dispatches from TJICistan

The best “What the heck is this all about!?!?!” financial FAQ I’ve stumbled across.

I’ve been trying hard to get all the details, so there’s little in here that shocks me, but it’s nice to have the confidence interval of my sketchy comprehension narrowed down snugly.

Here’s my ultra-short version:

Q: What’s going on?

A: A credit crunch.

Q: What’s that?

A: Because we’ve moved past the level of trading apples for chickens and chickens for pigs, to the level where we sometimes trade apples TODAY for chickens TOMORROW, we expose ourselves to unpredictable things … like handing over the apples TODAY and finding out that the chicken died before the sun rose again.

Q: Why do we do these things?

A: Lots of financially naive folks think that we can remove all risk, inflation, etc. by only ever trading apples for chickens on the barrel head, and doing away with paper money (so that all money is gold) and doing away fractional reserve banking, so that when I deposit one gold coin in the bank, the bank can then take that actual physical gold coin and loan it to someone else. It turns out that the friction involved in doing things this way is so huge that the effect would make The Road Warrior look like a children’s bedtime story. You want to borrow money to buy a car? The bank can’t just loan money that’s been deposited in someone else’s checking account – the bank has to get that person to sign a note saying “yes, I understand that this money is on deposit until that dude buying the card pays the bank back IN FULL”. And the lender, if he wants his money out ahead of time, is SOL. And even then, there can be a flood, and your car gets totaled, and you get Legionaire’s disease, and you can’t make the payments.

Q: OK, I get it – risk is endemic in the universe, and the banking system can’t avoid it, and even trying is like kneecapping the economy North Ireland style with a DeWalt cordless drill and a 3/4″ spade bit. But what’s a credit crunch specifically?

A: You take $10 and deposit it in the bank. I apply for a loan, and the bank takes $9 of your dollars and hands them to me. I’m going to buy a radio with that money, but not today, so I deposit it in the bank. The bank takes $8 of that money and loans it to the next guy. Etc. Now, imagine that there’s a spooky report on CNN about Wall Street, and I decide to pull “my” $9 out so I can buy that radio if it goes on sale … and imagine that the original depositor also wants his $10 out. There are just not enough bills on hand.

Now, to complicate it, imagine that the only reason that the bank lent me the $9 is because I let them hold the title to my bicycle as collateral (because in the worst case, if I don’t pay back the $9, they can at least take my $9 bike, sell it on Craig’s List, and get their $9 back).

…and as part of the report on CNN, the anchor reports “bikes are only worth half today what they were worth yesterday”.

The bank has loaned me $9 and only has $4.50 of collateral. AND the original depositor is trying to get his money out.

Let’s complicate it a bit more: what I posted as collateral was not a title to a bicycle, but shares of my company…and instead of renting DVDs, my company is in the business of writing people insurance policies declaring that if the value of their bicycles ever goes down, we’ll pay them. 9 years out of 10 prices don’t go down, and I rake in the profits. On that 10th year, though, I’ve got to pay a lot of debts.

…so if the bank is holding $9 of shares in my company as collateral, and I suddenly have a ton of red ink on my books, those $9 shares aren’t worth a whole lot.

Let’s complicate it further: it’s not just that I took in revenue 9 years running, and am now having a lean year: it’s that I predicted that lean years happen once in 500 years, so I’ve only been banking 1 part in 500 of my profits, and spending the rest. And now, after banking 9/500ths of what I need, I’ve got the phones ringing.

So, my bicycle insurance firm goes down the tubes, and in between using the fire extinguished to put out the fires in the server room, and using the fire extinguisher to fight off zombies angry customers and vendors, the absolute last thing I’m doing is even pretending that I’m going to pay back that loan to the bank.

The bank that loaned to me is SOL. And their depositor is screaming for his $10 back.

But that’s not the only depositor.

There are 1,000 other depositors that can either deposit their money in banks, or not.

…and suddenly, banks and other bank like entities are looking pretty sketchy. So those 1,000 other depositors are thinking “maybe I’ll just tuck that cash under the bed for a month, or 40, instead of loaning it directly to a guy who’s dumb enough to lose money insuring the value of bicycles, or loaning it indirectly to a bank that’s dumb enough to lend it to that first guy”.

If these 1,000 folks decide not to deposit their paychecks, or decide to yank last week’s paychecks out of the system, we’ve got troubles.

The fractional reserve banking that helps us in good times works against us here – each dollar pulled out pulls out more than $1 of liquidity.

Now, for the next complication, let’s also imagine that there are 300 million other people watching all of this, thinking “How bad is this? Should I go down to the gun store, stock up on .223 and 12 gauge shells, then stop by the veterinarians to see how much antibiotics I can cadge before heading to the hills” ?

And the Feds really don’t want 300 million armed folks heading for the national forests, so they first try to tell everyone who owns a bicycle “Hey, the value of your bike didn’t really drop! It’s still worth $9!”.

But no one wants to believe that.

So then they go to the guy who’s writing insurance policies on the value of bikes and they say “if you got $100 million, would that calm things down a bit?”.

And he says “sure”, to get his hands on the money. Except the feds either merge his company with someone else’s, or effectively take it over and fire the owner.

The feds then go to the bank that loaned the money to the bike value insurance guy, and say “if we shovel cash into you, can you keep making loans?”.

The problem is, this is all about information flows. It’s recursive, it’s a tightly knotted snarl of links, it’s a non-directed graph with tons of cycles. It stares into it’s own bellybutton.

Information is good. We can’t have proper prices with out it. But at certain spots in the statespace, huge interlinked systems have minds of their own.

The feds may very well be pissing into a hurricane. Or maybe not. The system will reach some self-consistent state. No one really knows just how complicated the state space is (it’s not entirely unfair to say that because there are 300 million Americans each with opinions on three or so axises, that there are 900 million different axises in the state space … more if you consider that the Europeans and everyone else are all tied in with communication channels that work at the speed of light.)

The feds are operating on those nodes in the financial network that have the most interconnections, that have the most outgoing signal propagating links, and have the most volume amplification.

…which makes sense as far as it goes.

Speaking of Europe, it’s all one system these days, and credit – while not totally fungible – crosses borders trivially, and this is not just a US problem.

Q: Yes, but can we assume that Travis, as a libertarian / anarchist, is against government intervention?

A: Surprisingly, no, my stance isn’t that simple. The first point I have to make is that despite the above, I don’t understand squat about all of this. Which is much less than most of the folks involved, even if what we have in common is that none of us knows enough to really know all the details.

What happens if a firm goes bankrupt? A lot of the staff is shed, and a huge amount of information disappears. In the wake of that, you can’t find the binders with the right files, you don’t know who to call to find the binders, and no one knows that special detail about loans that were made on February 29th of a leap year. So an orderly wind down (selling the assets, paying down the debts as fairly as possible) becomes much much harder, and may take much much longer.

Say that you’ve deposited $10,000 in a checking account, and you want that money out by September 20th to pay for your kid’s college tuition. If the bank goes bankrupt and all the employees walk out, and the server room is powered down, how long is it going to take to get your $10k back? A while … at best! In this case, one might agree that it’s preferable that the feds come to the bank, loan them $1 million, with a one month due date, and take as security the title to the headquarters building. This keeps everyone employed, and gets you your $10k out in short order (or, maybe $9k … and, yes, I’m ignoring FDIC insurance on purpose).

Certain nodes in the financial network can act like vacuum tubes, or transistors – they can amplify signals.

Let a bank shutdown in a disorderly way, and you amplify chaos.

I am in favor of winding down failing firms in a way that does not spread chaos … and does not reward the people who made bad business decisions.

So: I am against bail-outs.

…but I am not always against government involvement (although I will point out that – yet again – by government having a monopoly on this practice, they have driven out free market competitors who might otherwise have filled this role).

This entry was posted on Friday, September 19th, 2008 at 12:27 am and is filed under General. You can follow any responses to this entry through the RSS 2.0 feed. Both comments and pings are currently closed.