Hey Paul

Financial Crisis PrimerWith the recent financial meltdown, I'd been feeling awfully ill-informed. So I decided to start scouring the web in an effort to understand what the heck is going on, how it all happened and what it all means. This American Life had two recent shows about the crisis. First, there was The Giant Pool of Money, a show about the housing crisis and what it has to do with the turmoil on Wall Street. Then there was Another Frightening Show About the Economy which focuses more on the Wall Street end of the crisis. I also came across a piece by Paul Krugman (who just won the Nobel Prize in economics) in which he uses the analogy of a baby-sitting co-op to explain how economies work (or don't). And then there's this piece by Jim Manzi on The American Scene who uses a caveman analogy to explain the economy and the recent Wall Street crisis. If you've come across other useful resources to explain the economy and the Wall Street crisis, feel free to leave a link in the comments.

2 comments

Evan Jones said...: Good to have you back.

This is fun, but it's also a shell game on Krugman's part. He neglects to mention that the Fed does not loan coupons to people, it loans them to banks, which is an inconvenient truth. In his example, banks represent that portion of the people in the pool having children and therefore a need for baby sitting, perhaps even an exaggerated need, who because of their magnanimity in issuing, loaning and in some cases actually creating coupons accumulate for themselves fractional interests in a multitude of coupons. In other words, they don't sit, yet their children are sat. They can go out every night. You might say they're entitled to do so. As a result, the net actual value of each and every coupon in the system is diminished in value.

Krugman says that in the beginning everyone is provided with a coupon or coupons, which sounds like fairness itself. But if your great-great-grandfather was given a mule and an acre of land, does that make you a farmer? Does it make you a landowner? Can you sell the mule? Of course not. The initial problem is to get the ball rolling, to get the pool members to agree what nice and necessary people the bankers are and, finally, to make them feel grateful that the bankers take only what they do. New member to the pool are added without coupons. Eventually, they are added with negative coupons. They must babysit and babysit until the value of their coupons begins to approach going out at all.

Here's an even trickier turn. For couples who ran out of coupons for one reason or another it was necessary to institute borrowing. "To prevent members from abusing this privilege, however, the management would probably need to impose some penalty—requiring borrowers to repay more coupons than they borrowed." Notice the word "penalty". Let's put this in terms we can all understand. In order to accommodate future traffic, highways are built for more cars and higher speeds than are currently needed or recommended. At least that's always the plan. The system can absorb, therefore, a modicum of speeding. But if everyone starts to speed, or rather if too many people start to speed, we end up with a safety problem. Enter the Highway Patrol. We handle the problem by instituting penalties. Ah, penalty. Tickets. Something we all understand. Imagine now that you're caught speeding, given a ticket and ordered to pay Bank of America $250. And why not? A fine's a fine. The point isn't revenue enhancement, the point is to reduce speeding. If Bank of America serves as the recipient of fines, it does so for the greater good. Fines are monetary. Banks specialize in money. The fine has to go somewhere. Why not the bank?

If I borrow money to buy a home, it generates a penalty. Great-great-grandfather's acre is long gone. The alternative to buying a home is renting? And the alternative to renting? And the alternative to sleeping in doorways? The fed creates coupons for me to buy a home. Prints them up. Creates them out of thin air. If I wait fifty years to save inflationary cash to buy a home, I'll be dead. And yet, homes are up there with necessities like food and clothing. So, in order to have any stake whatsoever in life, I must pay a penalty, if not for the borrowing, then for the rent. The Fed creates the coupon, the cash for me to buy the house and the bank volunteers to accept the penalty. Otherwise, everyone might own a home and then there'd be no free baby sitting for the bankers.

Krugman would have us believe this is the best of all possible worlds, if we just understood the truth about economics. Think again.; Wednesday, October 15, 2008
Evan Jones said...: Or not.; Friday, October 17, 2008