On Bailouts, Boons and Bill Clinton

So living in New York City has made it damn near impossible to not be wrapped up in the minute by minute saga that is the US financial crisis. Moreover, the fact that here at Stern Business School, over 50% of our job prospects have evaporated with the slew of bankruptcies and buyouts has effectively forced this issue to the fore of nearly all of my conversations with people.

Given the magnitude, surprise and potential dangers of this crisis, I am about to break one of the unofficial rules of this blog and actually talk about something that is happening outside of India’s borders. I am doing this for three reasons: first, the effects of this financial crisis will no doubt have ripple effects the world over including people all the way in rural India; second, this financial crisis has very unique characteristics that we can learn from with regard to microfinance; and third, the global implications of how the US deals with this crisis has huge symbolic and practical ramifications.

In such an interconnected world, the viability of one financial market will inherently affect every other market it links to. As Indian companies and entrepreneurs seek outside funding to help them grow, the effects of the credit markets drying up in US and now Europe will be felt back in the motherland as well. When the US housing bubble first burst last summer, many Microfinance Institutions scoffed at the notion that something that seemed so innocuous could affect lending to the bottom of the pyramid. Since then, however, MFIs, in order to scale up, have been aggressively looking to outside funding for capital, and as a result have become inextricably linked to the global economy at large. Just as the saying ‘it takes money to make money’ goes, so does capital, and as these MFIs look now to their next round of investors, the sudden disappearance of liquidity will only make the terms at which they can negotiate less favorable, meaning that less can be funneled back down to clients.

More importantly, I have written many times on the importance of figuring out ways for microbusinesses to grow into small and medium size enterprises (SMEs) in order to actually contribute to job creation on a macro scale. While very early stage companies can turn to venture capitalists and other investors for money in exchange for equity, as a company grows they traditionally turn to debt or credit markets to finance their operations and growth plans. Cheap debt fuels entrepreneurial growth, as it encourages risk-taking and aggressive business models of high growth. Without such cheap debt, however, building your business has just become that much more difficult.

Second, in addition to its global implications, the current crisis has many unique characteristics that set it apart from other crises in history. Unlike the Stock Market Crash of 1929, the Savings and Loan Crisis of the 1980s, the Tech Bubble Burst of 2000, or even the Asian Financial Markets crash in the 1990s, the current problem is not occurring due to overvaluation of stocks or other financial products and thus being dumped back on the market. While that is how the problem started, now we are in a time where the actual willingness of banks and other creditors to lend money to each other and clients has been threatened. The very job that necessitated the invention of the banking concept is now in jeopardy the world over. If banks are uncertain that their own peers will be around long enough to pay them back on an interbank loan, what chance does a regular person have in obtaining a loan for a home or business?

The field of microfinance has enjoyed significant success over the last three decades greatly due to the very high repayment rates that such business models have been able to generate. But as the crashing back to reality that the past few weeks has shown, repayments by even the most respected financial institutions are not guaranteed. It is imperative that MFIs recognize this risk as they grow themselves to offer additional services and products to new customer segments. Funds like Unitus are measuring and monitoring those MFIs in which they have invested to make sure that their money is working effectively. They could pull the plug altogether, however, if they too became wary of repayment rates.

Nilesh Fernando at India Development Blog compared the implications of the bailout with that of the farmer loan waiver program in India and said that “the agent (the farmer or the banker) has done a bad job of satisfying whatever contract that exists with the principal and is therefore unable to make good on the promised return, be it to an MFI or the shareholders at Lehman.” While comparing a banker to a struggling farmer seems callous, the principal behind this argument is sound, although as I will now discuss still suffers from a fundamental flaw.

Finally, the direction that the US and other central banks take to rectify this crisis has major implications. The $700 billion bailout that is being vociferously debated in the halls of the US legislature will forever change the way markets will be viewed. In effect it is 700 billion voices screaming to the world that market failure is not only possible, but also probable if people are left completely unregulated. Thus Fernando’s comment on comparing a banker and a farmer fails to recognize that while the agents may be at fault, the actual system itself is also flawed by allowing people to make such risky and imprudent contracts in the first place.

Internationally, the very idea that the US government is even debating a bailout should serve as a slap in the face to every Latin American, African and Asian country that liberalized their economies in accordance to IMF and World Bank stipulations and were told time and time again that they would not receive help unless they promised to uphold their debts to creditors. Now the US government is turning to its own ilk and using taxpayer money to bail them out and forgive their debts. Developing/emerging economies the world over must continuously bring this hypocrisy to light and force the US to recognize that although this bailout is likely necessary, it is an acknowledgment of the ludicrous idea that free markets unchecked are an efficient and equitable means for resource distribution.

Fernando does recognize that nonforgiveness or nonintervention is a harsh road, but he argues that it instills the necessary discipline in the markets to ensure history does not repeat himself. However, interestingly, he then realizes that societies will often prioritize sympathetic or humanitarian factors above economic ones and so things like waivers and bailouts may be systemically necessary without adequate education.

Last week at the Clinton Global Initiative, Bill Clinton in his closing address said that the financial crisis should actually be viewed as an opportunity to invest in the world’s poor as it is now one of the greatest sources for profit. This statement while true only reiterates why we must approach this idea so carefully. In the end, when investors invest, they do so based on risk and reward — when they go awry, so does the entire world.