Global Economic Crisis: Just another ParetoEfficiency

As often happens when you want to get out of an undesired situation, you have to struggle for it. As explain by a brilliant editorial from last week’s Economist, in this troubled economic times, the trade-off doesn’t changes.

Credit Cards - One of the major sources of customer debit

Economies of western countries have relied heavily on debt to finance their growth.  While some countries, like the US, have seen debt mainly in the hands of customers (that have often financed their spending through generous credit lines), other economies, like many European states, have seen this debt in the form of unhealthy state-backed-up companies (such as banks, airlines, automotive companies, etc.), or national bonds issued to cover exposed positions.

The mistake done by many, is to consider debt as poisonous evils. Au contraire! On the contrary, debt is more like a medicine than a poison.

Debt is a great fuel for economic growth: without debt, Sara Jessica Parker wouldn’t be able to wear her Manolo Blanhik (as the author of the article says), Airbus wouldn’t be able to build its planes, and Spain would never be able to lower its unemployment level (putting aside the euro-currency complication for a minute). But debt, like any medicine when exceeded the recommended dosage, can become poisonous as well.

In recent years we have seen two main situations that have allowed debt to exceed the tolerable limits and create a financial crisis: bad debt, and financial speculation. Let me explained how they worked (simplifying a bit).

Bad debt:

  1. Loans have been granted to individual and companies that could not repay them;
  2. These loans have been grouped in to financial derivatives and spread in to the world’s financial markets;
  3. When people and companies defaulted, the financial derivatives lost any value, and individual and companies that held them defaulted as well;
  4. This initiated a domino effect.

Financial speculation:

  1. Companies have been listed in to the financial market ;
  2. The value attributed to these companies (over time), wasn’t even close to the true value of its assets that should justify that value (speculation – a bubble is created) ;
  3. When these companies defaulted (bubble bursts), the true value of its assets weren’t able to repay all the shareholders, and the money that was put in to these companies was lost.
  4. The interconnections created by the financial markets created, once again, a domino effect.

The succession of these events at a very large scale, brings us to the point where we are now: global economic crisis.

Allow me to go on with this extreme simplification of complex events. Let me also defer on the responsibilities for this series of event, and let me focus on the consequences.

When a crisis such this strikes on a county, the most immediate reaction is the economic paralysis, which inevitably leads to a worsening of the situation. Financial crisis are very much like gangrene: more we wait to intervene, greater will be the damages; and as it happens with gangrene, the reaction needs to be very drastic in order to avoid an even worse destiny (amputating the affected part in order to avoid death).

When related to the economy of a country, procrastination means exponential worsening of the situation for future generations, because what can be “bad” today, is going to be “horrible” tomorrow.

Someone has to pay

In order to recover from such a situation, consumption (spending) needs to be increased. This may sound a little paradoxical, because is like hear the doctor saying:”The poison you drunk is killing you; you have to drink much more in order to recover!”. But if you allow me to skip the explanation for the sake of brevity, I can assure you that this is what textbook macroeconomics says.

And here comes another problem: if we said that a global financial crisis has left people, companies and governments broke, how are we going to convince them to increase their spending?

As we said before the solution is going to be very drastic. In order to recover from economic paralysis, governments have to increase their spending, and since they are left with very little money (from the crisis), they either have to increase revenues (increasing taxes) or decrease costs (cut expenditures).

Unfortunately both solutions are very harmful to governments themselves, and here is why: If taxes are raised, taxpayers are going to suffer more. Since taxpayers are also electors, their malcontent is going to be reflected in their voting preferences. On the other side, any cost cutting initiative, since is aimed to “save the future”, cannot compromise younger generations (by decreasing spending in education, new grad jobs, research, etc.) and therefore is going to affect the well-being of the elder part of the population. Once again, the voting part of the population.

Why we are not going to get out from the economic crisis?

The only ones that can implement such initiatives are policy-makers, also known as “politicians”. Politicians in order to keep on being “policy-makers”, have to keep their electorate happy. Useless to say, that the bigger part of this electorate is made of the same people that should see their privileges cut.

This means that no politician is incentivized in doing what is good for the country (or the Res-Publica), but they are actually incentivized in doing what is good for them, that is…stalling!…or if we want to use the metaphor we introduced before, “allowing the gangrene to spread”.


I’m not! This is a Pareto efficiency and basic game theory: it is impossible to make one person better

off,without necessarily making someone else worse off; the paradox is that even if politicians are acting extremely rationally, they are producing an apparently irrational result!

Politics is also building consensus

Are we all doomed?

Fortunately reality does not always follow the rules of textbook theories, and the many inefficiencies that contribute to increase the level of entropy in the universe (and society), also allow diverting from what it seems to be an unavoidable future.

Most probably we are not going to se politicians that sacrifice themselves and their career (wages and benefits), for the sake of future generations. If we look at the Italian political class and the choices they are making, it is pretty clear that we are doomed to go back to the dark ages in just a few years!

But there is a hope! In a reality with multiple universes can coexist, probably one day we are going to see a country where some virtuous politician is going to be brave enough to make their voters aware of the dangers of such a situation, and convince them to give up something for the generations to come.  I hope this day will come pretty soon, because, you know… the gangrene is spreading fast!

Author: Paolo

Economist by education, marketer by profession, coffee roaster by hobby.