Saturday, October 27, 2012

Credit Boom in Coffeeland

In the previous post, Coffeeland had a railroad boom funded solely by direct foreign investment.   The people of Coffeeland only use gold coins for money, but still there was a boom, with higher nominal and real output and higher nominal and real wages.   In the first scenario, the improved economic performance was permanent, because coffee prices remained high.   In the second scenario, a shift in tastes away from coffee to tea by foreign consumers led to a deep depression.   The problem was that coffee prices were low.   While there was initially mass unemployment, lower nominal and real wages allowed employment to recover, though nominal and real output remained depressed.

Suppose that the foreign corporation that developed the railroad did not solely use equity finance, but also sold long term bonds.   The firm is quite conservative and plans a sinking fund, so that not only can it pay the interest on the bonds, it can pay off the principle.   As before, the funds raised are used to purchase steel rails, picks, shovels, and axes, as well as bags of gold, and shipped to Coffeeland to build a railroad to the central plateau.

The economics are no different.   In the first scenario, the debt-financed boom results in a permanent improvement in the economy of Coffeeland.   The new coffee plantations on the central plain generate enough business for the railroad to earn profits for the stockholders and pay all the interest and principle on the bonds.   The second scenario remains bad.   There is a depression as before, but just like before, it was caused by the decrease in the demand for coffee.   It is true, however, that the railroad company defaults on its bonds.   There is a "financial crisis."  There is not enough money generated from coffee to pay all of the interest and principle promised on the bonds.   The stock prices crash harder too.  

Now, if Coffeeland insists on closing down the railroad for an extended period of time until its finances are sorted out, then the inability to shift coffee to the exterior will cause tremendous disruption in the economy, especially in the central plateau.   But if they have any sense, and realize that continuing to operate the railroad will reduce the losses of the bondholders, then that should not be a problem.

So, Coffeeland has a debt-financed boom.   If the debt was used to fund a profitable investment, then all is well.   If the investment turns out to be a malinvestment, then there was waste--losses for the investors.  

What about financial intermediation?   Suppose some Coffeeland investors start up a railroad company and other Coffeeland investors open up a bank.    The Coffeeland railway investors put up minimal capital and obtain 5 year renewable loans from the Coffeeland bank.  The Coffeeland bank investors put up minimal capital and fund the loans by selling one year certificates of deposit to foreign investors.  

The economics are the same, but the railway boom is financed bank credit.     A trade deficit develops.   Real and nominal wages increase.   Real and nominal output increase.   And the railroad makes enough money to pay off the interest and principle on the bank loans, and the bank makes enough money to pay the interest and principles on the C.D.s     Opening the fertile plateau allows for permanently higher coffee production.  Coffee exports are enough to pay back the foreign investors.

Of course, if the shift away from coffee to tea leads to low coffee prices, Coffeeland suffers a deep depression as before.   The Coffeeland railway cannot repay its loans to the Coffeeland bank.   It defaults.   And the Coffeeland bank cannot repay the CDs to the foreign investors.   It defaults.

Was the depression caused by the previous boom?   No.   Was the bust caused by excessive bank loans funding the boom?   No.    The problem was the decrease in coffee prices.

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