The ongoing debt crisis problem is both, very real and extremely dangerous, with potentially devastating effects if not adequately handled.
The plain and sad truth is that, with very few quite remarkable exceptions, it is very evident that at one time or another, most countries on Earth have consistently proved their inability to appropriately manage debt. Mankind transferred from the barter system, to money many centuries ago. Unfortunately, credit –the inseparable byproduct of money– has not yet been properly harnessed by most modern societies; that is, an adroit credit management by nations has been badly missing.
Interestingly enough, there are plenty of corporations, SME (small and medium enterprises) and individuals that do appropriately manage debt. And by contrast, how come most governments haven’t reached that level of proficiency in such an utmost matter? The major explanation seems to reside in structural deficiencies and how political systems’ incentives/punishments have been functioned until now.
There are several approaches to truly and once and for all, solving the menacing World debt crisis (the EU, the US and Japan, are among the most outstanding current transgressors). One of the most logical solutions resides in reverse-engineering the causes that have produced that most undesirable effect (the massive debt bomb). Probably contributing in over 50% of the problem is the indispensable, yet very costly social net known as entitlements. There is no doubt about how vital the social net is to deal with the most pressing human needs: mainly health, unemployment and retirement benefits. However, in order for any system to be solid, high-quality, and effective, it has to be self-sustainable. Self-sustainability, in turn, means self-financing.
That’s exactly how the World has gotten into the big debt mess we are now in. The social net systems, by and large, have been operating below their break-even level for decades.
Very few political groups in the world have shown the wisdom, the depth and guts to stop the financial hemorrhage caused by the imbalance produced when the costs of providing a set of services has been consistently exceeding the revenues collected for that purpose. The easy way out has been to finance those deficits with debt, which has been accumulating and compounding throughout the years. The favorite solution resorted to, up to now, has been to kick-the-can into the future. The big problem is that the future finally arrived. There doesn’t seem to be much further room to maneuver, as in the past. The system is structurally flawed.
On a parallel angle, equally important, lies the extremely low capital base on which the banking system has been operating probably since inception. It does not make any logical sense at all for that state of affairs. It could be thought that operating with a meager capital base enhances profitability (along with risk). Most unfortunately, however, the world banking system is stuck in the worst of all possible worlds: extremely low profitability ratios with an extremely high risk profile. The extremely low profitability can be easily verified by checking the average ROA (return on assets), which compares profitability against total assets (including debt), not only versus equity (ROE).
The banking business is as correlated to the economic cycle as the construction and the automotive sectors, if not more. Thus, it stands to reason that it should, at the very least, adhere to the same capitalization rules of those other two sectors –roughly a 1 to 1 debt to equity, no more that that.
Going back-to-basics has proven, most of the time, to be very helpful, as a means to understanding the roots of any complex situation and how to solve it. The ongoing World debt crisis is no exception.