A way to think about the financial crisis

Financial crises are funny things. There is no war, no plague, no hurricane; no building is destroyed, no factory bombed, no orchard burnt. And yet, suddenly, the whole nation finds itself poorer: You can’t afford your new iPod, or new car, and perhaps if you really needed a new car, you lose your job. And now you can’t afford anything. And all this without so much as a house burning down!

When an invading army marches in, shells the houses, burns the farms, and loots anything not nailed down (and then loots the stuff that is nailed down, after shooting the nailer for making trouble for them) it is clear why people become poor. It’s easy to understand how wealth is lost when factories or roads are destroyed. But what’s being destroyed in this crisis, or indeed any crisis?

The basic answer is trust. Having a bank willing to lend you money is a form of wealth: It lets you smooth out disasters like having a car needed for your job break down when you don’t have the ready cash to replace it. Taking a loan is a much smaller problem than losing your job; it follows that having the ability to take the loan instead of the job loss is wealth. (If you had the money in the bank to replace your car, you would have a smaller problem still, of course, so that’s even more wealth.) This is why there are paycheck-loan joints all over downtowns: Even a really crappy loan is better than some major disaster like being unable to fix your car or go to the doctor. So access to a paycheck loan is also wealth. Not as much wealth as access to a mortgage or car loan, of course; if poor people were rich, they wouldn’t be poor. (Just as money in the bank is better yet than access to a good loan.) But still, some wealth.

However, this form of wealth depends on trust: The bank has to believe that you’ll pay the money back, or rather, that enough of its borrowers will pay the money back that, at the given interest rate, it still makes a profit. And trust, like any other wealth, can be squandered. If I drive my car into a river, I’ll be poorer. If I lend money to someone who doesn’t pay it back, I’ll be poorer. And if a lot of people overestimate the payback rate of their loans, not only will they be poorer, they’ll sharply curtail their trust. There’s only so much trust to go around in a given system; if it’s used on people who can’t pay their loans back, it’s wasted. That’s how a nation loses a really vast amount of wealth without having a single factory bombed.

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5 Comments

Filed under Economics

5 responses to “A way to think about the financial crisis

  1. Carillon

    But then shouldn’t the solution be to readjust rates of default as well as interest rates? It seems that there are other ways of dealing with this loss of confidence other than simply clamping down on all loans.

  2. kingofmen

    I don’t think I understand the point you are making. How would you adjust the rates of default?

  3. Hundhedning

    Ah, yes. Such is the way of capitalism.

  4. Carillon

    I misspoke, I meant the banks should adjust their rates to take into account the new rates of default, my appologies

  5. kingofmen

    Right, I’m sure they’re doing that too. But there’s still some loss of wealth, because clearly, a man who can borrow at 3% is richer than one who can only borrow at 6%. (This is basically how England was able to maintain itself as a Great Power against the likes of France, with its much larger real economy – the English had a better banking infrastructure and a more stable government (hence the banks trusted it more), and could borrow more cheaply.) Also, there’s a problem in that they don’t know what the new rates of default are going to be, so they’ll tend to adjust their interest rates up a bit more than is really necessary. Besides this, for really high-default demographics, the required interest rates are in the neighbourhood of 20 or even 30 percent, the kind of rates a paycheck-cashing company will give you. Nobody can borrow at that sort of rate for anything large (house, car, the sort of thing banks deal in) and expect to pay it back.

    You should notice that paycheck companies aren’t just being greedy when they charge 30% interest, that really is what is needed to cover the defaults. Nonprofit companies have tried to get into this market to give the poor better alternatives, and they’ve found that if they charge anything less, they actually run out of money from the defaults. And this sort of interest rate is basically the same as “no loans available” for anything but emergencies; you can pay it for getting your child to a doctor, or repairing the car that keeps you in a job, or some such disaster, but nobody rational will pay 30% on his house loan.

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