Thursday, November 27, 2008

Matter and Antimatter: How to Create a Crisis: A Thanksgiving Rant

Skilled physicists do not know how to take nothing and turn it into matter and antimatter, but finance behaves as if it had the capacity to do something similar. Imagine a simple market economy about to create a bubble. I want to tell the story of this bubble, only to put the current, crazy stimulus package into perspective.

Somebody says to me they have a piece of paper worth $1 million. I can buy for half the price. I borrow the money to cover most of the cost. People are willing to lend me the money confident in the belief that my paper will increase in value. Other people are engaging in the same transaction, spreading confidence that these papers are now increasing in value, say to $600,000.

The seller of the paper now has a half-million dollars, having given up nothing but blank piece of paper. I have a capital gain of hundred thousand dollars. My lenders have a credit with a half-million dollars. We are all better off, even though nothing has been produced.

Feeling secure in the increasing value of our paper, I along with the other "investors" now start consuming more, spreading prosperity for the economy. Virtually everybody is enjoying the benefit of the bubble. Within a short period of time, people throughout the economy making decisions based on the increasing appearance of health and the economy.

At some point, people realize that this paper is nothing more than a blank sheet of writing paper. The bubble may have stimulated some investment that is capable of producing real economic benefits, but mostly it has induced people to consume and commit themselves to pay back debts.

Remember, this prosperity was built out of nothing. In the end, matter and antimatter collided. The lenders have lost their money. The speculators and consumers are in debt. Most lack the wherewithal to repay their debts. But in the case of the current bubble, the economy does not have the productive capacity to put everything together. The loans came from abroad and so did many consumer goods.

At the same time, the government loans are ultimately dependent on another set of loans, also largely from abroad. How will these loans ever be repaid? Will new loans keep coming as the bubble engulfs the rest of the world?

Should the government come in and give me a half-million dollars so that I can repay my loan? Should I be rewarded for my stupidity and naïveté? Will that policy really make the economy healthy? Or will it policy just facilitate the creation of even greater bubbles?

Obviously, the most sensible decision would be to put the money into making a more healthy economy, one less susceptible to speculation -- something impossible under capitalism, but that is another question. Eventually, somebody will have to pay the piper. The policy today seems to be an effort to shield the very people who created the crisis, placing the burden on the most innocent.

The graphic picture of the stimulus package that I posted yesterday suggests a government response just as foolish as the speculations that set off the bubble in the first place.

Happy Thanksgiving.


Shag from Brookline said...

This could describe "Antinques Roadshow" and its potential bubble for "stuff" that we have in our attics. Fair market value requires a willing seller and a willing buyer, neither under the compulsion to buy or sell. Add to this willing lenders and willing investors in such willing lenders. And "Antiques Roadshow" provides the willing appraisers who themselves are not prepared to pay their appraisal prices, perhaps because there might not be willing buyers out there.Musical interlude: "I'm Forever Blowing Bubbles ...."

Michael Perelman said...

Excellent thought!

Anonymous said...

By any chance does the original seller of blank paper live in Nigeria? I have during the past several years received several solicitations from the Nigerian on behalf of someone said to have access to some great amount of cash. For some unexplained reason Nigerians seem to have great difficulty accessing that which is rightfully theirs. This Nigerian has requested my assistance each time, said assistance taking the form of a token amount of ready cash which would some how enable the associate of the Nigerian to gain access to the horde. I had been suspicious of these requests at the time the were first presented to me. Possibly I had allowed some personal bias to cloud my analysis of the requests from the Nigerian. I had heard from others that Nigerians were not thought to be fully trustworthy. Had the gentleman been able to provide some references, say from an established American firm like Goldman Sachs or Lehman Bros. I'd have thought more positively about his requests. I fear that I may have missed a genuine opportunity to earn a handsome return on a short term investment. It's just that Nigeria seemed such an unlikely place to find my personal
pot of gold.

Michael Perelman said...

You do have to appreciate the style in which some of these scams are written.

Your comment makes me think that maybe I could sell my claims on some of this Nigerian gold to others -- maybe get a ratings agency to give it some credibility, I could do quite well. I get several offers a day. If I discount them, keeping a mere 10% for myself, I could become too big to fail.

Jack said...

That's the point. It would appear that Wall Street was operating for the past decade as little more than a Nigerian scam. False profits generated by false prophets for the purpose of huge compensation. What happened to all that profitability that was the basis for those outsized compensation packages paid out over the past five to ten years?

Daro said...

A nice model of the scam...
Alternatively consider the person who studies the previous form of a financial instrument, reads the best predictions of the newspaper's experts, sinks cash into buying scrip of one of those instruments and at the expiry of the elected time period, the person either wins or loses money they placed with the brokers.

Now replace the word "financial instrument" with the word "horse" and we find these people are not investors as they claim but just gamblers. Mergers, the covering of positions and CDO's, etc. just seem like complicated trifecta and quinella combinations of the same horse race.

The only difference is, most punters on horse racing don't then amble out into the street, mug the next poor fellow for $700 million, and amble back into the racetrack to start betting again!