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Thursday, March 20, 2008

Financial Market Panic: Losing Our Marbles

Steve Waldman explains how the house of cards can collapse:

Credit Crisis for Kindergarteners, by Steve Waldman: David Leonhardt notes that it's pretty hard to explain what's going on in the financial world these days... Here's how I'd tell the tale to a child:

Alice, Bob, and Sue have ten marbles between them. Whenever one kid wants another kid to take over a chore, she promises a marble in exchange. Alice doesn't like setting the table, so she promises Bob a marble if he will do it for her. Bob hates mowing the lawn, but Sue will do it for a marble. Sue doesn't like broccoli, but if she ... promises a marble...

One day, the kids get together to brag about all the marbles they soon will have. It turns out that, between them, they are promised 40 marbles! Now that is pretty exciting. They've each promised to give away some marbles too, but they don't think about that, they can keep their promises later, after they've had time to play with what's coming. For now, each is eager to hold all the marbles they've been promised in their own hands, and to show off their collections to friends.

But then Alice, who is smart and foolish all at the same time, points out a curious fact. There are only 10 marbles! Sue says, "That cannot be. I have earned 20 marbles, and I have only promised to give away three! There must be 17 just for me."

But there are still only 10 marbles.

Suddenly, when Bob doesn't want to mow the lawn, no one will do it for him, even if he promises two marbles for the job. No one will eat Sue's broccoli for her, even though everyone knows she is promised the most marbles of anyone, because no one believes she will ever see those 17 marbles she is always going on about. In fact, dinnertime is mayhem... Mom is cross. Dad is cross. Everyone is cross. "But you promised," is heard over and over among the children, amidst lots of stomping and fighting. Until recently, theirs was such a happy home, but now ... no one trusts anyone at all. It's all a bit mysterious to Dad, who points out that nothing has changed, really, so why on Earth is everything falling apart?

Perhaps Mom and Dad will decide that the best thing to do is just buy some more marbles, so that all the children can make good on their promises. But that would mean giving Alice 19 marbles, because she was laziest and made the most promises she couldn't keep, and that hardly seems like a good lesson. Plus, marbles are expensive, and everyone in the family would have to skip lunch for a week to settle Alice's debt. Perhaps the children could get together and decide that an unmet promise should be worth only a quarter of a marble, so that everyone is able to keep their promises after all. But then Sue, the hardest working, would feel really ripped off, as she ends up with a much more modest collection of marbles than she had expected. Perhaps Bob, the strongest, will simply take all the marbles from Alice and Sue, and make it clear than none will be given in return, and that will be that. Or, perhaps Alice and Bob could do Sue's chores for a while in addition to their own, extinguishing one promise per chore. But that's an awful lot of work, what if they just don't want to, who's gonna force them? What if they'd have to be in servitude to Sue for years?

Almost whatever happens, the trading of chores, so crucial to the family's tidy lawns and pleasant dinners, will be curtailed for some time. Perhaps some trading will occur via exchange of actual marbles, but this will not be common, as even kids see the folly of giving rare glass to people known to welch on their promises. It makes more sense to horde.

A credit crisis arises when many more promises are made than can possibly be kept, and disputes emerge about how and to whom promises will be broken. It's less a matter of SIVs than ABCs.

Couldn't the parents force the kids to keep their promises (under threat of a large penalty for default)? Either do what you promised, or incur some punishment that makes doing the chores the only reasonable choice? That seems a lot like the way a court would enforce contracts, so we need one of the kids to declare bankruptcy (or simply refuse to work and accept the punishment of having assets stripped, getting sent to their room, grounded, etc.) to get this going.

Perhaps another way to make this work is to have one of the kids lose their marbles (literally, as in a bad investment) so that some debts cannot be repaid. This would break the chain, create worry and panic, and potentially generate a breakdown in the system. But in this case the role of the government (parents) is easier - if it acts fast enough it could replace the lost marbles using its magical marble making machine (print money), three or four perhaps, to make a loan backed by collateral to keep the system of credits and payments flowing.

As for the child who lost the marbles, the parents could teach him or her a lesson about being responsible by refusing to come to the child's aid, but that just wrecks the entire household - the other kids didn't do anything wrong. Better to loan the child the marbles to keep things flowing, enforce existing contracts, then once the crisis is past, determine how and why the marbles were lost. At that point, if there is reason for the child to bear the consequences of bad choices, then the consequences can be confined to the child rather than spread throughout the household. In addition, the parents could also consider instituting new rules (a regulatory response to the crisis), e.g. automatic penalties for non-performance of a contract (e.g. capital requirements, forfeiting a bike or some other toy to the other party, etc.) so that once a deal is agreed upon, the kids are less likely to renege, rules about how marbles can be stored so they aren't lost accidentally, and so on.

    Posted by on Thursday, March 20, 2008 at 02:58 AM in Economics, Financial System | Permalink  TrackBack (1)  Comments (44)


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