Seeing the Bigger Picture (1)

Grouping actions by time

When you analyse something complex into its simplest components (which in the case of the One Lesson are the actions represented by arrows), it’s easy to get lost in the details and not see the big picture. Last week we looked step-by-step at an example where Alice, a farmer, borrowed from a bank to buy extra seeds to sow. In this article and the next, we’re going to group the actions in different ways to get a better overview of how these actions fit together. This week, we’ll just group the actions into 3 sets of transactions¹ — ordered by time:

1. Borrowing phase. Alice borrows from the bank, buys wheat seeds from Bob, and sows them.

2. Repayment phase. Alice harvests the wheat, sells seeds to Bob, and repays the loan principal (the amount originally lent to her).

3. Interest payment phase. The bank pays Eve a dividend, Eve buys seeds from Alice, and Alice pays the interest.

To properly understand what’s going on, please make sure you know exactly how each action affects both² parties’ assets, liabilities and raw net worth³, and consider whether they would be satisfied with this. (If you’re not sure how to do this, check this table to help you). Remember that to work out how someone’s RNW is affected, you add all the arrows pointing towards them and subtract all the arrows pointing away from them.

If you find any transactions surprising because of how everyone’s RNW is affected, please leave a comment — I hope you do, because there’s certainly one transaction which appears to be uneven.

So here are the 3 diagrams with all the transactions numbered in time order.

Borrow

Borrowing phase

In case you didn’t read the earlier posts on this scenario, Alice starts with 200 bushels of wheat seeds to sow, but that’s only enough sow half of her land. She’s borrowing £1,000 from Eve’s bank to buy another 200 bushels.

Transaction 1 is Alice borrowing from the bank. The bank simply creates £1,000 in her account. This is called a deposit, even though she didn’t deposit any cash (although you can imagine that the bank gave her £1,000 in cash and she immediately deposited it back at the bank). It’s a new debt owed by the bank to Alice. In return, Alice promises to repay the bank the £1,000 — this is referred to as a loan in the bank’s accounts. It’s a new debt owed by Alice to the bank. And Alice has a second new debt for £25 owed to the bank: the interest⁴.

In transaction 2, Alice spends the new £1,000 deposit (by using a debit card) on 200 bushels of wheat seeds at Bob’s seeds shop. She’s transferring this existing debt (green arrow), and Bob hands over 200 bushels of seeds to Alice. The bank now owes £1,000 to Bob, and doesn’t owe anything to Alice. (Alice still owes the £1,000 + £25 to the bank).

Transaction 3 is simply Alice sowing all 400 bushels of seeds, so she doesn’t have them any longer⁵.

Repay principal

Repayment phase

When it comes to harvest time, the seeds have grown to plants with many more seeds, with the help of power from the sun.

In transaction 4, Alice harvests 20,000 bushels of wheat seeds.

She takes 1,000 bushels of seeds and sells them to Bob for £1,000 in transaction 5. (Bob pays by internet bank transfer. The bank now owes £1,000 to Alice again, and doesn’t owe Bob anything).

Now that Alice has £1,000 again, she can repay the loan in transaction 6. This undoes two of the new debts from transaction 1: Alice writes off the £1,000 deposit which the bank owes her, and the bank writes off the £1,000 loan which Alice owes it.

Pay interest

Interest payment phase

By this point, the bank has a £25 profit, since the only change to its assets and liabilities since the start of the scenario is the new £25 interest debt owed to it by Alice. Since it owes its profits to the shareholders (in this case Eve), it can pay her this in transaction 7 by creating a £25 deposit for her as a dividend.

In transaction 8, Eve buys 25 bushels of seeds from Alice for £25 (by automated phone banking), so the bank now owes Alice £25 (and no longer owes Eve anything).

Finally, in transaction 9, Alice uses this £25 deposit to pay her interest debt to the bank. As in transaction 6, both Alice and the bank agree to write off their £25 debts to each other.

Summary

Even a relatively simple scenario consists of a fairly large number of economic actions (represented by arrows in the diagrams). It can be useful to group them together to see the bigger picture more clearly. This week, we grouped them by the time in which the transaction occurred. Next week we’ll group them in a completely different way, which shows how the One Lesson can give us some unique insights.

1. A transaction is a set of actions where the people involved agree that as soon as the first action occurs, then all of the others occur simultaneously.

2. In this case, all the transactions only involve at most two people(/entities). But be aware that some transactions involve 3 or more people (e.g. when paying with a credit card).

3. Someone’s raw net worth (RNW) is what they own plus what they’re owed minus what they owe. It is a “heterogeneous” sum/difference, which just means that things of different types are added and subtracted, not monetary “values” which have been assigned to them.

4. People could argue over when Alice’s debt to the bank for the interest on the loan comes into existence, but the exact time generally doesn’t matter. Having said that, as soon as Alice signs the loan agreement, she has already agreed that if the repayment plan proceeds as everyone intends, she’ll have to make a £25 interest payment to the bank.

5. If we wanted to, we could explicitly represent this by saying it consumes her seedless land and produces seeded land, but that’s probably unnecessary detail.