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  1. #1
    Senior Member reason's Avatar
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    Default The Financial Crisis in a Nutshell

    I wrote this on INTPCentral in response to a thread and thought I would share it here. This is how the financial crisis makes sense to me, and I have heard or read few people who explain it similarly (except, perhaps, Peter Schiff, who saw it coming!) It was partially born from discussions with my economics professor from a few weeks back (also from working for two mortgage brokers over the last few years.) Any feedback would be appreciated.

    When someone borrows money they are redistributing income across time.

    Suppose that you are currently earning $10,000 per annum, and expect to earn $500,000 over the next ten years ($50,000 per annum on average.) But you want to increase your income now, and decide to borrow $30,000 from those expected earnings. This raises your current income to $40,000, and only decreases your expected earnings to $470,000 ($47,000 per annum on average.) By redistributing your funds across time you can achieve a steadier and more equitable income. An investment, meanwhile, would increase expected earnings. Suppose, for example, that without the $30,000 loan you only expect to earn $300,000 over the next ten years (perhaps it is going to pay for an education.) In such a case, the loan would qualify as an investment.

    Interest and lending criteria (capital requirements, credit checks, employment provisos, etc.) are the price of enabling this redistribution of income across time. One person's loan is another person's investment; what one person is expected to pay in interest another person expects to receive.

    Suppose that a loan is sold on false expectations, and moreover, it is predominantly spent on consumption (not investments.) A loan of $30,000 is given to you with the false expectation that you will earn $500,000 over the next ten years (in fact, you will only earn $300,000--or $30,000 per annum on average.) But you begin to adjust your consumption to your new $40,000 income. GDP is booming (production is effectively paid for by 'IOUs') and the economy looks in great shape according to the "experts." Eventually, the 'next ten years' begins, and your expected income was mistaken. Rather than having $47,000 per annum on average (down from $50,000 because of the loan) you only earn $30,000, and moreover, you still need to payback your loan!

    With a $27,000 income you cannot sustain the same consumption habits that you had with $40,000. Perhaps you even default on your loan. But remember, one person's loan is another person's investment. When you default an investor somewhere discovers that his expected earnings were also mistaken (since they were calculated on yours), and he cannot sustain the same consumption habits that he had with his previous income. Imagine that this occurs to hundreds of thousands of debtors and investors across the country, each linked to each other via the financial markets, dependent upon each other corrrectly predicting their future earnings. Suddenly, everyone is earning less than expected, while also paying for past consumption.

    Be wary of politicians who suppose to "fix" this problem--although its consequences are being felt now, the opportunity to avoid it has already gone. Too many people wrongly predicted future earnings, that was a mistake, but some, such as Obama, might try and change that mistake into a delusion.
    A criticism that can be brought against everything ought not to be brought against anything.

  2. #2
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    The biggest problem arising from the way the government has chosen to deal with this issue, which was predicted by MANY people, is that EVERYONE and their grandmother is now clamoring for government handouts and bailouts. Every company is becoming "too big to fail". It's getting out of hand.

  3. #3
    Senior Member ptgatsby's Avatar
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    Quote Originally Posted by reason View Post
    Be wary of politicians who suppose to "fix" this problem--although its consequences are being felt now, the opportunity to avoid it has already gone. Too many people wrongly predicted future earnings, that was a mistake, but some, such as Obama, might try and change that mistake into a delusion.
    That is well put, and yet I don't quite understand this last bit. What exactly are they trying to fix? In your statement, you say that both sides hurt, meaning that the system of smoothing (and while you don't mention it, capital investment) falls apart and, as you also say, the economy stops booming. In fact, it could contract violently.

    The bubble clearly did cause people to have horrendous future valuations, and that's a major issue... happens every time the fundamentals divorce themselves from reality... So I don't disagree, but...

    In this context, what are you worried about exactly?

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    Senior Member Maabus1999's Avatar
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    Let me put it as this :"Damned if you do, Damned if you don't."

    The whole point is this was seen by folks like myself for YEARS and no one lifted a finger. That is the problem. Heck, I remember when a statistic came out a few years ago saying only 7% of San Diego citizens could afford the median house value....7 percent for the median!!!!

    We still have a health care bubble though (20% of our GDP).

    Final thoughts: We will get through this, and I prefer the tough way which makes me more optimistic for the LONG term as it will instill a new sense of resilience into generation X and Y that we DESPERATELY need to help re-craft our national identity. We will get through it and America in the end will be A LOT better off.

    That is assuming no one does an uber mistake that causes hyperinflation or mass government reliance (aka structured capitalism/socialism).

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    Quote Originally Posted by Maabus1999 View Post
    Final thoughts: We will get through this, and I prefer the tough way which makes me more optimistic for the LONG term as it will instill a new sense of resilience into generation X and Y that we DESPERATELY need to help re-craft our national identity. We will get through it and America in the end will be A LOT better off.Y
    Look how long and hard people had to fight to get Enron execs in jail.

    These execs who always make bad decisions have no shame.

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    Senior Member Maabus1999's Avatar
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    Quote Originally Posted by Modern Nomad View Post
    Look how long and hard people had to fight to get Enron execs in jail.

    These execs who always make bad decisions have no shame.
    Not sure how this points to America as a whole but that is a point for another thread...the PLM!!!

    Basically we need to get rid of lawyers, go to single term politicians, and the media, well, not sure what to do with them without destroying free speech. Maybe assign non profit rules to them via FCC rules?

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    Quote Originally Posted by Maabus1999 View Post
    Not sure how this points to America as a whole but that is a point for another thread...the PLM!!!

    Basically we need to get rid of lawyers, go to single term politicians, and the media, well, not sure what to do with them without destroying free speech. Maybe assign non profit rules to them via FCC rules?
    Not sure, but foreign financial firms/car factories managed to do just fine in the US with the same lawyers, same politicians, same workers, but different management.

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    Quote Originally Posted by Modern Nomad View Post
    Look how long and hard people had to fight to get Enron execs in jail.

    These execs who always make bad decisions have no shame.
    Add to that Paulson has now been instated as an economic DICTATOR with virtually no oversight structures in place, and provisions from the bailout bill that say he cannot be prosecuted for anything he does. Whoever drafted this idea with Bush pushed it through the houses on the basis of fear for what they said would happen if they didn't (as was evident by several congressmen coming out and saying they were threatened with martial law). That is a dangerous trend that is continuing to present itself, as more and more companies and banks come to the front and look for the government to bail them out. I'm wondering if we wont have even larger issues to arise that'd completely push the fear tactic into use for international economic policies.

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    Senior Member Maabus1999's Avatar
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    Quote Originally Posted by Modern Nomad View Post
    Not sure, but foreign financial firms/car factories managed to do just fine in the US with the same lawyers, same politicians, same workers, but different management.
    Oh I'm not talking a bout business, I'm talking about restoring the US to its optimistic height. The PLM is too bloated, corrupt, and divisive. We need to return to what it means to be American: unbridled optimism, neighborly, and "can do no matter the challenge" spirit.

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    Quote Originally Posted by Risen View Post
    Add to that Paulson has now been instated as an economic DICTATOR with virtually no oversight structures in place, and provisions from the bailout bill that say he cannot be prosecuted for anything he does. Whoever drafted this idea with Bush pushed it through the houses on the basis of fear for what they said would happen if they didn't (as was evident by several congressmen coming out and saying they were threatened with martial law). That is a dangerous trend that is continuing to present itself, as more and more companies and banks come to the front and look for the government to bail them out. I'm wondering if we wont have even larger issues to arise that'd completely push the fear tactic into use for international economic policies.
    in general, I have a better opinion of Goldman Sach's managers (Paulson) than Detroit or Enron management. At least Goldman managers decided to give themselves no bonus so juniors can have bonuses.

    I don't think you truly understand how bad things would have been... literally imagine going to the atm and not being able to pull out cash. The total US housing market lost $6 trillion in value over the last two years. That loss, basically would have trickled down to everyone in some form or another. It's a real loss, i'm not sure if it can be tied to imaginary WMD in Iraq just because Paulson was appointed by Bush.

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