Understanding the credit crisis

Steve Waldman has done up a brilliant explanation of the credit crisis:

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 says pretty please and promises a marble, Bob will eat it off her plate when Mom isn’t looking.

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.

…

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 [sic] 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.

Steve later gives an example of the three balance sheets that count produce the situation he described:

Alice (equity: -19)

Assets	Liabilities
Physical marbles: 4
Marbles promised from Bob: 0	Marbles owed to Bob: 7
Marbles promised from Sue: 2	Marbles owed to Sue: 18
Total Assets: 6	Total Liabilities: 25

Bob (equity: 12)

Assets	Liabilities
Physical marbles: 6
Marbles promised from Alice: 7	Marbles owed to Alice: 0
Marbles promised from Sue: 1	Marbles owed to Sue: 2
Total Assets: 14	Total Liabilities: 2

Sue (equity: 17)

Assets	Liabilities
Physical marbles: 0
Marbles promised from Alice: 18	Marbles owed to Alice: 2
Marbles promised from Bob: 2	Marbles owed to Bob: 1
Total Assets: 20	Total Liabilities:

I really enjoy this sort of analogy, because I think that a lot of policy decisions can be enlightened by considering the actors to be individual people rather than the organisations (or entire countries) that they are. So what should Mum and Dad do? Steve also observes the three main possibilities:

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?

The ultimate answer is a combination of all three: Buy some extra marbles (but not all 30), declare each promise to be worth less than a full marble (but not as little as a quarter) and force Alice, and to a lesser extent Bob, to do some chores for Sue (but not full replacement).

The real question is this: Whose fault is it that Alice was able to continue running up debts she couldn’t pay? Should mum and dad been watching all along to make sure that everybody played nicely? Or should Bob and Sue have had more sense when Alice promised to pay them?