Sunday, 21 September 2008

Nobody forces you to borrow....or do they?

Or, the prisoners dilemma of borrowing and lending.

http://en.wikipedia.org/wiki/Prisoner%27s_dilemma

Two suspects are arrested by the police. The police have insufficient evidence for a conviction, and, having separated both prisoners, visit each of them to offer the same deal. If one testifies ("defects") for the prosecution against the other and the other remains silent, the betrayer goes free and the silent accomplice receives the full 10-year sentence. If both remain silent, both prisoners are sentenced to only six months in jail for a minor charge. If each betrays the other, each receives a five-year sentence. Each prisoner must choose to betray the other or to remain silent. Each one is assured that the other would not know about the betrayal before the end of the investigation. How should the prisoners act?

Rationally, each person should act to betray.

What has this to do with borrowing and lending?

Simply this - if you borrow you can purchase assets and then charge those who couldn't afford to buy the asset the interest via higher prices. It's rational therefore, to borrow when it is offered to buy assets. It's also rational to lend to people so they can buy assets up until the point where borrowings equal the sale value of the asset - one interest payment and a resale and a profit has been made.

A situation to consider -

John and Bob are both going to buy the same business, for example a water treatment plant. John has £10,000 in savings. Bob has £9,000 in savings. Other things being equal, John will purchase the water treatment plant over Bob because he can pay more for it. Let's introduce the banker, Jim.

Jim can lend both John and Bob money, he doesn't mind which one it is at all. If he loans Bob the money then Bob can buy the asset over John. What will almost certainly happen is that John will have to borrow an amount over and above his savings sufficient to keep Bob at bay. So if the bank was willing to lend £4,000 to Bob, then John will have to borrow £3,001 in order to acquire the asset. Consequently, the price of water treatment will have to go up to pay the loan off. (Or the water treatment business will fail because of the interest payments when otherwise it would have been fine.)

It's pretty obvious, therefore, that loaning inflates asset prices, it 's also obvious that the existence of someone making loans forces people to either borrow or lose the chance of ownership of assets and then spend their savings and wages on higher prices. While this might not be true for very flexible discretionary purchases, it's going to be a sliding scale according to the elasticity of demand for the asset in question, or the legislated inabilty to provide alternatives.

It's worth also pointing out that borrowing will increase until the level where it's as close as possible to 100% of asset value and interest payments are equal to 100% of earnings as everyone tries to borrow in a desperate attempt to own something before the next guy turns you into his serf via this debt mechanism. Once it's maxed out, then the whole system wll unravel because interest payments can no longer be made and all savings have vanished. under a fractional system this might take decades but is inevitable.

Once we have lending there are now two choices - borrow or pay higher prices to those who have. It's a prisoners dilemma and one in which the risky option is the right option to go for as an individual. This will increase systemic risks as "risk takers" prosper, putting "risk takers" in the decision making roles of society and the conservative non risk takers will get punished.

You can choose to be either smug or damned. You can choose to take risks on flaky business proposals or you can work in the factory or office of someone who has taken on stupid risks for ever diminishing wages while your efforts go towards paying their interest payments. You can choose to have a hefty mortgage or you can choose to pay someone elses hefty mortgage via rent.

Until it all collapses of course, at which point super-conservative behaviour will become the overwhelming force , those with gold, guns and a bunker full of beans will prosper. But, as has been said many times elsewhere - the market can stay irrational longer than you can stay solvent.

Still think that no one is forced to borrow?

Well, you are right. You are still going to pay the lender though, one way or another.

8 comments:

Anonymous said...

Like it Injin - this was a great thought provoking post.

This is relevant to me because I have seen all the risk takers prosper arround me. I have been brought up with an adversion to being in debt.

However, over confidence has got some of these people on the ropes.

The only hopes I have is that justice is done to the people that have over extended themselves, and the rules that I played by are applied equally to all.

I am starting to believe that our much admired freedoms are not the same as free will. We are all forced in one way or another.

Regards,

FWIW

Anonymous said...

I'm driven by the need for security. If the system cant guarantee that then its not much good.

Injin said...

I believe that's the problem also.

Nothing can guarantee security but everyone would really like there to be some. This creates a market for hucksters of various stripes -

Fear of financial failure - banks
Fear of others - government
Fear of failure - qualification papers
Fear of death - religions
Fear of the unknown - propaganda

and so on. Not that those things don't also have other aspects that are useful, but there is the security of the lie at all times within them.

As for the conservative losing out, yep. The current system punishes endlessly in a ma variety of ways the careful, the prudent and rewards the feckless, the "risk takers."

It's better to continually start up speculative businesses because your standard of living won't be much different than someone who just goes to work in an office or factory but there is the chance of an upside that office/factory workers just don't have.

This is because the office/factory workers are constantly bailing you out when you borrow and fail via inflation/benefits/welfare but you will get to keep the bulk of what you get if you hit the motherlode.

nicejimGEI said...

Your treatment plant example does not work.

John does not have to buy the asset. For example, he could choose to pull out or form a consortium to buy with or without borrowed money. John would be diluting his return from the investment, so his decision is now based on whether the diluted return is still worth the initial investment. If he can get a better return from the water treatment plant than some other activity, such as depositing the money with Jim, then he will buy it. The reason Bob is borrowing is that the return from the asset minus the interest paid on the loan is better than he can get elsewhere. The asset's price is set at the margin; it is not a function of Bob's ability to borrow but of the return each investor is able to extract from it and the return each can get elsewhere. It apears that borrowing has inflated the price, but only if you consider John's sole-bidder status as a functioning market.

The price of water will not have to go up to pay off the loan, it is set by competing suppliers and purchasers of treated water. If the new owner is better at treating water than the old then the price will come down, if not it will go up. If nobody can borrow or form coporations to buy an asset then assets be allocated according to how good people's parents were at running the assets they owned, and the price of water would almost certainly go up.

Clearly across the economy as a whole asset prices recently have been overvalued. This is not because people are able to borrow, it is because they are unable to value.

Injin said...

Thanks for your comment, Jim.

Maybe read what I write in future?

Thanks.


Injin.

nicejimGEI said...

If I'm going to read your future stuff it'll have to get a lot better.

This is not the prisoner's dilemma. The decision making of the players in your example is best examined by assuming it takes place in an auction room, not a police cell, and given accurate valuations the outcome will not be the one you describe. If valuation models work there will be no desire to use borrowed money to bid past the true cost of the asset.

Borrowed money has not been a factor in the art market, where multibillionaires continually raise their bids rather than miss out on a scarce asset. It has been a factor in the housing bubble, where people borrowed huge sums to get a meagre monthly return, thinking it was their last chance to secure their children's future in the householder class. Borrowed money was the catalyst but the cause was that market participants overvalued houses and undervalued gold, guns and beans. If they couldn't borrow they'd pay cash just like the art-loving billionaires and the price could still diverge from the fundamentals.

Injin said...

As far as I can tell, you aren't reading my blog right now, Jim.

Thanks for posting your thoughts on the post title though, much appreciated.

Joe Blow said...

sorry Jim but to me this IS the prisoner's dilemma.

one of the unique aspects of the boom was that there was almost unlimited borrowing available to almost everyone.

ultimately, that led to prices vs risk/return getting skewed for almost every asset out there.

towards the end the choice became more of choosing to invest in overpriced assets, and accepting meagre returns, or just opting out of investing all together.

if you chose to opt out totally, you still are ending up paying since taxes, inflation, prices etc are all going to take thousands from your packet anyway.

the biggest risk the average person was taking was that they might have to declare bankruptcy at some point if the gamble didn't pay off.

even if bankruptcy was filed, they wouldn't end up in too different a position from someone that never invested, but has lost much due to paying the price for those that did.

if you woke up back in 2000, with all of the information you have now, would you invest in real estate?

almost assuredly many/most would.

much like the prisoner's dilemma, almost all of the choices available involve pain.

the only way for a pain free choice is by taking part in the deal, and hoping that you come out on top of the other players (the other prisoner).

it was the same with housing, the only ones that came out on top were those that participated, but sold before the bust.

everyone else lost/is losing out.