Mismatched Socks

Khan Academy » Finance » Macroeconomics » Greek Debt Recession and Austerity (part 1)

So I’m a little late watching these videos, but they’re at the end of the Macroeconomics playlist; what was I supposed to do?

Anyways, Greece is majorly fucked. Their debt-to-GDP ratio is horrendous, with debt overshadowing GDP by 165%. Their GDP has been shrinking the last several years. Things are looking pretty bad.

So what’s the solution? Austerity! Austerity, derived from austere (just meaning minimalist, cut back to the bones; almost spartan), in economic terms is essentially just cutting spending. Cut education, cut garbage collection, cut water and gas and public services!

Okay, so if you haven’t figured it out by now, austerity is not actually effective at helping Greece climb out of this crisis. The thing about austerity is that when you cut spending like that, you can actually slow the growth of the economy — fewer services are provided for people to take advantage of, money circulates more slowly (as in any recession), but most importantly people are less wealthy and thus tax revenue decreases also.

So now you’re spending less, sure, but at the expense of critical public services (there are literally bags of trash on the streets of Greece right now) AND you’re making less revenue from taxes because unemployment is skyrocketing and people have no money.

So the cycle continues.

Khan Academy » Finance » Macroeconomics » Math Mechanics of Thai Banking Crisis

So in 1996 the Thai baht (Thailand’s currency) was pegged to the USD by Thailand’s central bank at an exchange rate of 1 baht <=> $25. It had been like that for many years, and in 1996 interest rates in the United States were about 8% and interest rates in Thailand were about 12%. 

Thai financial institutions couldn’t help but notice the opportunity for profit.

1. Buy $1 million for 25 million baht at 8% interest (let’s imagine a 2-year loan, so you pay interest for 2 years and then pay back the principle).
2. Lend out 25 million baht at 12% interest.  That’ll earn you 3 million baht per year in interest payments, which you can convert into $120K. A $1 million loan at 8% interest has you making interest payments of $80K per year, leaving you with $40K per year profit.
3. Repeat.

Seems like free money for very little risk — but it all rests on the assumption that the exchange rate between the baht and the dollar remains pegged at 25 baht per dollar.

Then 1997 happens, and for whatever reason the baht depreciates in value. Now $1 is worth 45 baht. So you still get your 3 million baht in interest payments, but now they’re only worth $67K; and since you have to pay $80K in interest on your original $1 million loan, you’ve just lost $13K. But it gets really bad next year — in 1998 you have to pay back the principle. So even if you made some great loans and everyone paid them back, you get 25 million baht and can only convert it into $556K — and you owe $1 million!

Of course, this was a contrived example to illustrate the Thai banking crisis. In reality, financial institutions had taken out not millions, but billions in loans (so just go through the example again and add a few orders of magnitude :D).