Sunday 21 October 2012

A man walks into a bar...

In a recent posting I asked the question, what's in a rate as a precursor to looking at some of the major factors which make up a rate.  But before I dive fully into that subject I'd like to point out that all of the theory based constituents of a rate are just that - theory based.  There's nothing to stop any two human beings or institutions in the world offering each other any rate they want to on financial contracts such as loans, swaps, forward rate agreements, etc.

It comes back to this question of the rational man, and the maximisation of individual utility which underlies the various kinds of reasoning associated with thinking like a rational utility maximiser.  The model of a utility maximiser gives you the possibility to arrive at a framework for arriving at a fair rate, and when you look at individual rate markets, you see live rates happening out there.  The degree to which you can 'read off' or calibrate parameters of your rational man model from current market rates is also the degree to which you think markets are rational.  This belief (rational expectations) is what allows some people to imply certain parameters of their fair value rates models.

But if you believe there are times when the markets for rates are behaving irrationally, then your system for implying model parameters from market facts breaks down.


In order to explain what I meant by the four characteristics of a fair rate (inflation, the market, participant profiles, this deal) I'd like to cast them all as permutations of the traditional joke opening line: "A man walks into a bar...".  The reason why I like this opening phrase is because you get a sense of some kind of connection between the man and the other people in the bar, but they're clearly not family.  In fact, perhaps a bar environment is in the same category as a market here.  Bars also famously double up as places were stolen goods get sold on, so they can literally act as a market.  Con schemes, new business ventures can all be implemented here.  Indeed weren't the first permanent markets in England originally coffee houses, which are slightly more sober versions of bars.  The relationship with the man and his bar is thus nicely situated for me.   It appeals to my inner anarchist anthropologist.  Also there's a plethora of versions of jokes which start that way.  I hope the familiarity allows you to capture what's really different in each case.

Version 1: 
A man walks into a bar and asks the people in the bar for a lend of £100 for a year, at which point he'll return and give the £100 back.  A healthy show of hands among the customers shows strong interest.  He picks one, takes the £100 and walks out again.  Sound plausible?  Maybe.  

Version 2: 
A man walks into a bar and asks the people in the bar for a lend of £100 for a year, at which point he'll return and give the £100 back.  Despite some interest, no-one in this particular bar has that sum of money ready to hand.  They're all out with meagre drinking budgets.

Version 3:
A man walks into a bar and asks the people in the bar for a lend of £100 for a year, at which point he'll return and give the £100 back.  There's some interest, but again no-one has £100 free cash.  But though they may be poor, they are kind and communal spirited.  So they organise among themselves a collection of cash, each giving what they can, until they reach the £100 requested, and hand it to the man.

Version 4: 
A man walks into a bar and asks the people in the bar for a lend of £100 for a year.  One person sitting in a cubicle recognises the man as a distant cousin and happily hands over the cash.










Version 5: 
A man walks into a bar and asks the people in the bar for a lend of 1 penny for a single day, at which point he'll return and give the penny back.  It gets more plausible as you reduce the amount to 1 penny and 1 day. The lender probably thinks nothing much of it, and doesn't much care if the man never comes back with the penny.  Perhaps the penny becomes the price of some entertaining pub conversation which follows.

Version 6: A man walks into a bar and asks the people in the bar for a lend of £1,000 for ten years, at which point he'll return and give the £1,000 back.  It gets less plausible if you increase the amount to £1,000 and ten years.  

Version 7: A man walks into a bar and asks the people in the bar for a lend of £100 for a day, at which point he'll return and give the £100 back.  But he takes from his pocket a Rolex watch which he's happy to leave with the barman and says the lender can keep it if the borrower doesn't show up with the money.  There's a rush of people to the bar, all willing to lend him £100.


So far, none of these variants have involved a lend with interest.  You are probably thinking that most are unlikely scenarios as a result of this.  Though version 4 (a relative) and version 5 (a penny for a day) are the most likely, followed by version 7 (Rolex).  Though I'm sure you're wondering of the Rolex is a fake, aren't you?

Let's see how far I can press this without introducing a rate of interest for the lender.

Version 8: 
A man walks into a bar and asks the people in the bar for a lend of £100 for a day, at which point he'll return and give the £100 back.  One customer agrees and hands over the money.  But then that customer, several hours later, gets a call from home and needs to return in a hurry.  He asks the rest of the bar if anyone else would like to take on his obligation?  One man agrees, so, the departing customer gets £100 from the new lender, who in turn sits waiting for the original man who walked into the bar.

Version 9:
As with version 8, but this time the obligation gets passed around a whose series of customers of the bar, all coming and going during the day.  By the time the original man who walked into the bar returns, the entire bar population (including bar-staff, who've changed shift) is different.  But just by shouting 'where is the guy I owe this money to?', the original borrower is able to return the £100 to the current lender.

Version 10:
As with version 9, but the original man is confused.  He doesn't want to hand over £100 to some stranger.  No-one there is recognisable to him.  He begins to wonder if this was even the right bar.  He leaves the bar still holding the £100, vaguely promising to himself to return tomorrow to see if he could see the lender.

Version 11:
As with version 10, except this time the lender who has now inherited the loan gets quite angry, and frustrated at his lack of any ability to convince the borrower to return the cash.  



In these newer (but still rate-less) versions, the bar is falteringly beginning to operate somewhat like an exchange venue (it doesn't deserve to be called a market quite yet, but markets are many things, including being exchange venues).  Whereas version 9 looks to be a healthy exchange venue, versions 10 and 11 show it breaking down through lack of trust and operational clarity.  In the original version 1 of the story, you were immediately clear in your own heads that there's an issue of trust at play - between the potential borrower and the potential lender.  Now you can see that there's a second dimension to this issue of trust.  The re-distribution of this loan and the borrower's willingness to settle with someone else are clearly dependent on a wider sense of trust - the trust placed in the perceived fairness of the bar as honest institution.


Version 12: 
 A man walks into a bar and asks the people of the bar for £100, which he says he'll keep.



Version 13:

 A man walks into a bar and asks the people of the bar for £100.  He says he "needs a whore bad" but doesn't have the cash to pay for one.  "That's where you come in", he smiles.







Version 14:
 A man walks into a bar and asks the people of the bar for £100, which he says he'll use to buy a warm coat for that homeless man out on the bridge since it is coming in to winter and the snow's arrived.





With these variants, we get to see the reductio of any 'lending' operation, one where the money is not returned.  The act itself seems like a form of charity, though the versions where the borrower states his purpose clearly can have an effect on the lend.


Version 15: 
 A man walks into a bar and asks the people in the bar for a lend of £100 for a day after which he'll repay.  He gets his money and departs.  Fifteen minutes later, another man comes in, also asking for £100 for a day, promising to repay.  He also gets his money.  This carries on every fifteen minutes until no-one in the bar had any money left to lend.





Version 16:
 A man walks into a Zimbabwean bar and asks the people in the bar for a lend of 100 Zimbabwean dollars which he'll pay back this time next year.

From just these bar stories, it ought to be possible to develop a theory of the rate of interest, a theory which tries to explain what a fair lending rate might be.

In the next posting, I'll introduce variants of the story where forms of payment are made to the lenders.  As you will have noticed, so far, no policemen, no financial services authority, no formal contracts, no lawsuits, no government guidelines  have been brought into the story.