Understanding the financial crisis

As individuals we will act according to what we think will be best for the group. For example, even if we think it might be a good idea to take our money out of the bank we will be reluctant to do so if we think it will cause system-wide failure. We might be willing to close our account if we think only our bank will fail but if we think all banks will fail we don't act, instead leaving our money in the bank.

So, assuming people do act like this, and given that all banks are in fact a single entity, we can treat "the public" as if it were a rational discrete entity.

So why then do we have a financial crisis? The financial crisis is caused by asset prices becoming too high and houses being unaffordable for people. Collectively, we have decided that this is not a good thing and that something must be amiss. We can't understand where all the money is coming from...

We can describe this feeling as "doubt" in the financial system...

As knowledge of the market becomes more complete among the participants, behaviour will change. The optimal strategy for everyone (including someone who already understands the system) will change as other people gain knowledge of the market.

So what happens now and how can this doubt be assuaged?

People aren't sure where all the money is coming from and aren't sure that the way the banking system works is a good thing... Their way to communicate that to the Powers That Be is to hesitate to take on more credit. They are effectively asking for the system to be changed, or at least examined.

The Powers That Be will respond with an attempt to reassure a sufficient number of individuals (as they think necessary) that things can't be improved, so that things return to normal. If the public disagree and think that the system can be improved the crisis will not go away.

The people suspect that Fractional-reserve banking is not a good system (partly as a response to the credit boom) and are agitating to find out if something can be done to improve it. In response, the Powers That Be will need to give assurances that at least something will be done to improve the system in the future.


18th February 2009