The Real Cost of Debt

Fr. Sean McDonagh, SSC

During the past few weeks I have been writing about the current financial turmoil and calling attention to the fact that this is not the first time in recent decades that banks have impoverished people and destroyed the environment through their irresponsible lending policies. Previously, I focused on the horrible consequences of reckless lending to countries in the third world in the 1970s. Servicing these loans has caused pain, suffering and death to many people during the past 30 years. It also devastated the environment in crucial ecosystems across the world.

Third World debt repayment benefitted the first world countries in two ways. Firstly, the economist Susan George estimated that, in the period from 1982 until 1990, US$418 billion was transferred from poor countries to rich countries to service the foreign debt. This money ought to have been spent on education, health care, social services for the vulnerable in poor countries and on building up a diversified, local economy. Instead it subsidized the economies of rich countries and increased consumption. Secondly, most poor countries had very little manufacturing activity and were almost exclusively commodity-producing countries. Between 1974 and 1988, the price of a basket of 28 basic commodities, including lead, tin, zinc, sugar, coffee and teach, fell by a staggering 48%. The Economist magazine estimated that the first world saved US$65 billion in 1985 alone. This, of course, kept inflation low in developed countries during the 1980s and 1990s.

There were two reasons for the drop in commodity prices. The first had to do with the recession in the rich countries, caused by the hike in oil prices in 1973 and again in 1979. The second reason was a direct result of the economic policies forced on third world countries by multilateral financial agencies such as the World Bank and the International Monetary Fund. These policies dictated that poor counties reshape their agriculture programs away from subsistence agriculture, geared to feeding the local population, to planting export-oriented crops. For example, many more poor countries were encouraged to plant coffee. This led to a glut in the market and the subsequent collapse in the price of coffee on the world market in the mid-1980s.
Low inflation in the first world during the 1990s and the early part of this decade was not due to shrewd economic policies designed by politicians and central bankers as they would like us to believe. It was as a result of an ever larger variety of cheap goods being imported from China. As a consequence, China began to run up huge financial surpluses, particularly with the United States. Some of this saving went into US government bonds, but the bulk was invested in various assets, often property, in various parts of the world. These assets began to increase in value driving up property prices around the globe.

In response to these trends central bankers around the world were faced with a dilemma. They could either target consumer inflation, even though cheap Chinese consumer goods was keeping inflation low anyway, or they could address the asset inflation side of the equation.

Unfortunately, the Federal Reserve in the United States, under the chairmanship of Alan Greenspan, decided not to interfere in the market and thus curb the explosive growth of risky and often fraudulent mortgage lending. On October 4th 2008, he told a Congressional hearing that the largely unregulated business of spreading financial risk widely through the use of exotic financial instruments called derivatives, had gotten out of control and had added to the havoc of today’s crisis. As far back as 1994 he had resolutely opposed tougher regulation on derivatives. His status as an economic guru in the eyes of both Republicans and Democrats blocked any effective regulation.

As the property market collapsed many banks had too much debt and too little capital to provide sufficient credit to keep the economy moving. Some of the banks have tried to meet their debts by selling assets. Because confidence in the financial system has evaporated, the value of these assets has fallen through the floor, reducing banks’ capital even further. Governments have tried to step in with a number of schemes, some to guarantee depositors, others to buy bank shares, reduce interest rates and/or recapitalize the banks.

Thus far the financial markets have not responded as confidence in the system is at a very low ebb, probably the lowest it has been since the Great Depression.