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The economic crisis made simple: the world economic crisis is often portrayed as too complicated for most people to understand. This article strips out the complications and presents a simple analysis of its cause, the main strategies adopted to deal with it and the key factors determining their success.

The problem

There are many problems with western economies which, through world trade, have knock-on effects for economies all over the world. However, the one that attracts most attention and is potentially most serious is the level, and growth, of national debt. Public sector net debt in the UK was [pounds sterling] 944bn at the end of June 2011, equivalent to 62 per cent of gross domestic product (GDP).

Such numbers are difficult to comprehend and I will not bombard the reader with volumes of data or technical jargon to complicate the issue further. As management accountants, we need to understand the principles and dynamics behind what is going on in our economies. We can then anticipate and respond to actions taken by governments and enable the organisations we work for to be part of the solution and not part of the problem. I have therefore set out to reduce the complexities of the economic crisis to simple terms. In so doing we may learn the lessons of the dot-com bubble, Enron, and the recent financial crisis by understanding the reality of the situation and not be misled by jargon and fancy formulae.

The following simple analysis applies to any nation that has got into debt and is seeking to get out of it. It applies to the UK and the US and, in particular, to countries in the eurozone such as Portugal, Ireland, Greece and Spain, which are limited in being able to follow independent monetary policy through changes in exchange and interest rates. The analysis shows the basic options available to any debtor country and the conditions under which these will work - or fail. It also highlights the relationship between nations that have debt to those that have surplus. It is also important for creditor nations, such as China, to understand the impact on them of different strategies taken by debtor nations to clear their debt.

As we know from the principle of double entry, for every pound borrowed there is a pound lent. There is much borrowing and lending between individuals, companies and financial institutions within a country. However, where lending is the result of saving, and borrowing is used for investment, this is a healthy activity and is contained within the nation's economy. The problem arises where borrowing exceeds the resources of a nation - and is only matched by lending from outside the country. In the current world economic environment it is the emerging nations such as China, Brazil and the sovereign wealth funds of the Middle East that provide the lending. This is where the relationship between lender and borrower becomes key and, as we shall see later, is potentially dangerous.

The cause

So how did countries get in this situation? Essentially, it is because for some years they have been consuming more goods and services than they have been producing. They have been able to fill the shortfall in production by importing from abroad - more than they have been exporting - and thereby creating a debt to those nations. Such debt may be held in cash, government bonds or other forms, such as loans to companies or financial institutions. Over the years this debt has risen to the level it stands at now; in some cases at a level at which creditor countries could buy out the equivalent of more than a year's production by a debtor country, leaving them with nothing to live on. Alternatively, debtor countries could seek "one-off" sales of national assets. This process has already begun through privatising energy supplies and transport infrastructures and is due to accelerate as the crisis becomes more chronic and acute. Some sales may not be transparent. For example, it is difficult to assess how much of the companies listed in the UK's FTSE 100 or the US Dow Jones index are already in the hands of foreign shareholders.

The objective

If countries are to free themselves from this hold over their production and assets, they need to repay their burden of debt. To sell their entire production abroad for the time being or offer a "fire sale" of national assets to their foreign creditors would get rid of the debt in the fastest possible way. But the former is not practical and the latter does not address the underlying problem. So what is the answer?

The solution

There are two possible long-term solutions for a debtor nation. The first is to consume less than it produces; the "austerity" strategy of cutting public expenditure and raising taxes. The second is to produce more than it consumes; the "growth" strategy. However, in either case, the resulting reduction in consumption must be achieved through lower imports or the increase in production must be exported in order to pay down the foreign debt.

If production exceeds consumption and is not exported, like tomatoes left on the vine, it will be wasted. Whether counted as wasted consumption or valueless production, it does not contribute to reducing the debt. Indeed, either reducing consumption or increasing production may not reduce debt if, in turn, they only reduce production or increase consumption.

Alternative strategies

Of course, there are alternatives which avoid the pain of sacrificing standards of living or working harder for the same reward. These may or may not be deliberate strategies, but are ones that many countries around the world are now facing or are engaged in. One is to default on loan repayments or to declare bankruptcy. Another is to promote or allow a combination of inflation or a weaker exchange rate (denied to individual countries tied to the (euro) to reduce the real value of a country's loan in the lender's currency.

If this can be achieved alongside low interest rates, as has been the case in the UK over the past few years, the cost of servicing the loan is also minimised. There are other, more radical and provocative strategies, such as privatising assets held by foreign creditors at below market value or creating trade barriers that artificially limit imports or apply duties to them. These strategies all amount to the same thing: reducing or eliminating the value of a nation's debt. And they all run the risk of generating hostile responses, including reciprocal trade wars, a breakdown in trading relationships or even actual war if access to key resources is denied.

The outcome

Thus, if public expenditure cuts lead to redundancies and unemployment, the reduction in expenditure is matched by a reduction in production and finances may well fall short if welfare benefits have to be paid to the unemployed. The result is that debt actually increases - the vicious spiral of recession.

Similarly, if an increase in production generates higher income which in turn is spent and not saved, standards of living may increase, but it does nothing to reduce the national debt.

Indeed, if increases in production are achieved through borrowing for investment, it makes the situation worse. What is key is that the surplus generated in each case by production exceeding consumption must be exported. Otherwise the outcome is uncertain.

The lesson

So what are we to make of this analysis and how does it affect the organisations we work for or with? One simple lesson is that it is unhealthy to allow debt to other nations to increase unabated. It increases the claim and ultimate threat those nations have over one's productive resources and limits the policy options governments have to manage the economy. Secondly, national debt, by definition owed to foreign nations, can only be repaid through exporting more than one imports.

Therefore, any strategy to reduce consumption or increase production will only be effective in reducing that debt if it leads to a reduction in imports or an increase in exports. To be effective, any such strategy needs to be targeted to achieve this. Tax increases should be applied where there is a high propensity to import so that a reduction in disposable income leads to a greater than proportionate reduction in imports. Similarly, cuts in public expenditure should be applied where services lost will not be replaced by foreign providers. And growth incentives should be targeted at those areas that will result in the higher exports of goods and services rather than generating increased domestic demand.

If a country is to reduce its burden of debt so that it can be eliminated over time, together with its attendant threats, the firms and industries that will contribute to it, and thereby likely to benefit, will be those that generate exports or provide domestic substitutes for imports.

This should be a key consideration in developing a business strategy and one which management accountants can facilitate through understanding these simple principles.

Further reading Vince Cable: The Storm - the world economic crisis and what it means.

John Lanchester: Whoops - why everyone owes everyone and no one can ever pay.

By Richard Bull MA (Oxon) ACMA ACMI Regular contributor to Financial Management
COPYRIGHT 2011 Chartered Institute of Management Accountants (CIMA)
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Title Annotation:Technical notes
Author:Bull, Richard
Publication:Financial Management (UK)
Date:Nov 1, 2011
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