The Two-Cow Model of The Current Financial Crisis

Tuesday, October 28, 2008

(subtitle: Credit Default Swapping for idiots)

You have two cows. You keep one cow for reserve and you lend one cow to a poor farmer and ask another farmer to vouch for the borrowing farmer. In case the borrowing farmer accidentally overmilks the cow and kills it, the vouching farmer will give you a cow. In exchange, the vouching farmer gets "insurance" milk for every week the borrowed cow is insured.

The vouching farmer does this kind of insurance business to a lot of cow owners. Which is good, because he can sustain the giving of cows to people who get their lent cows killed. Unforunately, because of the rising costs of cow maintenance, lots of cows die at the same time, and the vouching farmer has to give everybody who lent cows replacement cows. He then goes out of business.

Now you have just one cow, and another that is being used by a poor farmer, but is now no longer protected in case the cow dies off. But because the rising costs of cow maintenance affects everybody, the farmer who borrowed your cow gets your cow killed. Now you get no cow in return.
You have one cow left.

Now imagine that besides lending cows, you also vouch for other people's cows like the vouching farmer earlier. And all those cows you were vouching for died too. Now you have to give them cows, but all you have is one cow left and a few "insurance" milk which will spoil after a while.

Eventually you'll have no cows left.

In two-cow terms, you're fucked, and so is every farmer in your farmerland.

Suppose there's a central cow economics committee that doesn't like the farmland without any cows. Using a large number of "insurance" milk, they start giving free cows to the farmers who like lending their cows. The free cows aren't really free, and the farmers are going to pay for them eventually with whatever milk they can make with the new cows.

That's called a cow bailout.

Now suppose that even with this new cow introduction, nobody wants to borrow cows anymore. Farmers who live off vouching lenders won't get their "insurance" milk, and the borrowing farmers will remain without any cows, because they're afraid they'll just get their new cows killed.

Meanwhile, lots of cows lay in the fields with no real owners. The farmers just find other things to do (like find another job, get chickens instead, or just die from starvation) and the farmerland eventually shrinks.

That's called a cow recession.

After a while, people will start missing beef and milk, and the farmers will start needing cows again, more and more, until the point that they can't take care of the cows again and we get problems like this again.

So all in all, it's all in how you take care of your cows.

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