Dreams and disaster happening at the same time.

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  Margaret and Joel

About a year or so ago a poster designed by Milton Glazer began appearing on the sides of telephone booths in Manhattan. It featured a hand, the fingers of which displayed the colors of the world’s races. The title of the poster was “We are all African”. The brilliance of its design evoked the factual knowledge that we all have evolved from the African continent and the emotional truth that we are all our brother’s keeper. Its intent was to encourage people to become involved in fighting world poverty.

But there is now another way in which “we are all African” and it is one that increasingly uncomfortable and increasingly impossible to ignore. It is the story of interest rates and the management of risk.

In the 1970’s loans were made to African nations on a bilateral basis (country to country), a multilateral basis (IMF, World Bank, etc.) and via private banks. Very little of this money reached the people who were supposed to benefit and in due course, additional loans were provided to pay for the original ones. Research done at the London School of Economics by Professor Gavin Capps details the resulting problem. Between 1990 and 2002, $540 billion in loans were made to Sub Saharan Africa and $550 billion in payments were made to the lenders leaving an interest balance of $245 billion.

During this time, the IMF and World Bank instituted “austerity programs” and required debtor nations to comply as a condition of renegotiating further loans. These austerity programs have resulted in massive layoffs, sharp reductions in credit, higher interest rates, cuts in spending on health and education and currency devaluation. On its face, these programs result in the inability to create and maintain an educated workforce that could expand the economy and reduce the debt. The efforts of Bono and others to “forgive” these debts is really a negotiation about the rate of interest – the principal has long since been repaid.

So how is this analogous to the industrialized western nations? In addition to the sub-prime crisis that is fueled by ballooning interest rates on home mortgages, Fortune magazine reported in October of last year that credit card debt in the US is $915 billion. The interest charged on this debt is anywhere from 7% – 36%. The federal laws against usury were repealed during the Depression and some states (notably South Dakota where many banks have relocated their credit card businesses) have no laws at all – so the sky is the limit as far as the amount of interest and fees that can be charged.

On the Federal level, our national debt is $9.4 trillion. In 2006, the interest payment on a lower level of debt was $406 billion – the same year that we spent $15 billion on education. Internationally, the British citizens hold more personal debt than their counterpart in the US and, according to Alan Greenspan last week, Spain has a proportionally larger real estate bubble than the United States. Debt on a national and personal level in the industrialized west is so high that it seems to defy a solution.

Interest has always been justified as the cost of capital. There’s the opportunity cost (if the money is loaned to A it can’t be loaned to B or invested in C) and the operational cost (processing the loan, collecting the payments, etc.) – and then there is the risk factor. International standards, such as Basle II, require financial institutions to allocate capital to a reserve account – the amount depends on the level of confidence that the loans will be repaid or the investment will reap benefits. The riskier the counterparty, the greater capital reserve.

In credit cards and adjustable rate mortgages, the principal has been redefined in a way that seems counterintuitive. The riskier a customer you are, the higher interest rate you must pay. If you become riskier still (by not paying on time) your interest rate increases. At some point you will default, probably after you have run through your savings. The entries on your credit report will then effectively take you out of the pool of potential customers for the bank. And then perhaps you will think about how we all wagged our heads and shook our fingers at those African nations that couldn’t pay their debts. The process to insolvency is surely different, but the result is the same.

And what did we get for all this debt? Better schools? We were ranked 18th out of 24 industrialized countries in 2004. Better healthcare system? We are 37th – just ahead of Slovenia. Better infrastructure? We have 30,000 bridges and tunnels with a failing safety rating of 50 (out of 100) or less. The CIA fact book lists us as the most indebted nation in the world.

There don’t seem to be any signs that the financial system is addressing the issue. The past week has been filled with banks and investment houses buying each others debt offerings or taking ownership percentages in return for equity. The stock market is up. Perhaps Bear Stearns will be the only casualty. My grandmother would describe that kind of thinking as “whistling past the graveyard”.

There is no question that we are far, far better off than the vast majority of Africans but there is also no question that our indebtedness and the associated interest costs are going to have a very corrosive effect on our standard of living and our way of life. Clarity on how we got to where we are is essential in developing a solution. Left to their own devices, people will have no choice but to default. That’s what has already happened in the subprime market and what could very well happen with home equity loans, automobile loans and credit card debt. The burden has just become too great for too many people. Belief in the system can’t take too many more shocks.

Risk used to be defined by the likelihood of success. Now it is defined as the likelihood of failure. That definition is a self-fulfilling prophesy. Unfortunately, it seems likely that we will have to experience a bit more of the crushing effects of pervasive debt and higher and higher interest rates before we come to our senses.