Thursday, March 26, 2009

Global Slowdown Solutions V: Global Crisis - first principles

Global crisis is a result of three elements freezing together - an overleveraged buyer unable to buy more, a seller without access to credit to create supply and non-existant market where no one trusts anyone.

We cannot fix all three together as all three elements are vastly globalised and hence too big to fix all at once. So it makes sense to get back to basics. The entire economic system was created with demand at the center. When demand existed - supply emerged and market appeared to match producer and consumer. So we need to fix demand first, help supplier get started and things will start taking care of itself. But!

First lets get demand straightened out. Demand in recent past was excessive - it will never be that high any time soon. But however small - we need it. Demand comes from wages and employment certainity. This is the basic of Keynesian stimulus - create jobs system will fix itself. So this would have solved our problem this time as well - had it not been for credit starved supplier.

The supplier, earlier, was driven by equity and debt was but a cash-flow smoothening mechanism. Then we realised the power of leverage to amplify returns, create surplus wealth thereby creating a separate investor class specialising in just providing capital unleashing entrepreneurial energy. This class made the entrepreneurs leverage themselves to the maximum possible limit. This culminates today into credit being necessary mana for the suppliers to produce goods. Without supplier there is no market!

The market essentially is an infrastructure provided to suppliers to help them address demand - through exchange of goods and services. Market works on marginal cost of exchange. Markets usually take care of themselves so long as demand and supply exists. The maximum fixing markets needs is through ensuring rule of law - enforcement of contracts, protection of aggreived, ensuring people don't cheat or muscle out others etc. Markets are even oblivious of fairness of law - so long as law exists and they get implemented markets will get created.

Hence the crisis will be resolved if we solve the demand (consumers') problem first. Then we need to fix suppliers' access to credit. It is ok to have latent unsatisfied demand - that often gets channeled into savings. But excess supply translates into inventories and they have costs and lead to supplier anemia. Ensuring law and order will help markets get back in shape soon enough.

US Solution has been antithetical to first principles
The solution so far has exactly moved in opposite manner. We tried to make market functional by rough-shodding over contracts and ensuring cheater get away with it. We tried to ensure liquidity to help with supplier credit. All this while - the consumer is facing increasing credit card debts, lower job prospects and total loss of confidence in possible return to reality. We haven't really done anything to prevent creditors making predatory moves on consumers.
The solution to the crisis is essentially a modified Keynes' approach. We need to create jobs while fixing the system in coordinated precision. The kind that won Nadia Comaneci her perfect 10. And the stakes are higher there is not saffety net - no silver medal!