A practical lesson from the People’s Republic of China on societal collective action.

When a fabric company called Jiangyin Xueyuan Textile Co collapsed, the troubles soon cascaded through other firms in this mill town.

A machinery maker, paper producer, manufacturer of faux-wood flooring and textile maker had one thing in common. They had promised, in the event of default, to repay the loans taken on by Xueyuan.

Indeed, they had all guaranteed each other’s loans, promising to pay the lender should one of them fail. Yet in the PRC’s current economy, they’re all having trouble making their own payments, and some have, as a result, refused to honor their guarantees of the others’.

Xueyuan’s court-appointed bankruptcy administrator, Zhang Fuliang, had this to say on the general practice:

[T]he big problem among private firms is that you owe me, I owe you, and in the end, if something goes wrong, then everyone gets tangled up together[.]

A policy outcome likely will look like this one: The People’s Bank of China, the PRC’s central bank, has lowered its benchmark lending rates, in the expectation that “private” and “commercial” banks will lower theirs commensurately and thereby stimulate the PRC’s economy. However,

banks likely will hesitate to lower the cost of loans for fear of hurting their profits.

Those profits aren’t only tied to the spread between the banks’ deposit interest paid and loan interest collected. They’re also tied to the likelihood the loans will be repaid at all. When an individual firm fails, the loan is lost, but the loss is limited to the single firm. When an individual firm fails, and the network of fellow firm guarantors default on their guaranty, the single loan still is lost, but now the bank must worry about the credit worthiness of each member of that network of guarantors. That’s going to hold up interest rates for the entire network as a hedge against the loan’s default—and as a hedge against default on more of the loans the network is guaranteeing for each other. And as a hedge against the loans made to other networks. And….

Hmm….