I had two utterly insane thoughts today.  The second I cannot share.  The first however, is fair game.  Following my fascination with economics recently, it’s an attempt at a solution to the liquidity trap.

What’s a liquidity trap I hear you cry?  Well, take the following scenario:

A visitor enters a hotel in a small town.  The people of the town are in a financial crisis.  They are all in debt and have no money to pay their particular debt.

He gives the hotelier £100 as a deposit while he inspects his room.  The hotelier realises that the £100 will pay off the money he owes to the baker, so he rushes to the baker and gives her the £100.

Upon receiving the money, the baker realises she can pay off the farmer, who realises he can pay off the fisherman, who realises he can pay off the bait supplier, who realises she can pay off the hotelier.

Just after the bait supplier leaves the hotel, the visitor returns, complains about the room, takes back the deposit and leaves.

Before the visitor arrived, the town was in a liquidity trap.  When all the debts were totalled up, nobody actually owed anyone anything, but because each individual could only see what they themselves owed or were owed, they thought they were broke.  Note that no-one earned anything in order to pay off the debts.  It was the mere presence of the money that enabled it.

This story illustrates current theory on how to beat a liquidity trap.  Someone else needs to step in, loan some money, then take it back again a short time later.  In modern parlance, this is called quantitative easing.  However, in theory a better solution would be to get everyone together and work out who actually owes what to whom, because it can often be less than everyone thinks.

When Lehman Brothers went bust, there were $400bn of Credit Default Swaps written against it, which in theory could have toppled more banks, triggering more CDS reckoning, causing more failures etc.etc. However, the CDS resolution process allowed everyone to work out final totals of what was owed before anyone paid anything and when it was all finally worked out the amount of money actually owed between the parties was approx $7bn, as most parties with positions on one side, also had positions on the other side (which does raise the question of why they bothered in the first place, but there you go!).  What was feared as a harbinger of doom turned out to be a damp squib, as most of the debts cancelled each other out.

That fear however, was very real prior to the resolution and would have had an affect on what the market did at the time.  What would be even better, would be to be able to automatically resolve liquidity traps and cancelling-out trades as they happen.  To do that though would mean everyone would have to see everyone elses financial status, which has obvious fatal issues.  Which is where Identity 2.0 comes in.

The theory behind services like Cardspace is that they can be used to handle complex data relationships while only releasing the minimum amount of personally identifiable information.  In the case of liquidity trap resolution, in theory that means no identifiable information at all, as what’s important are the amounts, not the identities of the debtors/creditors.  If it’s possible to trace through a debt chain and find that it’s circular then it can be wiped out automatically.  It would also hopefully show when you are actually *not* in a liquidity trap, where quantitative easing is a hinderance rather than a help.

Like I say, it was an utterly insane thought. I promise though it wasn’t as insane as the second one.  I’m going to be losing sleep over that one.