29 November 2007

Credit and Confidence

One can get the impression that things that happen in the economy - like the recent credit difficulties - are the outcome of some strange arbitrary game played by bankers. It is worth pausing to explain the story, not in terms of ABCP issued by SIVs holding MBSs but in terms of real people and real stuff.

Credit is letting someone else use your stuff for a while. Lets say we have two farmers who each have one field, neither of which can be efficiently divided. In the long run the fields produce more if left fallow from time to time, but neither farmer can afford to do without his only field this year.

They make an agreement. Farmer B will leave his field fallow this year, and Farmer A will give him some of his output, to make it possible. Next year, they will switch; Farmer B will provide A with part of the output of his newly nitrogenated field, and A will rest.

A is giving B credit. A is running two risks: one is that he will later discover that he needs, or can make better use of, the product he's given B. The other is that B might not stick to the agreement - he might get sick, or have his crop eaten by locusts, or run away with blacksmith's daughter.

Nonetheless, if A is confident that he will get back his stuff, he will make plans based on that assumption. He may even make agreements with other parties that involve him giving some of that stuff to them after he gets it from B.

If something then happens that makes it even doubtful that B will be able to give A his stuff, there will be some immediate effects. A may have to change plans he has made, and abandon projects he has already started. He might not be able to make the deals with C that he was hoping to make, because C doubts whether he will have the stuff he is owed by B. If he has already promised stuff to D, then D will have to start revising his own plans in the same way. Thus a fall in confidence in credit can ripple through a wide network, and have large effects, even before any debts have actually defaulted.

I have deliberately left out of this explanation money and banks. In the real world they play a major role in making credit deals easier, but the fundamental situation rests on people and on stuff.

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