More money than sense

Cropped Thinking 500x144Daniel Kahneman, the 2002 Noble laureate in economic sciences, proved that value is a relative concept1. Marketers of luxury goods are very successful at using Kahneman’s ideas. In the stores that cater for people with more money than sense, you will find at least one item that even the wealthiest won’t buy. Those highly overpriced items are there to establish the relative value, so that a $12,000 handbag, is a good deal in relation to the one placed ostentatiously in the center of the store, priced at $37,000. They make huge profits using that technique.

That’s until Oprah, believing she is the world’s wealthiest woman, wants to buy the $37,000 handbag. The store assistant has been told not to sell that bag – it makes the store a lot of money just sitting there – but she can’t tell Oprah that, so she says it’s not good value, and that Oprah can’t afford it.

Actually, the wealthiest woman in the world is the Queen of England, who is also a very astute businesswoman. It also helps that for most of her life she was not liable for tax. She only appeared on Forbes’ list of wealthiest people once in the 1990s, and immediately afterwards ‘arranged’ her affairs so that she never appeared on the list again. She certainly would not buy a handbag costing $37,000.

Perhaps that’s because she has more sense than money.

More at:
Daniel Kahneman, Thinking Fast and Slow
Oprah Winfrey ‘racism row’ a ‘misunderstanding’

  1. Daniel Kahneman, Thinking Fast and Slow chapter 16 []

Why save the banks?

The 1%, that’s shorthand for the world’s wealthiest people, have $122 trillion of investible assets. That’s 174% of the world’s GDP.

The financial crises started with a collapse in the value of financial assets, mostly made up of the sub-prime bonds, amounting to about $3 trillion. So where’s the problem. The money was lost under capitalism – and capitalism is about promoting success and terminating failure. Write off the $3 trillion, and let’s just carry on. It’s a small percentage of the $122 trillion.

But it’s not that simple.

Many of those bad financial assets were held by banks. When the savers who have money in the bank, and they are definitely not the 1%, hear that it might go broke, and that’s where their life savings are kept, they try and get it out – fast, and all at the same time. That’s called a bank run, and it’s what happened in the great depression. Letting that happen is considered to be one of the BIG mistakes that government made that time round.

A banking crises is a crises of confidence. Savers think that the bank won’t be able to pay them their money. Now, that may just be a liquidity crises – the bank is not broke, it just does not have enough cash to meet the demand for withdrawals. When that’s the case, the bank goes to the markets and borrows the money. If it’s credit rating is in question – the credit rating agencies have downgraded it, it has to pay a higher interest rate, and it does because survival is at stake, and it lives to fight another day.

If the bank is broke, that is after writing off the dodgy assets, the liabilities of the bank exceed the value of the remaining assets, then no-one is going to lend it money, except perhaps the government. That’s what Ireland did, and that’s why Ireland eventually had to ask Europe to help it out. It’s also one of the problems in Spain at the moment.

Often the solution is a matter of proportion. The size of the borrower’s shortfall in relation to the size of the lenders available funding. Spain’s requirements are a lot bigger than Ireland’s were. Italy’s are even bigger. Europe does not have sufficient resources to fund Spain, let alone Italy.

The 1% do. We figured that out at the beginning.

They (together with other investors) invest in governments via the bond markets. When a borrower looks as though it may not be able to repay it’s debts, the only way that it can borrow is to pay higher interest rates. At some point the interest rate becomes so high that the lender cannot generate sufficient income to cover the interest, and default becomes inevitable. So the 1% won’t lend the money unless they get a return that’s high enough, and that might eventually make failure unavoidable.

The irony in this is that the $122 trillion is not real money. It’s the value of existing investments. If there is a depression at the same level of magnitude as the one that happened in the 1930s (which might happen if the politicians don’t start dealing with these issues), a big proportion of that value will disappear. Much of value exists in the stock markets of the world, representing the value of the earnings of the corporations listed there. If the earnings disappear, which is what happens in a depression, the value will go too. So the 1% have got a big interest in helping to sort out this mess.

Perhaps someone should tell them.

More at:
Wealth management Private pursuits
Spain’s banking system Teetering