1. The Problem – micro view
1.1. Theory
Let us explain very basic economic theory first. Below is Cost Volume Profit graph.
Figure 1
Every business has cost, with 2 main components – fixed cost and variable cost. Fixed cost includes things like cost of machinery, premises, staff salary etc. Crucially, it also includes interest payment on loan – assuming all businesses have some debt which is loan taken from bank and/or investors to raise the capital. The variable cost is often proportional to revenue or sales.
Here we shall use the term sales and revenue interchangeably, to denote earning of the business.
If a business procures more number of product units, higher quantity raw material needs to be purchased – so this is how it linked with revenue. So this is the variable part of the cost.
The earning is shown by blue line. The expense is shown by red line the above graph.
We know the simple formula, Profit = Revenue – Cost
If profit is negative, then it becomes loss. This is same as saying, Savings = Income – Expense.
A business needs to pay tax on profit – so tax is also a cost. But for simplicity, we leave tax out of our discussion.
The point, where revenue becomes more than cost, is known as breakeven point. Until the business reaches this point, it is loss making. Once business is way past breakeven point on the right, it is profitable. In fact, all business tries to move as much right as possible for sustained growth and profit.
A business can borrow more (cost goes up as interest payment) to increase revenue (more sales), resulting in more profit. Now, how much a business needs to borrow in order to increase profit is a complex calculation which depends on type of industry, business strategy, market condition and many other factors.
At normal time, all businesses operate in an equilibrium. Business pays interest to bank, buys the raw materials from suppliers, manufacturers product in factory, pays salary to employees and sells products to customers who pay the price and so on. For a service based business, the theory is still the same. Here, instead of producing items in factory, the company sells intellectual expertise of their employees.
1.2. Recession
Let us see what happens in a recession. The pandemic has led to people being fearful and cities have been locked down to encourage social distancing. As a consequence, all sales have gone down (except very few like supermarket shopping where people are stockpiling for the Armageddon).
Due to very low (or nothing at all) sales, the revenue curve will flat out. However, the fixed cost component will remain mostly the same. This means, for a long time, the business will not make any profit.
Figure 2
This is shown in above figure. Note that we are now showing time on horizontal axis.
While cost of the business also falls due to less sales, the revenue falls rapidly as people are scared away from purchasing. This will drive down the businesses into further loss.
How quickly a business comes to grinding halt, again depends on industry, geography, mitigation factors etc. For example, airline industry, which has a high fixed cost (as the cost of flying a plane with one passenger vs 300 passengers almost the same) are already near bankruptcy.
For a person, disaster does not strike as soon as he or she loses job (i.e. salary stops coming). This is because the person can still sail thru troubled times using own savings. Here savings is the money in bank saved during good time.
However, a person becomes bankrupt when his/her savings become zero and cannot pay for anything anymore.
Similarly, a business does not go bust just because it is making loss. A lot of businesses, especially those like start-ups, make losses during initial years. However, they carry on as long as investors pump out money to them. This is cash flow.
A business goes bust only when it runs out of cash.
In normal time, a business can increase their cash reserve by adding the profit to their cash reserve. Every business has a finite amount of cash reserve. The amount again depends on industry, strategy, demand etc.
Also as the demand falls during recession, the supplies must also go down as more competitors now try to get a slice of same shrinking market. This further drives many businesses into downward spiral of lower sales thus more losses.
As businesses go into losses, they start laying off employees, which collectively reduces further demand on the market, leading to panic and mayhem.
2. The cause – macro view
2.1. Pre-pandemic
Here we shall take a step back and discuss how the world economy (mostly capitalism or market driven economic model) works.
Our economy is underpinned by the banks and the government. The depositors (i.e. common people) deposit money in the bank. Let us say a bank collected £1000 from depositors. The bank will pay a tiny interest to the savers. Bank will earn money by lending money to borrowers (for starting business, buying house etc.) at a higher interest. The different between interest earned and interest paid (from bank’s point of view) is the profit for the bank.
But the twist is fractional reserve. This is adopted almost universally worldwide. Under this model, if a bank has only £1000 deposit it can create more money out of thin air, while lending. So basically the banks are allowed to lend more than the actual money they have. In our example, a bank can lend £10000 to borrowers! This means, the bank has created 9 times more money (1000 + 9000) than the real deposit amount. This fictitious money is then lent to people and businesses. This fictitious money is the debt.
Our economy is debt driven economy.
In olden days, when gold was used as currency, fictitious money was not possible. Once the banks introduced fiat currency, by abandoning gold standard, banks got the freedom of create fictional money and debt.
The fiat currency is what our bank notes are. These have no intrinsic value (unlike gold etc.) but people use it as if it has purchasing power purely driven by trust as guaranteed by the government.
Creating this fictional money is not necessarily evil per se. Had the bank not created fictional money, it could have lent only £1000 (in our example) to people who wanted to buy houses or start businesses. However, by creating fictional money of £9000 more, bank is able to lend to more people, enabling more people to buy their dream houses or fund their own businesses. In theory, it actually elevates more people into better life. When we say better life, this is by more consumption of goods and services. With more transactions, nation’s GDP goes up.
As long as continuous growth is happening, everyone is happy in this model. This is why all politicians and big businesses love growth. It makes everyone feel good.
Thus, in a debt driven economy, more money is analogous to having better life.
2.2. Post pandemic
Things become dramatically different during and after pandemic!
As everyone borrows more and more, the debt burden increases. Remember, all debts are to be paid off someday! In normal time, people do not think much for paying of debt. The house price mostly goes up. So even if house owners default on mortgage, the bank can repossess the house and can sell at a higher value than outstanding mortgage amount. So even if individual business or people are bankrupt, the country level economy (known as macro economy) pulls thru as usual.
During pandemic time, the revenue of most businesses fall so low, that most business cannot make profit at all. The business will also default on their loan payments and soon become bankrupt. With millions of people becoming jobless it will be a national calamity.
The government, as in any recession, usually intervenes. This is done by financial stimulus like printing money (known as Quantitative Easing) and reduces interest rate to encourage business to borrow money and sail thru the cash flow issue.
The important part is, government will give further loans to businesses. These loans are meant to be paid back when situation improves.
This will lead to a situation depicted in the next graph.
Figure 3
The key message here is that with even more debt (on top of existing debt) most businesses will not be able to see profit for a very long time. So they are going to see cash flow problem again after some time, requiring another bail out. This will lead to even more debt – which will increase the fixed cost even more as interest payment will also go up and this cycle will continue for foreseeable future.
No business can run in loss forever (only exception is some nationalized public services). Unless the shareholders/investors see some return on their investment, they will not be interested in paying money to the business.
This is a deflationary economy, dreaded by all. Whereas deflation did happen in the past, this time, clubbed with the pandemic (i.e. loss of lives) the blow will be huge.
The philosophy of the capitalism is survival of the fittest. In capitalism, people with more money are considered better off. People with more money can have a better life. But a pandemic, affects rich and poor equally. Hence, if money does not improve people’s lives, people may not be willing to increase their earning more. Thus the fabrics of run after money philosophy fails!
Although, even during pandemic, the rich and powerful in somewhat privileged as they are able to get tested for COVID19 whereas normal people cannot unless they are serious ill and rich people can still buy essentials at an inflated price from black marketeers.
3. The solution
I admit that I do not know what the solution is. If I were that intelligent, I would have received Nobel prize by now. But still, we can make some attempt to find a solution that may work.
One option could be writing all the debt off for everyone. This means everyone can start with a clean slate. This will help majority of the people. But this will not go very well with the banks and the government. Why?
Because in debt driven economy, the control of economy in the hands of privileged few, namely the banks and the government. If debts are written off, their own flow of income will stop. They will also not be able to control the population saying work hard else you will die starving.
From historical times, society has mostly been unequal rather than equal. Even in Ancient Egypt, there were rich and almighty pharaohs and slaves who served the riches. As the folktales say, when Moses tried to free the slaves, the pharaoh refused. Among many other tricks, the God of slaves unleashed a plague which affected pharaohs’ family only and spared the slaves’ families.
The analogy here is illustrating that rich and powerful always controlled the masses – in olden days with fear of death and in modern days’ fear of (lack of) money!
Usually in recession the government often bails out (i.e. provide cash to big businesses as loan) but this seldom goes to employees. Big corporations claim these saves the jobs, but alternatively, government can help everyone by giving them money directly in the form of Universal Basic Income (also known as Unconditional Basic Income i.e. not means tested). The unconditional basic income is claimed to be easier to manage than means tested benefit system. If this scheme is adopted, the big corporations can simply fail if they cannot run their business efficiently.
The other path could be gift economy. It mode of exchange where valuables are not traded or sold, but rather given without an explicit agreement for immediate or future rewards. This is like catching fish to eat but not catching too much to make a big profit. This model already works in Open Source Software where people write software for others for free and users can donate if they wish. Couch Surfing as another such example where people stay in others’ homes during holidays without paying anything.
Designing an alternate economy model is extremely complex and beyond the scope of this article. My aim here is to drive the thought process of everyone so that collectively we may invent something more egalitarian than greed driven economy.
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