by Girish Menon (Adapted from: Talking to my Daughter about the Economy by Yanis
Varoufakis)
How does a new
entrepreneur start?
Let’s call her Indira. Indira will need some money (capital)
to hire the factors of production i.e. to pay wages, for raw materials, machines and for rent to
start her business. Since she will only get money after she has sold her goods,
she has to take a loan to get started and the loan taken to get started is called
Debt.
Also, since the amount of wages, raw materials and rent are
decided in advance the only person who does not know what she will end up with
at the end of the process is Indira the entrepreneur. Hence achieving a profit
becomes the most important goal for Indira in order to survive and not to end
up with unpayable debt.
---For earlier articles
Explaining GDP and Economic Growth
Quantitative Easing
What is a Free Market
---
Entrepreneurs as time
travellers
When Indira takes a loan to get started, what is she
actually doing? In the format of a sci-fi movie, she is looking into the future
through a semi-transparent membrane. Sensing an opportunity, she then pushes
her hand into the future and grabs the revenue she will make and pulls her hand
back into the present.
If Indira has discerned the future accurately, then she will
be successful and will earn enough to repay the loans that she borrowed to
start with. However, if she has predicted the future wrongly then her business
will fail and she will be unable to repay her loan and become bankrupt.
Bankers as time
travel agents
Nowadays bankers create money out of thin air. Yes, they
have the power to type the numbers in your bank account and money is created.
Since bankers have very few constraints on the amount of money they can
conjure, they have great incentive to lend money and earn interest and other
fees. After all the more money they create and lend in an economy the greater
the profits for themselves.
Bankers - Heads I win
and tails you lose
Earlier, bankers would lend to entrepreneurs like Indira if
they trusted her to able to repay her loan in the future. But nowadays banks
have found a way to insulate themselves from Indira’s failure. For example,
once a bank has given a loan of say £400,000, then the bank would chop up this
loan into little pieces and sell it on to others i.e. in return for lending the
bank £100 each; four thousand investors would each be given a share in the £400,000
loan. Thus the bank has already recovered the loan and will make a profit when
Indira repays her loan. If Indira goes bankrupt then the four thousand
investors will lose their money.
Positive Multiplier
Suppose Indira is successful, she will hire workers, buy raw
materials… these factor suppliers will receive wages and rents and buy more goods and the
process of recycling goes on a positive and upward scale increasing GDP, more
employment, more new businesses etc.
The Crash
As the economy grows, banks will lend even larger amounts of
loans until it reaches a point when the loans they have made are so vast that
the economy cannot keep pace. At this point realization dawns that the large
loans will not be repaid and the economy crashes.
Due to the bank’s enthusiastic lending the once successful
Indira may now find it difficult to repay her loan. She will now have to close
down her business and the workers and suppliers will no longer get wages or
rents. This may affect other businesses and a downward spiral starts resulting in
bankruptcies, lower GDP, unemployment….
Debt, Profits and
Crashes
Thus debt is indispensable in capitalism. There can be no
profit without debt. However, the very same process that generates profits and
wealth also generates financial crashes and economic crises.