economonkey

People in the UK are saving the lowest amount of money in almost fifty years, according to research from the Office of National Statistics. In the first three months of 2008 Britons saved just 1.1% of their income, compared to 3% in the winter of 2007 and 6% in the summer of 2006.  The last […]

Put two economists in a room together and you’ll get three different opinions on the state and future direction of the economy. Surely economics, the dismal ’science’, could learn something from one of the true sciences, such as physics?

Certainly there have been efforts to do so, particularly among large investment banks and hedge funds, who have used quantitative analysis tools running on powerful computer systems to try to tease out the signals from the noise of price movements, taking into account thousands of different influences from interest rates to tax variations, asset prices to currency exchange rates and much more, all on the basis that there is some underlying predictability, some ‘law’ that governs price movement.

Which makes it all the more surprising that so many of them got it so spectacularly wrong; to the tune of $188 billion and counting. Why?

(as found in everything from your common or garden mortgage to major investment bank funds)

“Give me a place to stand and a lever long enough and I will move the world”, said Archimedes.

And he was right. Although the Earth would have to be orbitally stationary relative to his position, and it would have to stop rotating, and he’d have to be in a spacesuit, and the lever would have to be made from something immensely more light and strong than even carbon nanotubes, and the pivot would have to be frictionless, and wherever he was standing would have to have sufficient mass to counteract his exertions, and…

In fact the whole thing’s daft, really.

But you can see what he meant: little movements can have a big effect if you have the right leverage. And, just as you can shift a heavy boulder with the aid of a small rock and a big stick, so you can shift a lot of money on the back of geared loans secured upon bricks and mortar.

Because that’s what a mortgage is; a form of leverage. Most people can’t afford to buy their house outright, so they put down a deposit (usually) and take out a loan for the rest. For the sake of argument, let’s say that Mr and Mrs Average put down £20,000 on a £200,000 house, borrowing the remaining £180,000. They now have a leveraged ‘investment’ - sometimes rather quaintly known as a ‘home’ - with a gearing factor of 10.