Is holding illiquid assets an easier way to save because humans are myopic?

Author: Ken L. White

VS

Myopia

Most people, even savers find spending money an easy task. This is because the physical money we hold in our wallets, safes and banks are the most liquid assets. Humans are more at ease with spending than they are with saving, we are myopic and place more emphasis on short term satisfaction.

Hyperbolic discounting is a time inconsistent model of discounting that the human mind uses when making spend save decisions.

Proposition 1: I offer you £100 today guaranteed or £200 next week with a 95% probability of you getting the money, which would you choose?

Many of you would choose the £100 today because you view this as the higher pay-off, whereas in reality the greater pay-off is (£200*95%)=£190 next week. This basic concept that induces humans to take the lesser pay-off is myopia. In making the decision to take the £100 today you are in effect saying that it is worth more than the 95% chance of the £200 next week, which we calculated to be £190. This is not rational behaviour because we know £100<£190, so why make that decision?

The dangers associated to myopia don't end at my proposition, they are far reaching. Consider a goal of locking away £10000  for 5 years in a fixed rate bond paying 7% pa. If this sum of money is a large percentage of your income it is unlikely that you would be willing to tie it up for that period of time. However, if you had £10000 and could afford to buy a relatively new sports car, this would be an easier proposition. The value of the car in 5 years will be half what you paid for it, but the value of the savings you have in the account would be £11193, or a 12% gain over the period. The short term satisfaction gained from spending on goods drives us to lose out on opportunities to amass wealth.

How to combat myopia

One way to limit the impacts of myopia on your wealth is by holding illiquid assets, this could be precious metals, property, livestock, land, jewellery etcetera.  Having to turn these assets into the physical money we use everyday before being able spend it is a tool that will help you save more. The process of getting your assets to market, getting a fair price for them and completing the transactions is one that allows an investor time to think about their long term goals and hence stop the process, thereby retaining wealth.

My personal favourite for this strategy is to accumulate the money necessary to buy 1 oz. bars of gold then buying one. They usually trade for less than £800, so are easy enough to convert to cash if it is really necessary,  but significant enough for me to not  want to sell one so I can go out on a Friday night and party. Creating these types of strategies are very important to long term wealth creation and maintenance. Another option is to put your money in government or corporate bonds. These should limit some of the urges associated with holding cash.

One the higher end of the scale holding over £80000 in the bank puts an individual at risk because the government insurance only covers up to this amount in bank accounts (you could have £80000 in different account once the banks are not under the same umbrella and the money will still be insured). Instead of holding the cash, converting it into an illiquid asset may help with the negative impacts of heuristics on your personal wealth as well as gaining you higher long term returns than a current account.

The key

The key is to keep what you need to get by as liquid money (coins, notes, bank account) and tie the rest up in illiquid mediums such as those suggested. After repeating this process for an extended period of time you should see a marked change in how you process situations of saving versus spending and therefore this should help you amass more wealth at a faster pace and keep it for longer periods.

Any questions just let me know!

2008 Financial Crisis and who benefited from it

Author: Ken L. White

A bubble in the US housing market precipitated the financial crisis of 2008 and lead to

markets around the world being affected (Soros 2008 FT). There was excess money in the economy 

as a result of an artificially low interest rate and when all the credit worthy borrowers no 

longer demanded the money, financial institutions turned to ones who were able to repay 

loans at the lowered interest rate (riskier borrowers). These sub-prime mortgages would 

have only been the problem of the US if banks did not package the toxic assets with other 

assets and sell them on to third parties around the world. The inability of these third party 

institutions to verify what exactly made up these financial securities was a key factor in how 

high the velocity of trade in these assets was. Returns were dependent on these borrowers 

repaying their loans at the prevailing interest rates, which proved to be impossible due to the 

lines of credit on individuals and firms being restricted leading to massive defaults. 


Under FRFB, the artificially low interest rate attracts individuals who would otherwise be 

unable to borrow; they are able to do so and pay the lower rates once borrowing continues 

by other individuals in the future. This is the (X+r controversy); the banks provide X 

amount of money and require X plus interest. This model is unsustainable unless individuals 

continue borrowing and most of them repay debts. However, game theory tells us that what 

is optimum for an individual is not always socially optimal. The moral hazard problem arises 

when banks know that there is a bailout clause in the form of the government, should they get 

into trouble because the economy and banking system are interconnected. 


The crisis was similar to others that have occurred since world war two; however, it marked 

the end of credit expansion based on the dollar as the international reserve currency (Soros 

2008 FT). Soros (2008) states, “The boom bust process usually revolves around credit and 

always involve a bias or misconception”; this is usually a failure to recognise a reflexive, 

circular connection between willingness to lend and the value of the collateral, highlighting 

the myopic nature of individuals. 


The easy access to credit generated demand for houses that push the property values up, 

leading to more availability of credit. The bubble was created when individuals attempted to 

refinance their mortgages at a profit (Soros 2008 FT). Quantitative easing (QE) allowed the 

process to continue whenever there was trouble in order to stimulate the economy.

Market fundamentalism became popular in the US in the 1980’s; fundamentalists believe that 

markets always tend towards equilibrium. However, without government intervention they 

would not survive, so it was the government, and not the markets themselves that prevented 

the breakdowns.  


It is argued that had the products (securities) not become too complicated to calculate the 

risks associated with them, the financial system would not have crashed as it was the inability 

for objective organizations (government and credit rating agencies) to rate them that lead 

to banks being deceptive. The quantitative easing programme could have continued its 

successful trend of economic stimulation. 


The financial crisis affected the UK’s banking system as a whole. Many of the major 

institutions found themselves in dire need of liquidity in the form of government loans 

(bailouts). The government has a controlling stake in the Royal Bank of Scotland and a 

minority stake in Lloyds banking group resulting from the bailouts provided.

Since 2008

The government has sold some of their stake in Lloyds at below market price and still managed to make a profit. This sale sparked a ‘feeding frenzy’ among investors, only somehow the government managed to prevent some of them from gaining access to what the were providing. So the UK government profited from this investment (bailout of the banks) and those institutional investors  who purchased the shares sold by the government profited from this sale because of arbitrage (under arbitrage you are able to buy at a below market price and instantly make a profit by selling at market price to buyers, while taking on no risk).

The taxpayers who assisted in helping bail out these financial institutions received nothing from this initial sale of shares, however it is anticipated that within the next year more shares in Lloyds held by the government will be sold.

Some other stakeholders have feared off even worse than the investors and the government. These are the individuals who are in receipt of less now than before the crisis because of loss of jobs, inflation eating away at what wealth they do hold, falling house prices (outside London) and pensioners (those whose portfolios comprised of stocks and property).

Questions
1. How have you been impacted by this crisis if you have been living in the UK?
2. How much of your portfolio consisted of stocks (from financial institutions) and what was the capital loss or reduction in wealth faced by selling or holding on to these stocks?
3. Have the lower interest rates had a noticeable favourable impact on your mortgage repayment (if variable) and how long do you expect this to last?

The Fractional Reserve Banking system in theory and practice, and arguments for and against it being used

Author: Ken L. White

The fractional reserve free banking (FRFB) system came into existence following the

realisation that not all bank deposits needed to be repaid simultaneously. Individuals or

firms that deposit money at a bank receive a deposit account, which is a liability to the bank

on their balance sheet. With these deposits, banks could lend out the money to individuals

charging interest from lenders and paying interest to and depositors.


Legally banks have authorized to provide loans that exceed the deposits it holds by a certain

multiple because it is accepted that depositors will not withdraw at the same time. The

loans that it gives out in theory come back to the bank and they can do the process again. In

contrast to other goods and services, money is not used up in consumption or production; its

ultimate use lies in the fact that it is exchanged for other goods (Davidson 2012 pp. 198).

Central banks set and regulate the reserve ratios and hold some of the commercial banks

deposits as security against the possibility of bank runs. In the case of providing confidence

to depositors, central banks insure deposits (insurance) and are a lender of last resort to

commercial banks in the event of a bank run.


FRFB was seen as a monetary and a fiscal framework for economic stability (Warburton

1952 pp. 523). There is constant debate within the Austrian School of economics as to

whether FRFB should be allowed to take place. Many have argued for the benefits of this pre

and post 2008, and the evidence provided by all parties must be analysed.


The Austrian School economists prefer a gold standard (all bank issued media fully backed

by gold) to one where banks can generate redeemable IOU’s (Selgin 2000 pp. 93). Selgin and

White (1996) argued for fractional reserve banking; however are not defenders of fiat money.

Economist like Rothbard have long argues that FRFB is inherently fraudulent (Selgin 1996

pp. 86).


Many critics condemn FRFB for three main reasons, firstly, the practice is inherently

fraudulent and it only survived because of banker’s dishonesty or government mandated

deposit insurance (Selgin 2000 pp.94).

 Secondly, critics of FRFB say that under a gold standard, any bank created exchange media

not backed by gold will fuel the business cycle. In issuing spendable IOU’s to borrowers,

banks reduce interest rates below their natural levels, promoting investment at the expense

of other producers and consumers who find themselves bidding against bank borrowers for

scarce resources. The bidding war forces up prices and interest rates, restoring the purchasing

power of the money stock to its pre-expansion level. However, when this happens resources

would have already been allocated to unsustainable projects, given the amount of voluntary

savings available from the public (Selgin 2000 pp.94).

“The collapse of unsustainable projects (subprime mortgages), followed by the consequent

restoration of a pattern of resource use something like the pattern that proceeded the issue

of fiduciary media, marks the bust and recovery stages of the business cycle” (Selgin 2000

pp.94).


Thirdly, FRFB is vulnerable to bank runs when their customers lose confidence in them,

such as in Cyprus after a proposed bailout charge on savers. Fractional reserve banks by

definition are not able to meet the demand of its depositors at a given time (Selgin 2000

pp.94). Confidence plays a great role in the banking system, as we will see later.

My belief is that most individuals are blissfully unaware of the fact that their deposits are not

backed one hundred per cent by reserves; however, with the payment of interest on accounts,

they can figure out why they are being paid for the bank to safeguard their holdings.

Borrowers, such as those who took out subprime mortgages in 2008 were to me unaware that

in an efficient, non-FRFB system, the money that savers deposited would not be available to

them.


Economists who have critiqued the FRFB system have been looking at the fraud issue from

the banks perspective, however most of my analysis will be focused on the system’s ability to

affect economic growth and the reasons HSBC faired out better than its contemporaries since

the crisis.

The ability of the banking sector to affect the business cycle, not only domestically, but also

internationally was evident in 2008 driven by continuous globalisation and the expansion of

financial institutions.  Additions to the money stock are able to aggravate the business cycle.

However, this is dependent on whether there is a pre-existing increase in the public’s demand

for money at the going rate.

Austrian Business cycle tells us that if the expansion of supply of money creates an overall

excess of money, people will spend the excess (Selgin 2000 pp.97). This increased spending

will not be offset by a reduction of spending of other individuals and this stimulation to

overall demand for goods and services together with the pattern of spending prompted by an

artificially low interest rate will have adverse business cycle consequences described by the

Austrian theory (Selgin 2000 pp.97).

Student loan debt. When and how to pay it off.

Author: Ken L. White


These picture explain how I felt when I opened a letter from the Student Loans Company (SLC). 




This topic is very near and dear to me having completed two degrees and being the owner of the most important variable attached to those two degrees. Not the actual education or degree certificates, but the student loan company account with a debt that exceeds any graduate salary I could expect in today's economic climate.


The main thing that bothers me is that now when I repay this debt, I must pay tax on income before doing so. There are many factors to consider before paying more than the required amount back early, because you are taxed on your income, in real terms for every £1 you pay to SLC, it costs you that plus whatever rate of income tax you pay. 

For example, if your threshold means that you pay 20% income tax, for a payment of £100 to the student loans company, it will cost you £120. 

Be advised that this is important to you when considering what other debt you are able to take on such as mortgages or car loans. So understand it and use it to better yourself. 

Below are some of the ways which you repay and how much you are liable to repay depending on your level of income. You can elect to pay back more than the minimum if you wish to get rid of it earlier. However, consider your more urgent and immediate debt and get rid of those first (overdraft, credit cards etc). 

Repayments

You must pay back Tuition Fee Loans and Maintenance Loans. You pay interest on these. You don’t have to pay back other student finance, eg grants and bursaries.

How much you pay back

If your course finishes before 2016, repayments won’t start until April 2016.

Your repayments are linked to your income. You only make repayments when your income is over £21,000 a year. If your income drops below this amount repayments stop.

Part-time students sometimes start repayments while they’re still studying.

Each month you pay back 9% of any income over £21,000.

Your income per year	Monthly repayments
£21,000 and under	No repayments
£25,000	£30
£30,000	£67
£40,000	£142
£50,000	£217
£60,000	£292

Interest on your student loans

You pay interest from the time your first payment is made until you pay your loan back in full.

For courses that started on or after 1 September 2012 the following interest rates apply:

Income	Interest rate
While you’re studying	Rate of inflation (Retail Price Index) plus 3%
£21,000 or less	Rate of inflation
£21,000 to £41,000	Rate of inflation plus up to 3%
£41,000 and over	Rate of inflation plus 3%

Making repayments

You can pay some or all of your loan at any time without an extra charge.

If you’re an employee your employer will work out your repayments and take them out of your salary with your tax.

If you leave your course early, you still have to repay your student loan.

If you go abroad for more than 3 months you need to fill in an overseas income assessment form. Student Finance England will then work out your repayments.

With a rate of 9% on any income over £21,000 which means you will probably be paying this as most graduate salaries exceed this. 

Example

A total income of £25,000 means that (£25.000-£21,000=£4,000) on that £4,000 you pay 9% which equates to £360 annually. There are some ways to avoid excess payments, you can utilise you annual tax free allowance via an ISA. 





Questions

1. How much student debt did you have when you graduated and what year did you graduate in?

2. Has paying back over the compulsory amount drastically affected your ability to consume to any noticeable effect?

3. How has your student loan affected your ability to borrow for a mortgage or a car loan?