David Leonhardt notes that it's pretty hard to explain what's going on in the financial world these days (ht Felix). Here's how I'd tell the tale to a child:

Alice, Bob, and Sue have ten marbles between them. Whenever one kid wants another kid to take over a chore, she promises a marble in exchange. Alice doesn't like setting the table, so she promises Bob a marble if he will do it for her. Bob hates mowing the lawn, but Sue will do it for a marble. Sue doesn't like broccoli, but if she says pretty please and promises a marble, Bob will eat it off her plate when Mom isn't looking.

One day, the kids get together to brag about all the marbles they soon will have. It turns out that, between them, they are promised 40 marbles! Now that is pretty exciting. They've each promised to give away some marbles too, but they don't think about that, they can keep their promises later, after they've had time to play with what's coming. For now, each is eager to hold all the marbles they've been promised in their own hands, and to show off their collections to friends.

But then Alice, who is smart and foolish all at the same time, points out a curious fact. There are only 10 marbles! Sue says, "That cannot be. I have earned 20 marbles, and I have only promised to give away three! There must be 17 just for me."

But there are still only 10 marbles.

Suddenly, when Bob doesn't want to mow the lawn, no one will do it for him, even if he promises two marbles for the job. No one will eat Sue's broccoli for her, even though everyone knows she is promised the most marbles of anyone, because no one believes she will ever see those 17 marbles she is always going on about. In fact, dinnertime is mayhem. Spoons are placed where forks should be, and saucers used for dinner plates, because Alice really is hopeless in the kitchen. Mom is cross. Dad is cross. Everyone is cross. "But you promised," is heard over and over among the children, amidst lots of stomping and fighting. Until recently, theirs was such a happy home, but now the lawn is overgrown, broccoli rots on mismatched saucers, and no one trusts anyone at all. It's all a bit mysterious to Dad, who points out that nothing has changed, really, so why on Earth is everything falling apart?

Perhaps Mom and Dad will decide that the best thing to do is just buy some more marbles, so that all the children can make good on their promises. But that would mean giving Alice 19 marbles, because she was laziest and made the most promises she couldn't keep, and that hardly seems like a good lesson. Plus, marbles are expensive, and everyone in the family would have to skip lunch for a week to settle Alice's debt. Perhaps the children could get together and decide that an unmet promise should be worth only a quarter some fraction of a marble, so that everyone is able to keep their promises after all. But then Sue, the hardest working, would feel really ripped off, as she ends up with a much more modest collection of marbles than she had expected. Perhaps Bob, the strongest, will simply take all the marbles from Alice and Sue, and make it clear than none will be given in return, and that will be that. Or, perhaps Alice and Bob could do Sue's chores for a while in addition to their own, extinguishing one promise per chore. But that's an awful lot of work, what if they just don't want to, who's gonna force them? What if they'd have to be in servitude to Sue for years?

Almost whatever happens, the trading of chores, so crucial to the family's tidy lawns and pleasant dinners, will be curtailed for some time. Perhaps some trading will occur via exchange of actual marbles, but this will not be common, as even kids see the folly of giving rare glass to people known to welch on their promises. It makes more sense to horde.

A credit crisis arises when many more promises are made than can possibly be kept, and disputes emerge about how and to whom promises will be broken. It's less a matter of SIVs than ABCs.

Update: Mark Thoma offers characteristically thoughtful comments. I also liked this, by Alex Whalen. (BTW, I don't have children, though my wife is urging we remedy that soon.) In the comments, Arun Garg is reminded of Paul Krugman's Baby-sitting Co-op, whose influence I'm happy to acknowledge. Krugman is a master of this sort of parable, see also hot dogs and buns.

Update 2: (Not for kindergarteners!) There've been comments here and elsewhere suggesting that the numbers in this story can't be made to work. They can. Note that the 40 marbles the children think they have is before netting. As the piece says, "They've each promised to give away some marbles too, but they don't think about that, they can keep their promises later, after they've had time to play with what's coming." That's realistic. It's why people who borrow from banks think they have cash, even though, if you net it out, that cash is offset by a liability to the bank. On idealized balance sheets, the promises made to us are represented as assets. The promises we've made are our liabilities, and the promises that can't be kept show up as negative equity. On net, across people, all promises sum to zero, and all equity sums to the real value of all the stuff. It's the distribution of gross numbers that gives rise to a credit crisis. It's an accounting identity that, on net, everything balances. But that doesn't help anybody.

For the very geeky among you, click the link below to reveal balance sheets that comport with this tale.

Update 3: (Only for very neurotic grownups!) The balance sheets posted in "Update 2" miss a constraint implied by the tale. It is claimed that, if promises were devalued to a quarter marble, everyone would be solvent. But given the posted balance sheets,, Alice would still be underwater. One can come up with balance sheets consistent with the constraint, but in doing so one runs afoul of another implication of the text, that Bob owes Sue more than Sue owes Bob. I don't think that both constraints can be satisfied. So, I'm changing the text, from "a quarter" to "some fraction", because it's the right thing to do. I think everything works out now, and the balance sheets previously posted are fine.

Update History:
  • 20-Mar-2008, 1:30 p.m. EDT: Added update re Thoma, Whalen, and Garg comments, Krugman acknowledgement.
  • 20-Mar-2008, 6:40 p.m. EDT: Added update 2 with balance sheets.
  • 20-Mar-2008, 6:40 p.m. EDT: Added sentence about bank loans to update 2. Changes a "the" to an "a" and added "not for kindergarteners" to same update.
  • 24-Mar-2008, 2:05 p.m. EDT: Added update 3, struck "a quarter" and replaced it with "some fraction".
Steve Randy Waldman — Thursday March 20, 2008 at 3:18am permalink
Bryan (mail) (www):
Excellent - should be read by all bankers!
3.20.2008 10:13am
Robert B Rowe CIMA (mail) (www):
Excellant piece, which should be distributed to all children AND ADULTS in the country. The only way we will work our selves out of this problem is to first recognize how we got here.

Thank you for the insight and thought.
3.20.2008 12:09pm
Arun Garg:
This reminds me of Krugman's "Baby-Sitting the Economy" explanation for inflation &deflation:


3.20.2008 12:11pm
shtove (mail):

Do any of the children get perp-walked out the front door, straight to federal prison?
3.20.2008 12:55pm
Would apples and trees be a better analogy?:
I enjoyed your analogy, but then read a comment on Mark Thoma's post which asked how come there could be 40 marbles required after neeting all promises. It may well be that one or more kids positions will be negative when taking into account promises. But the whole set of promises does not increase or decrease the holdings since this is a closed system.

Suppose instead of dealing with a fixed, static set of marble money, the kids each had an apple tree. The kids promised each other apples. Of course, new apples grow on the tree.

So, if they net out their apples, they may see that they owe someone more apples than they have, but that's ok because they will, in time, augment their stash as their tree produces more fruit.

So, they can balance their books by adding an accrual for future crop production:

IN STOCK: 4 apples
NEXT MONTH'S CROP: 5 apples (From my kids' valuation model)

Total holdings: 2 apples

With this accounting, the kids will roll-over their promises.

The fact tht (4-5) is less than zero is not a problem.

The kids know that the trees are getting bigger each month and so feel confident in cranking out promisee.

However there will come a point in time when you have:

INSTOCK: 4 apples
NEXT MONTH'S CROP: 25 apples

But then it is noticed that the trees are not growing a foot a month anymore. Horticultural textbooks are dusted off and consulted, and it is found that, in fact, apple trees do not keep growing forever and ultimately plateau off, and ultimately die. This was not factored into the kids' view of apple production growth. They though apple trees kept producing more fruit each month than the month before.

Then the kids start to worry about those valuation models and will discount the future delivery of their promises and they start to refuse to exchange promises and want to settle out right now.

This is different from the marbles because the kids have both investments (trees) and income form them (fruit).

Investors have not borrowed more than their capital, they have borrowed more than their future income can service.

Mark R
3.20.2008 3:08pm
Benjamin Reeve (mail):
With due respect, apples and trees is somewhat a better analogy, and would perhaps be an even better analogy were there several varieties of apple each with different periods to maturity, and there was some opportunity in the "family" to exchange and promise exchanges of apples. The risks attending apple growth, too, bugs and weather and so forth, being no small part of it either, in part because money, like every other form of information is created non-conservationally. (Money, of course, is created -- new money, never before seen on earth money -- by means of transactions, particularly transactions styled as "lending" of one form or another.)
The value of the extension of the analogy would not be so much for its own sake, but to consider whether it would help "model" other associated ideas. One that comes quickly to mind is the very idea of "confidence."
If one of the family members over-promises apples, and her tree has a particularly bad year, interesting that we would think the lawn will soon be neatly mowed and broccoli will be eaten if we hear that this kid who is in some apple-straits will get an infusion of several dozen apples from previously uninvolved Uncle Sid in exchange for an aging sneaker.
3.20.2008 4:47pm
Edward Ulysses Cate (mail) (www):
Great story, but nobody lied in this story. That's the problem I had with Leonhardt's commentary that's been picked up all over the place. He says, "All these investments, of course, were highly risky. Higher returns almost always come with greater risk. But people — by “people,” I'm referring here to Mr. Greenspan, Mr. Bernanke, the top executives of almost every Wall Street firm and a majority of American homeowners — decided that the usual rules didn't apply because home prices nationwide had never fallen before." What??? These two experts on the Great Depression??? So I wrote a polite email directing him to simple statistics and the commentary at GreatRedDragon.com entitled: "What Did I Just Read???" No reply.
3.20.2008 4:53pm
Thai (mail):
Great post!
3.20.2008 8:07pm
OrganicGeorge (mail):
I have another story

A family has credit card debt, a mortgage, car payments, college fund, retirement, etc. but they are living with in their means.

The family across the street had much more debt and an adjustable mortgage that is resetting in 30 days, so they are gong broke

The family across the street has a rich uncle that decides to help the family and accepts all their bad debt and mortgage in exchange for a personal guarantee

It happens that the first family works for the rich uncle and to help finance the family across the street the uncle uses the company retirement fund to accept the debt and issue cash

So the family that has good connections gets bailed out by a rich uncle and the family who did not exceed their needs get the shaft.

Does that explain this situation better?
3.20.2008 8:35pm
dug (mail):
In the children's defense their parents told them it's perfectly legal to have only 1 marble in reserve for every 10 they promise, because their parents could always counterfeit some more to make up the shortfall, and if that ponzi scheme doesn't work out they can always legislate all their problems away (or at least force someone else do all the chores).
3.20.2008 10:25pm
afferent input (mail) (www):
This is great. I've been looking for a "simple" explanation to give to friends and family. Nice post.
3.21.2008 1:23am
Of the twenty primary dealers, many are foreign securities firms. Will the Fed be taking their toxic collateral as well? To date, only US firms have been mentioned. Admittedly the Fed is only offering a loan in exchange for collateral, but its indeterminate duration suggests quasi-equity, as previously discussed. If this collateral is eventually taken on the Fed's balance sheet as a permanent asset, even allowing for a haircut, will US taxpayers wind up giving foreigners a bailout as well?
3.21.2008 5:36am
Excellent. As a kindergarten teacher I see the give and take of your scenario everyday. Kindergarten children can often grasp the concepts better than their parents who lose the ability to understand the logic of events. Many times, adults don't have the patience to think about their actions. Many parents would go into their own debt to buy their children the extra marbles in order to not deal with the complaints.
3.24.2008 11:47am
This is great way to explain it. It is exactly what happen. A lot of people, buy new house with small down payment, big mortage. As soon as they see the big house price drop, they found out that default the mortage is cheaper than keep making payment for the next 25+ years. (Note here: I am talking about people who can afford to keep making payment.)

At the end, the SMART people with money walkout on a bad investment (house), and the sub-prime market forced to take the over-priced house. And the SMART people who walkout on a bad investment still got to keep the car, and most of the money. Only losing a little down-payment.....
3.26.2008 12:41pm
Just happened to run across this post so apologies for being so late to the party. In a discussion at another blog last year on monetary matters, Krugman's parable was also brought up. It doesn't to me seem to survive closer scrutiny very well.

I had a look at the Krugman article last year and also, out of curiosity, looked for the original article from the Journal of Money, Credit and Banking on which he based his story. (Only the front page — out of four — is available without shelling out US$44 so I contented myself with that). Interestingly, it seemed to confirm what had seemed to me the most obvious fallacy with Krugman's analogy. Let me quote the relevant excerpt from that first page:

Whatever the lessons from the board's experience [an amusing reference to the Fed], the lessons from the co-op's are clear. (1) The co-op has been increasing its money supply (scrip) per capita, by running budget deficits, and this has generated inflationary forces. (2) However, the main commodity this scrip buys is baby-sitting time, and the price of baby-sitting is pegged at one unit of scrip for every one-half hour of baby-sitting. Hence, this system of price controls means the inflationary pressure does not drive up the scrip-price of baby-sitting, inflation is suppressed, and shortages are found.

Exactly. To solve the imbalance, they simply had to allow the price of the scrip to fluctuate according to the demand for and supply of baby-sitting services. But then it would really just be an ersatz form of money, something which I don't think has ever worked out terribly well. There's a deeper flaw with using this little scheme as a monetary analogy, though, since the scrip could primarily only be used for one service. To the extent that natural, chronic imbalances — whether seasonal or otherwise — occur in baby-sitting, they would always have problems using one-purpose scrip. In real life, on the other hand, money can be used for any purpose so come summertime, you're either willing to pay up to get your sitter or you stay home with the kids. Winter, you could get it for next to nothing.

No insoluble problem there.
4.7.2008 11:36pm
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