The Financial Crisis - A (controversial?) Balance Sheet Analysis

econ_books.jpegFollowing a conversation between CotL director Andy Flanagan and Chris Rimmer at New Wine, Chris was encouraged to put his ideas of a novel illustration of how economics works into writing. With a fresh look at balance sheets, what do you think of Chris' theory?

In 2008, while trying to evaluate claims that our monetary and banking system is inherently fraudulent, I realised I had discovered an apparently novel economic model – balance sheets.

Each "person" (real, or corporation – businesses, government, charities, etc.) has a balance sheet showing:

  • What they own. (Assets)
  • Debts owed to them. (Also assets)
  • Debts owed by them. (Liabilities)
  • Net worth. (Assets minus liabilities).

We can picture a balance sheet as a pair of glass tanks, one containing white wine vinegar (representing the amount owned) and olive oil (representing the amount owed to the person), and the other tank containing water (representing the amount owed by the person):

glass-tanks.pngBalance sheets can change in exactly seven ways:

  1. Production – adds to vinegar
  2. Consumption – removes vinegar
  3. Transfer of owned assets – transfers vinegar from oneperson to another
  4. Transfer of owed assets – transfers oil
  5. Transfer of liabilities – transfers water
  6. New debt – adds equal amounts to one person's oil and another's water
  7. Write off debt – removes equal amounts of one person's oil and another's water

Every transaction in the economy consists of one or more of these. For example, if I buy a saucepan in a shop with cash, the shop transfers vinegar to me (the saucepan) and I transfer oil to the shop (cash is a debt from the Bank of England to the bearer).

Notice that the only changes to the world's total net worth are from production and consumption. Absolutely everything else just transfers it from one person to another. Also notice that a person's net worth can be negative (they are insolvent) if they have more water than vinegar and oil combined. Then they either write off some debt in bankruptcy, or have to produce enough excess over consumption to become solvent again.

 

With this model in mind, what is a banking crisis? There are actually two types:

In a liquidity crisis, depositors (creditors of banks) worry that banks are insolvent, and demand repayment in cash. In order to pay, the banks may have to sell assets, or use them to secure loans, perhaps from the Bank of England as lender of last resort. But as long as they have enough assets (including the debts owed by their borrowers), they can do this.

solvency crisis is far more severe. This is where banks are actually insolvent, often by making many loans to borrowers who cannot repay. A solvency crisis may not be noticed for some time – not until it becomes a liquidity crisis when confidence drops. This could take years.

Was 2007- a liquidity or solvency crisis?

2007- was undeniably a liquidity crisis, but the question is whether there was an underlying solvency crisis. If the banks were actually insolvent, then they did not have enough assets to pay all of their depositors, and the problem was actually huge. It would mean that the nation was not as wealthy as it thought it was, because many people's assets were debts which banks could not pay – these deposits would just disappear as banks wrote off their debts in bankruptcy.

I will leave the reader to speculate whether the banks were insolvent, and if so, to consider what the following policies have in common:

  • Government recapitalisation of banks
  • Good bank / bad bank split
  • Reduction of interest rates
  • Quantitative easing
  • Austerity
  • Fiscal stimulus
  • Stoking inflation
  • Promoting consumption
  • Promoting house building

The answer is that none of them acknowledges that the banks' assets are insufficient to pay the depositors, and that someone's net worth is lower than they believe. By delaying the write-down, great uncertainty remains as to who will eventually suffer the losses, although it is certain that it will be someone with a positive net worth. In that environment, there is very little incentive to work hard to build up wealth.

A healthy economy relies on confidence, specifically that if someone sells something, they can use the money to buy something of roughly equal value later. In the short-to-medium term, feelings of confidence dominate economic behaviour, but in the long term, it is the reality of whether those in debt will actually keep their promises which dominates.

Conclusion

I hope that this has begun to show the value of balance sheets in understanding economics. There is much more which could be said, but I would urge readers to consider the effects of any policy on the balance sheets of people throughout the economy.

While avoiding the chaos of bank bankruptcies is an understandable desire, transferring vast wealth from the rest of the economy and allowing the bad debts to fester is no solution at all. It would be far better for insolvent banks to be resolved, losses allocated, and depositors compensated if necessary.

Net worth cannot be created by fiat.

 

Chris Rimmer has been an amateur economist for 8 years, applying his knowledge of mathematical modelling from a degree in mathematics and computation, and a 15 year career in software development.  He is a member of the Association of Christian Economists (UK).  He is passionate about truth, and is concerned that flaws in common economic theories are both causing injustice and leading to a much greater crisis than 2008.  

 

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