Poverty and Required Leverage – a Correction

In my previous interest rates model here I denied a connection between squeezed incomes and poverty and the amount of leverage an economic agent demands.  I was wrong.

My reasoning, as far as it went, was sound.

 is a fundamental mistake to characterise demand for money as fundamentally an attempt to extend consumption beyond income, to ‘go into the red’. The most attractive candidates for loans will be those with significant savings and substantial future income streams to pay for premium and interest. If the affordability assessment of the lender shows the borrower ‘in the red’ the loan is unlikely to be granted, and of course a borrower would be irrational to seek the loan.

I set out a model where existing income was levered via loans to bring forward future income – based on the Kelly formula approach as developed by Ole Peters to explain demand for leverage.

The reasoning went that as total loans were a function of current income +savings for deposit by the leverage ratio.  By this formula higher incomes would lead to more demand for loans and lower and squeezed incomes would lead to less.  But I had missed the significance of something, in my formula there was an additional term

Lamda is a measure (0-1) of the risk aversion of the investor with this inversely proportional to income and inversely proportional to uncertainty and time.

This leads to a ‘fractional Kelly’ approach where lamda is a measure of the willingness of someone to ‘bet the house’.  My formula had it ‘inversely proportional to income’ but I had missed its significance.  Given this it is possible for the demand for leverage to rise when incomes are squeezed amongst certain categories, even though the total amount of leverage for the economy as a whole is a function of income.

This struck me looking at a new book, ‘Scarcity: Why Having Too Little Means So Much by Sendhil Mullainathan and Eldar Shafir’ 

They give an example of Indian Street Vendors

Every morning, they borrow 1,000 rupees to sell fruit. They earn maybe 1,100 rupees by the end of the day, and they have to pay back the loan. They pay an interest rate of 5 percent per day, half of their profit. Why is it so hard for them to get out from under that apparently insane situation?

Effectively, what the money lender or the predatory lender is doing is to be the middle man between you and your future self, and to taking the rents. But why shouldn’t your future self come immediately and say, “Look, you want to borrow? Fine. Borrow at high rates, but let’s pay me. Don’t pay that dude.” That type of product is not so different from predatory lending. We know it’s going to do well because predatory lending does well. Only the consequences are fundamentally different. Instead of all of that stuff going outside of your own system, it’s sticking in your system, and a savings account is being built.

This is an important point we have repeatedly made, demand for loans is effectively financial intermediation between you and your future self rather than between those with a propensity to save and those without and neoclassiciasm claims.  Rather lenders intermediate between those who are liquid with wealth and those without.

The authors claim that scarcity leads to bad decisions, true to a degree but bad decisions are not an explanation of poverty. Studies repeatedly have shown that poor people are typically better at managing budgets than the rich.  Rather poverty forces bad decisions because lack of wealth precludes other better decisions – for example capital accumulation – because the por and their families have to eat.  So an important but flawed book.

In terms of our required leverage model it means we have multiple RL required leverage curves rather than just one, the economy wide RL curve is just a rough estimate, or classroom gadget if you will. This leads to a problem of optimisation amongst lenders, to they provide lending power curves to each and every possible borrower to derive an interest rate?  No they divide loans into multiple products depending on the duration of the loan and the wealth and risk of the lender (whether secured or not).