Friday, March 20, 2009

Marx my words !

"Democracy will ultimately collapse into socialism(communism)" - Karl Marx

Before embarking on writing this blog entry, I would like to emphatically proclaim that I am a proud free-marketeer who believes in the tenets of capitalism.
Yes , this blog is going to be about economics (yawwwnnn :) ). Well, I would be deceiving myself if I were to believe that this topic would appeal to most people. But however keeping in mind the current economic downturn, it would be nice to delve into the reasons that got us here.
I consider myself a layman in financial issues (but however, it is also one of my passions). Lemme try to explain what I understood from this financial chaos.

What exactly happened

Let us consider a guy called ABC and a bank called XYZ. ABC has seen that property prices are going up everywhere. So, he decides to buy a house. The house costs Rs. 70 lakhs. Even though ABC is unemployed, the bank XYZ gives him a loan of 70 lakhs. Why ?
Isn't giving a Rs.70 lakh loan to an unemployed person risky ? how will he give the money back ?

The beauty here is that the banks never expected to get their money back :)

what the bank XYZ thought ---> "ok...this guy will not give the money back. So, we can seize the house when he defaults on the loan. By the time the guy defaults, he defaults, the house price would have shot upto Rs.80 Lakh. We can sell the house at that price and make a cool Rs.10 lakh profit "

well, in a few months, the price went upto 80 Lakhs.

What ABC thought--->"ok, the price of the flat has shot up to Rs.80 lakh. I have already got a loan of 70 lkahs from the bank. Now, let me borrow another 10 lakhs. With this new loan of 10 lakhs, let me buy a huge car and go on a vacation. Afterall, if something happens, I will sell the house at 80 lakhs and give the money to the bank. "

The bank XYZ gives this 10 lakh loan, because, after a few months , the house will be worth 90 lakhs rite ????

What actually transpired ----> The housing bubble burst. Housing prices collapsed. The house that ABC bought at 70 lakhs is now worth 30 lakhs, and sinking fast.
ABC has no option but to file for bankruptcy , or default on his payment.
Remember, ABC actually owes the bank 80 lakhs (70+10). So, the bank seizes the house. But finds that it is worth only 30 lakhs.
Bank has a loss of 30-80 = 50 lkhs

Now, banks are facing huge losses. So, they stop giving loans to people like they used to.
But if people dont get the money they want , they are pissed. What do they do ?
They vote out the government.

what the government thinks -----> "Damn ! if we dont get these banks up and running and lending to people again, the people will get pissed and not vote for me. Hmm...there is one way out. Whatever tax money I have got out of the people, I will give it to these banks so that they can lend more money to undeserving people."

So, this is how money gets transferred from law abiding, non risk taking , hard working citizens to jobless people (remember XYZ) who took unbelievable risks

It is interseting to note that the same thing is happening with "BIG FIRMS"
Firms like General motors, Ford etc having huge losses. Why ? They had labour unions which demanded a large pay for a small amount of work. So, their cars became expensive.
So, in such a downturn, people stopped buying these cars and went in for Japanese cars which were cheaper. So, what happened ?
GM and Ford are facing huge losses. They have 3 million workers working for them directly and indirectly. They have no choice but to file for bankruptcy. But if they do, some other company will take them over. If some other company takes over, they will fire 1.5 million and retain the other 1.5 million workers.
So, 1.5 million are unemployed. They are pissed.

What the Government thinks ----> "Oops, if i dont pump more money into GM and Ford (which are practically dead), I will lose 1.5 million votes. So I will take tax-payer money and give it to GM and Ford "

Money which should have been used for development and other purposes goes for propping up a failed business which hardly deserves any sympathy.

But why are communism and socialism collosal failures ? I shall try to explore that next :D

-Tejas

3 comments:

Deep(a) Insights said...

Simple economics yet troubling :P..awesome article. I now realise, how safe is conventional banking system. Our nationalised banks and scheduled banks are working perfectly fine compared the boastful private banks.

Meera said...

Well explained Tej :) Can't wait to read about the communism/socialism article. I was beginning to wonder if they were the future, but couldn't quite accept that,since they have equally gaping holes.

Unknown said...

Whoa Tej!! I actually understood what the crisis is all bout now....more clearly!! Layman's terms you say and so it is!!! Good one!! :) Me likey :D