this e-mail is worth the paper it is NOT printed on, but
because many people found it "useful" it perhaps behoves me to explain why the
situation being described has nothing whatsoever to do with the global
financial crisis per se.
There is no interest on any of the transactions, that is, we are discussing a
quasi-barter economy rather than one in which each piece of debt carries its
own coupon rate. If the supplier charged an interest rate on what the hotelier
owed him and the farmer charged the supplier, the easy math of money flowing
through will no longer work.
Isn't it interesting that everyone in this list has offsetting debts, that is,
that they all appear to have a net debt of 0? The hotelier owes the
supplier money who owes the farmer and so on. This, of course, isn't what we
have in reality today: the US and Europe owe trillions more than their assets
are worth for one thing, while Asians have less claims on future incomes thanks
to the machinations.
The amount of debt across the different parties is the same, again rather
different from the version that will be played out in reality. It affects the
outcomes to a greater degree if the amount being passed on for debt reduction
was say 10 euros lower in every stage: in which case the hotelier would have
passed on 90 euros, the supplier 80 euros, the farmer 70 euros and the
prostitute 60 euros; leaving the hotelier with a deficit of 40 euros (or 30
euros if you include the 10 euros note he hid in the first instance) when the
Russian came back down to demand his 100 euro note.
In this village, it costs the same to buy a pig, rent a room or spend an hour
with a prostitute: the very definition of a socialist ideal that has no place
in useful economic discussions.
Still, now that the door has been opened to these kinds of magic formulae, it
probably behoves us to consider how different economic rescue packages stack up
on this front. (See also
Truth is too hard to handle, Asia Times Online, May 12, 2009.)
The administration of US President Barack Obama leaves $100 at the hotel
reception but walks away without explaining anything to the receptionist. The
receptionist "forgets" to put the $100 note in the till, and instead puts it
into his pocket.
Figuring that he is now rich, the receptionist goes to Saks and buys a pair of
sunglasses for $500 on his credit card. The credit card company takes a look at
his $500 charge and decides to remove his credit limit; demanding instant
repayment. The cardholder, with only $100 in his pocket and massive debts,
declares bankruptcy immediately, giving up his house as well - the bank that
made the mortgage loses $1,000 on this deal.
Of the $500 at Saks, $200 goes back to pay a bank debt and Saks pays $300 to
the company making the sunglasses, which is a multi-national company (MNC).
The bank that got money from Saks is the same one that lost $1,000 previously,
so is slightly helped by the $200 from Saks; but decides just in case there is
a future problem to cut the company's credit lines by 50%. Saks immediately
suspends further inventory purchases until Christmas.
Meanwhile, the MNC that got $300 from Saks pays its Chinese supplier $200 for
the glasses and uses the other $100 as severance payment on one of its workers
who had been at the factory for the past 10 years because Saks cut its future
This person joins the hotel receptionist in the bankrupt list, and also
defaults on his mortgages and credit cards.
The bank is now worried about its rising losses and decides to punt the $200
received from Saks on the credit markets, buying up high yield debt including
that of retailers. Prices, for the moment, rise. (See
Easy bets with other people's money, Asia Times Online, May 23, 2009.)
Meanwhile, the $200 notes from the MNCs stack up at the People's Bank of China
(PBoC), which then goes and buys US Treasuries for $100 and a triple-A rated
credit card asset-backed securities (ABS) for $100. PBoC does notice though
that a year earlier it got $1,200 from the MNC ... so realizes that total sales
are down by $1,000 (see next section).
Needless to say the triple-A ABS falls in value to zero after the defaults by
the hotel receptionist and the MNC employee. PBoC writes off the $100 ABS but
still retains the $100 US Treasury holding.
The US administration announces a stimulus program of $1,000 for the bankrupt
hotel receptionist and the MNC employee to be funded by new borrowings.
Now that it has sold $100 in new debt to the Chinese, the US government thinks
that it has got back the money "left" at the hotel reception, and decides to
leave a bit more this time, so targets $1,000 for this.
The Chinese government, meanwhile, (see
China's unreal estate" Asia Times Online, April 10, 2009) announces a
$1,000 stimulus program to counter the $1,000 in falling export revenues (from
the previous section).
The two companies that are paid $1,000 by the government to build new hotels
actually only spend $600 on the construction, leaving a profit of $200 each.
They spend $100 between them buying up stocks and put the balance profit of
$300 into the local bank. Of the $600 spent on the hotels, $300 goes for
Chinese workers, who promptly save $120 of that in the local bank.
No company wants to manage the hotel because there are already too many hotels
in the city where it was built. They remain beautiful but empty shells.
The bank now has new deposits of $420, and decides to lend $300 more to the
property company that owns the hotel sites (because it is the only company
borrowing in China); but mainly because that company is close to defaulting on
its existing $1,700 in debts.
The supplier to the MNC realizes that orders have tailed off and closes down
one of its shifts, lying off a few hundred workers. As workers leave the
factory city, property prices fall; in turn hurting the property company that
borrowed money from the bank. The property company goes bust, the bank loses
all the money lent ($2,000).
Government has to now lend $2,000 to the bank to recapitalize it, which it does
by selling $2,000 of US Treasuries.
Global interest rates rise, leading to further declines in Chinese exports.
Back in France: 1. French President Nicholas Sarkozy, accompanied by his wife Carla
Bruni, announces a 1,000 euro stimulus plan.
2. No one cares ...
Based on even relatively simplistic scenarios such as the above, it is easy to
see that the central role of governments in this crisis is exactly the wrong
way to go forward. There is no free money, and all actions have consequences.
Americans and Europeans have to cut their total debts - personal and government
respectively - and there is simply no other way about that. Sitting around
imagining fantastic scenarios that could solve the debt crisis magically
doesn't do anyone any favors.
Financial assets are merely claims on future earnings, paid for using regular
payments (debt) or uncertain but variable payments (stocks). If the total
income of any economy is itself dependent on the generation of debt and its
refinancing, then any solution will have to focus on the reorientation of that
economy towards income generation. This is still missing in the US, not to
mention Europe where all focus remains on how much further exports will fall.
Meanwhile, developing countries like China and Brazil are wasting precious
resources supporting what cannot be ultimately sustained; namely the continued
holdings of US Treasuries and European government bonds. Reducing their
holdings of these assets in favor of physical commodities or capital means of
production is what they need to do; in turn sparking domestic consumption.
Taking a gradualist approach to a crisis that deserves greater immediate
attention simply leaves the balance of negotiating power with the deadbeats in
Washington and Paris rather than the savers in Beijing.