The Other I

March 9, 2010

Other People’s Money

Filed under: The Economy: a Neophyte's View — theotheri @ 4:21 pm

I was in my early thirties when Peter and I decided to start saving to buy a house.  That was when I thought it might be a good idea to learn at least the basics about investing.  I didn’t learn a lot, but I did learn a couple of basic principles:  1) to diversify so that risk is spread and all ones eggs are not in one basket, and 2) to use OPM to amplify the power of ones own.  OPM is credit, or to put it more bluntly, Other People’s Money.

But it wasn’t until the credit crunch happened two years ago, that I began to understand just how important OPM is the smooth running of the whole economic system.  OPM is essential not only to improve our already comfortable life styles, but to reducing the most grinding poverty.    OPM multiplies the purchasing power of money.

For instance, when I take out a mortgage, the bank effectively lends me somebody else’s money, which I then give to the person who is selling me the house.  So the seller now has that money to spend.  But the person who put his money on deposit in the bank which bankrolled the mortgage still has his savings to spend as well.  So now there are people who can spend more or less the same money.  If the original owner of my new house then takes the money he made on the sale as a down payment on another house on which he also takes a mortgage, that money goes to yet a third person.  Meanwhile, the bank may take a bundle of mortgage loans it has made and sell the bundle to another bank or investment institution.   So at this point, the same money is being used by 5 or 6 different people.

And that is why so many people became so much more prosperous in the late 90’s and early years of this century.  The effective amount of money individuals and  businesses had to spend was being multiplied and then multiplied again.  It wasn’t just bankers and financiers who became rich.  Millions of people were lifted out of poverty;  the standard of living in many underdeveloped countries improved too.

This is also why governments around the world could not let the banks fail two years ago.   It is why it could have plunged the world into a depression the likes of which we have never seen.  Because the money that would have been lost would not have been just the money belonging to banks’ depositors.  It would have been that money multiplied by tens or maybe by hundreds.  The same money was leveraged and borrowed again and again and again in a system that became so complex that nobody, absolutely nobody, could untangle.  Banks literally did not know the sources of the money they assumed they held as security.

The temptation, of course, is to conclude that borrowing money is imprudent and irresponsible.

But it isn’t.  The Bank of England was one of the first governments to realize the power of credit .  In 1699 they issued the first government bonds to build better ships which, among other things, led to a trade bonanza with countries around the world.  The quality of life for almost the entire population improved beyond recognition.  Borrowing money is like fire:  it can do immense good.  And immense harm.

Without quite realizing it, what the banks around the world were almost all doing for the last 15-20 years was putting all their eggs in the same basket.  Their loans were not effectively diversified, and so when the eggs in the basket began to break, the loans that were dependent on the first loan had been multiplied by tens or maybe by hundreds.

Unfortunately, the problem isn’t finished evolving.  A lot of the long-term  mortgages and loans made to homeowners and businesses during the time of the great expansion were long-term, to be paid back over a period of 25-30 years.  The banks, however, lent more than their depositors’ money.  They themselves borrowed much of the money they lent in mortgages from the short-term markets.  The problem now is that the banks need to refinance these loans of 2-5 years.  But the short-term market is no longer there to feed the banks’ voracious appetites.  So if banks  cannot find an alternative place to borrow money, they could be in trouble even if homeowners do not default on their mortgage payments .

Here in Britain, banks say that within the next couple of years there is going to be a £300 billion (about half a billion US dollars) funding gap.  Savers can make up part of that.  But the bulk is going to have to come from the government.  Which ultimately means the taxpayer.

In the meantime, banks are increasingly lending only to the more credit-worthy customers with large cushions of security. So businesses, especially small businesses, are finding it difficult to borrow the money they need to expand, and the housing market is still in slow motion.

I would like to drive the short-sighted, obscenely over-paid, self-interested bankerss to the wall.  But unfortunately, they’re not the ones who would be nailed if banks are allowed to fail.

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