In an earlier post,
one attempted to decode the fundamental principles of circular flow of income. While
the post elucidates the interlinkages among various actors in an economy, it
also brings to the fore certain interesting pointers on the demands of economic
protestors in many parts of the world. Some years ago, in the aftermath of the
financial crisis, there arose a protest movement in the US called Occupy Wall
Street. It had many demands that sounded appealing to many. However, as it goes
with many things, the supporters had little idea on what it would mean for them
if these ideas were taken to the logical conclusion.
In fact, many
protests jump on the bandwagon of anti-corporate image. The imagery that a
corporate or the multinational to be more particular evokes is certainly not
flattering. In pursuit of their profits and reducing costs, many firms have cut
a sorry figure to the society. The imagery is not new and has been pretty old. The
working conditions to which many are exposed bring to the fore the short cuts
the corporates are willing to endure in pursuit of the super normal profits.
Secondly, the imagery is also of the governments being hand in glove with the
corporates and ensuring the corporates go tax free. The regulatory capture is
not without evidence from many countries. The perception that corporates avoid
taxes and get waivers from debt repayment is too widespread. Hence Occupy Wall
Street and their cousins across the globe are normally consistent in their
demand of the full waiver of loans. They believe that the borrowers are the
normal people on the street and thus should get relief. However, the
consequences of all blanket loan waiver is highly unintended and needs to be
examined for the same. There are a few indicators that emerge from a
prospective blanket waiver on debt repayments across.
The first one is
of course the moral hazard problem. If the borrower knows that the debt would
be waived off at some point of time, there is little incentive for repayment. This
keeps on happening in countries like India where farmer loans are often waived
off for electoral considerations. This actually creates a disincentive for
farmers to repay the loans. Furthermore, it makes banks reluctant to lend in
high quantity to those groups whose loans are likely to be waived off.
Aside of the
moral hazard, the waiving off loans has serious macroeconomic implications. We take
refuge in circular flow of income model again to understand the same. To reiterate, circular flow of money talks
about flow of income among firms, households, governments and the rest of the
world. The firms produce goods and services which are consumed by the
households. To produce the goods and service, the households provide factors of
production to the firm in return of which they get the factor income. The factor
income thus earned is used to buy the goods and services produced by the firm
thus creating a circular flow. The households however do not utilize all their income
in buying goods and services but have to pay taxes to the government while
engaging in external sector for exports and imports. However, the most
important component would be the household savings. The households,
irrespective of the objective of the savings have to channelize these savings
through financial intermediaries. These intermediaries like banks, capital
markets, route these savings from households to the firms who use it for
investment. Thus these intermediaries act as a bridge between ultimate lender,
the households and the ultimate borrowers, the firms. The households are in
excess of funds and the firms, deficient of funds. Thus the largest pool of
savings come from the households.
When the firms
borrow funds from the financial intermediaries, they are in effect borrowing
from the households. The intermediaries are just the bridge in between. The transaction
costs of securing the best rate of return for the excess funds given the level
of risk makes the household approach banks. The transaction costs of securing
cheapest borrowing rate for given level of funds required makes the firms
approach the banks.
Let us examine a
scenario wherein the loans are waived off. The borrowers have nothing to lose. There
is gain to them not just with the principal amount but the interest saved. Furthermore,
they can gain interest on the principal. The banks will lose the interest
income but will have to pay the interest expense to the depositors. In the
absence of interest income, the banks will find it difficult to pay the interest
expenses. Moreover, if the waiver is official catering to the demands of the
protestors, the banks will have little recourse to securing their loans. They cannot
even attach the assets. On remedy would be the government bearing the cost of
the loans. The government on behalf of the borrowers repay the banks their
principal and interest amount. If the government do not pay, banks will not be
in a position to pay interest to the depositors. To make it worse off, the
banks might end up in a situation wherein they cannot even pay the principal
amount to the depositors. The end result is the depositors losing their hard
earned money kept in the banks. The banks are ruined so are the depositors
almost all of them being common men and women. So the first line of impact and
severe as it looks would be on the common depositors in banks and other
institutions.
Let us assume
the government steps in and repays the loans. The government must have money for
the same. The government gets its income from the taxes. It is the tax income
that government routes to fund its government expenditure. Capital expenditure will
earn a return but expenditure on loan waivers is revenue expenditure which does
not have any return. Thus any expenditure on the waiver of the loans falls on
the tax payer. The government might bear its impact, but the incidence on the
taxpayer though might not be visible but nevertheless severe over the years. It
is akin to a financial ruin event.
If the
government on the other hand, decides not to use the tax money but decides to
print money or as they term monetizing the deficit. The outcome is increase in
money supply, a rise in inflation creating price pressures. The rising prices,
lower PPI all point again towards severe troubles for the common man.
As one observes,
the demands of blanket waiver of borrowings might sound romantic and alluring,
yet a deeper analysis reveals otherwise. The gainers are in fact the corporates
and large borrowers. They are freed from the encumbrances besides gaining from
this. The losers are the households who will bear the worst irrespective of the
mode of waiver. Thus what sounds alluring is in fact very poor economics and
goes against the very interests the protestors claim to be fighting for. On the
contrary, the interests against whom they are allegedly fighting for are the
biggest gainers.
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