A funny, scary story for every investor and taxpayer

[ Copied story from equity master article for my reference.]

A friend recently shared a very witty allegory on the state of economics in current times and the making of a financial crisis. It was both hilarious and scary. We thought it was very important that our readers know about it. So here it is…

John, a bar owner in Europe noticed that almost all his frequent customers were unemployed alcoholics. That means people with no jobs plus a drinking problem. What to do? If they had no jobs, they would soon run out of money and stop visiting the bar. And the business would have to shut down. How could John avert this impending crisis and salvage his liquor business?

After much brainstorming, John had his Eureka moment. He came up with what he thought was a genius marketing idea. The idea was simple: drink now, pay later.

So his customers could have as many drinks as they desired and not worry about having to pay immediately. John, on the other hand, kept track of all the bills and granted customer loans to his loyal drinkers. Both seemed happy. The customers didn’t have to bother about paying up upfront. And John was able to revive a declining business. The marketing plan created a buzz and John had his sales grow exponentially. From time to time, he was able to easily hike prices of the drinks. And his customers never complained. John was now the proud owner of one of the busiest bars in Europe. Not to forget the real cash earnings existed in the future, if at all.

Seeing his growing business, the bankers were happy to increase the borrowing limits for John. They saw the debts of unemployed alcoholics as valuable future assets. Some young ambitious geeks at the bank saw a big opportunity here to transform the customer loans into securitized tradable bonds. Then of course, these securities were bundled and traded on the international bond markets. The investors do not know that what was on offer was really a bundle of debt of unemployed alcoholics. They simply joined in the extravaganza of this new hottest-selling bond and the bond prices went flying skywards.

Guess what? Everybody seemed to be making money and getting richer. John had a thriving business. His customers were happy. The bank was doing great business. The brokers were earning great commissions. The rising bond prices also made investors rich.

Sounds like the economics of happiness? Well, this story, as you may have guessed, certainly does not have a happy ending. Finally, a newly joined risk manager at the original bank saw the debt pile and decided it was time that the debt be repaid. He approached John, who in turn demanded payment from his customers. But well, where was the money? Most of them were still unemployed. And this was precisely where the party ended. John was forced into bankruptcy. The bar shut down.

But this is not all. When the news of the non-payment spread, the bond prices came crashing down. Investors saw a massive wipe-out of wealth. The local bank that had lent heavily to John witnessed a critical credit crunch and was unable to issue new loans.

And there were even more parties involved. For instance, John’s suppliers had significantly relaxed their credit terms. Some of them had to shut down. Others had to downsize their operations.

But there were some who came out of the crisis untouched, in fact, much richer. Who were these people? Can you make a guess? Well, the answer is bankers and brokers. Theircronies in the government were happy to help them out with a multi-billion euro cash infusion, all in the name of saving the economy from a systemic collapse. But where did all this bailout money come from? As it turns out, the bailout money was raised by levying higher taxes on employed people, most of whom were non-drinkers. Now you see who paid for all those drinks?

If you have been wondering what’s going on in the global economy, this allegory does explain quite a bit. Many of the developed economies are in a mess right now because they consumed a lot more than they could pay for. They were consuming their future incomes in the present with this magical concept called debt. But when you have too much of it, you have a crisis eventually. We saw how the global financial crisis that broke out in 2008 rocked the world economy.

Some may think it is pointless to worry about the world economy or the monetary policies of the developed economies. How does it concern India and Indian equity investors?

The world economy and the global financial markets are way more interconnected and interdependent than ever before. If developed economies pump in cheap money, a lot of it finds its way to developing and emerging markets. This flood of money is not coming out of real earnings and savings. It is a dangerous monetary experiment that various central banks are toying with. Whenever this money changes direction or reverses back, it could rock the already fragile global financial markets. And India would be no exception.

Are you banking on the flood of cheap global liquidity to drive valuations  higher?