Friday, October 10, 2008

A game of chicken

It seems to me today's economic woes are the result of a game of chicken gone bad. In the first place, let's make the assumption that money represents a trust that an obligation will be repaid in the future. It follows that the value of money in circulation represents our expectation of what will be our future output.

Usually this value is represented well by the amount of money flowing around. This is because with sane currencies, you hardly ever have to worry about 10% depreciation happening overnight, for example.

So let's say investor A thinks the future output will be higher than what he perceives is the predicted future output. So he invests in things, thus using money that has to be replenished. To some extent, this causes demand for more money. So, by his actions, investor A makes his prophecy a reality.

Investor B sees that and thinks that he cannot be possibly outdone. He also invests, and predicts future output higher than that of investor A. So now investor A is underinvested, and an arbitrage process keeps everybody on the same page.

Now, as long as everybody is investing, they cause more demand for money. How much is this demand? Well, by how much do the investors want to see growth? Invariably, the return is expressed as a minimum yearly percentage growth target. This is an exponential function, and therefore within a relatively short period of time their prediction will effectively outstrip future output.

Then we enter fantasy land. Because tell me my friend, when everybody is investing, do you have it in you to pull out? Few people do. The rest play a game of chicken, with ever rising stakes.

Eventually they are forced into the realization that it's impossible to keep investing, and they all crash.

So now we see the reverse game being played. Investor A sells, which leaves investor B overinvested. Investor B sells, leaving investor C overinvested, etc.

If we think the current market behavior is nonsense, so is the growing phase that precedes the crash. The issue is our desire for exponential growth. If we do not stop this ridiculous expectation, then today's problems will happen again.

PS: of course this was my blog's post number 666.

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