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The Inevitable Crash

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Lidless
Post subject: The Inevitable Crash
Posted: Fri 13 Mar , 2009 3:13 pm
Als u het leven te ernstig neemt, mist u de betekenis.
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Over the next week or two I shall attempt to explain why the recent crash was inevitable and why anyone in the financial community could have, and should have, seen it coming. Let’s start with basics first. Most will learn nothing new here I'm sure, so apologies in advance for the first post.


Risk vs reward.

It sounds like a catchphrase, something we’ve all heard, but it is the fundamental balance that underpins every single decision sentient life makes – from grazing in the open plain where predators might be lurking, to running a red light or ordering something new on the menu.

Each being has its own natural balance that applies to them. Some are adventurous, some are naturally timid. Some people like sky-diving; some people like diving. Some people like to invest spare cash in the stock market; some prefer to just put it in an interest-bearing account.

There is even a children’s fable that tries to teach the extremes of each type of behaviour: The Tortoise and The Hare. Countless movies are morality tales of taking too much risk in the long term.

Game shows also work on the principle of risk vs. reward, none more so than Deal Or No Deal which works purely on probabilities, expected outcomes, and the individual’s assessment of risk vs reward.

Imagine you are given a choice: either to be given USD 500k here and now, or toss a coin where if it is heads you get USD 1m and if it is tails you get nothing. The expected, or average outcome is the same – USD 500k. Some people will take the gamble for the bigger prize, some will not. What if the here and now is only USD 250k, or only USD 100k? On paper you would be choosing the smaller expected amount, but it’s guaranteed. Each person has their own balance. A multimillionaire for example will probably take the initial gamble because the second USD 500k is ‘worth’ the same to him as the first USD 500k. A struggling young couple looking for their first home will almost certainly take the first option even if it’s only USD 250k because it’s more life-changing to them than the extra money they could win.

The financial markets, not surprisingly, work exactly the same way. Treasury bills and government bonds offer a low rate of return compared to other ways you could invest your money. Why? Because they are, or at least were, considered as risk-free as it gets. The value of these T-bills and bonds has decreased in the last year (and thus the higher profit or return you get when they mature since they are cheaper to buy now) because there is more risk (or perceived risk to be accurate) these days that the government will default on the payment. A higher risk *must* mean a higher reward for the balance to be maintained.

Imagine the risk-free rate was 3%, and there was an investment that could be made, also risk-free, that could generate a 10% return. Banks could borrow money at 3% and invest it at 10% and not have any risk. Money for nothing it seems. Well, no. What would happen is that the cost of the investment (eg share price) would increase as demand for it increased until the price was such you would only get 3% return overall. If the price for this investment was initially USD 100 per share, with a guaranteed USD 110 back, the price would almost automatically rise to around USD 107 per share to get a 3% return.

In fact the investment would never have been offered at USD 100 in the first place unless the offerer was an idiot. It happens, of course, but the market quickly corrects.

Now before anyone points it out, no one can borrow money at a risk free rate. The above is just a simple illustration. There will always be an extra premium to be paid because the lender is lending the money to someone that themselves is not risk free – there is always the possibility of defaulting. The higher the loan, the higher the chance of a default, and therefore the higher interest that is charged. The poorer the person lending or the less security they can give the lender, the higher the premium. That’s why banks have a high premium for mortgage lending, and the higher the initial deposit you make, the lower the interest rate that is offered.

I say perceived risk above because in real life it’s just an estimate. The same is true in most cases of the perceived reward. Every investor not only has to try and work out the risk and reward, but also whether that risk is worth taking. Share prices go up and down as individuals continue to reassess their estimates and rebalance accordingly.

Most people have heard of hedge funds but do not know exactly what they do. Few, thankfully, think that it’s part of a reforestation scheme. In general, hedge funds invest in things that are not highly correlated with the stock market. Some hedge funds even invest in things that will go up in value if the stock market goes down. Some investments are highly risky in their own right (and therefore some hedge funds generate great returns and some dive into the ground). Hedge funds even advertise the level of correlation (or more precisely lack of) they have with the stock market as an advertising tool. It is one of the first things an investor will ask.

Many investors like to put some of their money into a hedge fund because if the stock market crashes, not all of their investment will go crashing down with it. They are spreading their risk, hedging their bets, hence the name.

The hedge fund market has grown massively over the last five years – not because they are making great returns, but because the perceived risk of the stock market crashing grew and grew and so more money was diverted into them to cushion the oncoming blow whilst still making hopefully decent returns.

The diversion of money itself was a sign that the financial community saw it coming, or at least perceived that it might be coming, if I’m being generous.

Risk vs reward. It is what drives the markets. It is the only thing that drives the markets.

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sauronsfinger
Post subject: Re: The Inevitable Crash
Posted: Fri 13 Mar , 2009 3:41 pm
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Lidless - what do you think was the impact of the repeal of the Glass Steagall act in late 1999 upon this situation you have discussed?

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vison
Post subject: Re: The Inevitable Crash
Posted: Fri 13 Mar , 2009 3:48 pm
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Lidless wrote:
The higher the loan, the higher the chance of a default, and therefore the higher interest that is charged.
I don't agree with this. If you are talking about "consumer" lending it might be true, but in the business world it's not.

A large loan is not necessarily riskier, is it? A healthy company borrowing $10 million is not any more likely to default than its competitor borrowing $5 million?

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Cenedril_Gildinaur
Post subject: Re: The Inevitable Crash
Posted: Fri 13 Mar , 2009 4:29 pm
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Lidless is right under the "all things being equal" assumption. All things being equal a bigger loan is riskier. You are introducing the extra variable of the creditor's worthiness, which changes the equation entirely.

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sauronsfinger
Post subject: Re: The Inevitable Crash
Posted: Fri 13 Mar , 2009 4:31 pm
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So if we examined all loans, the larger the amount the larger the interest?

Is there any factual documentation to support that besides theory?

I have always heard that the lowest loan rates are the very short term rates that banks charge each other. That would have to be a total massive annual amount.

Vison has a good point. Categories of loans might make a difference... and a major difference in that.

Lets say somebody like Bill Gates wants to borrow $200 million for seven days and is willing to put up rock solid security. Would not his interest rate be very low compared to somebody making 40 grand a year asking for a morgage on a $150 K house?

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There are two novels that can change a bookish fourteen-year old's life: The Lord of the Rings and Atlas Shrugged. One is a childish fantasy that often engenders a lifelong obsession with its unbelievable heroes, leading to an emotionally stunted, socially crippled adulthood, unable to deal with the real world. The other, of course, involves orcs. - John Rogers


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laureanna
Post subject: Re: The Inevitable Crash
Posted: Fri 13 Mar , 2009 4:58 pm
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Thanks for the refresher. It's been 35 years since my last economics class, but things appear to still work the same way. I do recall, back when I had extra money, that I would put part of it in a stock-indexed mutual fund, and some of it in something totally crazy, like an Asian New Markets fund, on the theory that the crazy fund's downward spiral balanced out the other fund's climb, and they would switch eventually. (They didn't - they both went down together. Sigh.)

It was pointed out to me that I picked the perfect time to send my daughter to college, three years ago. I completely cleaned out my savings to send her, so now I don't have anything in the stock market to tank. :P

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Lidless
Post subject: Re: The Inevitable Crash
Posted: Fri 13 Mar , 2009 7:11 pm
Als u het leven te ernstig neemt, mist u de betekenis.
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vison wrote:
Lidless wrote:
The higher the loan, the higher the chance of a default, and therefore the higher interest that is charged.
I don't agree with this. If you are talking about "consumer" lending it might be true, but in the business world it's not.

A large loan is not necessarily riskier, is it? A healthy company borrowing $10 million is not any more likely to default than its competitor borrowing $5 million?
I should qualify, I mean change, my statement.

On an unsecured loan the potential loss from a default, rather than the *chance* of a default, is higher the higher the loan is. The person being lent the money will only have a X amount of assets to settle their creditors if they go bust. So if we talk about a 'healthy company' we mean one where the perceived risk is minimal and might not even factor into the equation if we are talking about USD 10m as opposed to USD 5m.

There are many types of risk when lending. Most of the first post has been talking about counterparty (aka 'credit' or 'default') risk. Another type of risk which is strongly allied to it - one that often (but not always) distinguishes business from home owners, is liquidity risk. What if the loan is made to a person or company whose main asset they are securing the loan with cannot quickly and easily be turned into cash - a house for example, or a bespoke manufacturing plant.

What I was alluding to originally was yet another type of risk - concentration risk - either to an individual or a particular business sector. Eggs in one basket type of thing. Borrowing the same amount of money from a large bank is usually cheaper than from a small bank for exactly that reason. The larger bank is less exposed even though we are talking about the same amount of money.

Bank to bank lending, mortgages, size, secured / unsecured, the basic principle applies. Risk, in all its forms which differ between lender and borrower, between different types of investment, means a higher price to pay. Risk and reward.


CG and sf, I'll go at my own pace. You may en masse debate between yourselves.

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vison
Post subject: Re: The Inevitable Crash
Posted: Fri 13 Mar , 2009 9:57 pm
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En masse?

Hey, I ain't massy.

Much.

Good thread.

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Cenedril_Gildinaur
Post subject: Re: The Inevitable Crash
Posted: Wed 08 Apr , 2009 6:09 pm
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sauronsfinger wrote:
Lidless - what do you think was the impact of the repeal of the Glass Steagall act in late 1999 upon this situation you have discussed?
It made it worse - it sharpened one claw on one foot of the tiger that is now mauling us.
Cenedril_Gildinaur wrote:
Lidless is right under the "all things being equal" assumption. All things being equal a bigger loan is riskier.
sauronsfinger wrote:
So if we examined all loans, the larger the amount the larger the interest?

Is there any factual documentation to support that besides theory?

...

Lets say somebody like Bill Gates wants to borrow $200 million for seven days and is willing to put up rock solid security. Would not his interest rate be very low compared to somebody making 40 grand a year asking for a morgage on a $150 K house?
Read the bold part.

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It is a myth that coercion is necessary in order to force people to get along together, but it is a persistent myth because it feeds a desire many people have. That desire is to be able to justify hurting people who have done nothing other than offend them in some way.

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sauronsfinger
Post subject: Re: The Inevitable Crash
Posted: Wed 08 Apr , 2009 7:17 pm
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Therein liesthe problem. What world do you live in where all things are equal? It is nonsensical to pace such a proviso on a statement since things that make up all the varied factors in a loan are never equal or the same. There are always different and varying factors.

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There are two novels that can change a bookish fourteen-year old's life: The Lord of the Rings and Atlas Shrugged. One is a childish fantasy that often engenders a lifelong obsession with its unbelievable heroes, leading to an emotionally stunted, socially crippled adulthood, unable to deal with the real world. The other, of course, involves orcs. - John Rogers


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Cenedril_Gildinaur
Post subject: Re: The Inevitable Crash
Posted: Wed 08 Apr , 2009 9:17 pm
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sauronsfinger wrote:
Therein liesthe problem. What world do you live in where all things are equal? It is nonsensical to pace such a proviso on a statement since things that make up all the varied factors in a loan are never equal or the same. There are always different and varying factors.
When doing science, even social science, there are variables and controls. In order to get a useful answer the objective is to have as few variables as possible so that the answer is more reliable. For instance, testing the reaction of protiens in a biochem lab when many outside factors are removed does give us useful information as to the behavior of those protiens even though those outside factors are present outside the lab, and those behaviors help us design medicines. Designers of airplanes put initial models into wind tunnels for initial testing even though those wind tunnels lack cross currents, without believing for a moment that the plane will never be subjected to cross currents. In both cases they are learning something useful by holding as much as possible constant.

Deriding that assumption is to deride how science itself is done and to deride that we are able to learn anything at all. To deride that statement is to say wind tunnel tests do not help in manufacturing airplanes. But instead in the real world we can make useful statements based on the concept "all things being equal." The same is true of the social sciences which also assume that in implementation not all things are equal but that useful and valid principles can be derived from that useful and valid statement.

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It is a myth that coercion is necessary in order to force people to get along together, but it is a persistent myth because it feeds a desire many people have. That desire is to be able to justify hurting people who have done nothing other than offend them in some way.

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sauronsfinger
Post subject: Re: The Inevitable Crash
Posted: Wed 08 Apr , 2009 9:30 pm
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Loans are not wind tunnel tests.
Loans are not proteins in chemical labs.

People who apply for loans do not all behave the same.
People who apply for loans do not have the same history.
People who apply for loans do not all apply to the same lender.
Lenders do not judge all applicants by the same standards.
Lenders take into consideration many variables which can change from lender to lender.
Lenders sometimes make decisions based on gut instinct and individuals charcter.

This is this. This is not something else.

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There are two novels that can change a bookish fourteen-year old's life: The Lord of the Rings and Atlas Shrugged. One is a childish fantasy that often engenders a lifelong obsession with its unbelievable heroes, leading to an emotionally stunted, socially crippled adulthood, unable to deal with the real world. The other, of course, involves orcs. - John Rogers


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Cenedril_Gildinaur
Post subject: Re: The Inevitable Crash
Posted: Wed 08 Apr , 2009 9:41 pm
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sauronsfinger wrote:
Loans are not wind tunnel tests.
Who said they were?
sauronsfinger wrote:
Loans are not proteins in chemical labs.
Who said they were?
sauronsfinger wrote:
People who apply for loans do not all behave the same.
Who said they do?
sauronsfinger wrote:
People who apply for loans do not have the same history.
Who said they do?
sauronsfinger wrote:
People who apply for loans do not all apply to the same lender.
Who said they do?
sauronsfinger wrote:
Lenders do not judge all applicants by the same standards.
Who said they do?
sauronsfinger wrote:
Lenders take into consideration many variables which can change from lender to lender.
Who said they don't?
sauronsfinger wrote:
Lenders sometimes make decisions based on gut instinct and individuals charcter.
Who said they don't?

This is this. This is not something else.

Last edited by Cenedril_Gildinaur on Wed 08 Apr , 2009 9:41 pm, edited 1 time in total.

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It is a myth that coercion is necessary in order to force people to get along together, but it is a persistent myth because it feeds a desire many people have. That desire is to be able to justify hurting people who have done nothing other than offend them in some way.

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yovargas
Post subject: Re: The Inevitable Crash
Posted: Wed 08 Apr , 2009 9:41 pm
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If you'd like, CG, you can put sf on your ignore list and I'll just tell you exactly what he would say in response to pretty much anything you say. His arguments have long ago become so predictable that I'm sure I can approximate a suitable substitute.




( :salmon: to self)


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Cenedril_Gildinaur
Post subject: Re: The Inevitable Crash
Posted: Wed 08 Apr , 2009 9:44 pm
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yovargas wrote:
If you'd like, CG, you can put sf on your ignore list and I'll just tell you exactly what he would say in response to pretty much anything you say. His arguments have long ago become so predictable that I'm sure I can approximate a suitable substitute.
I've been avoiding responding to him for about two weeks now. There has been no reduction in the bilge coming from him.

Since I'm going to get condemned for responding to him whether or not I respond to him I feel that once in a while (every one to two weeks) I can respond to some of his more absurd points.

Last edited by Cenedril_Gildinaur on Wed 08 Apr , 2009 9:57 pm, edited 2 times in total.

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It is a myth that coercion is necessary in order to force people to get along together, but it is a persistent myth because it feeds a desire many people have. That desire is to be able to justify hurting people who have done nothing other than offend them in some way.

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sauronsfinger
Post subject: Re: The Inevitable Crash
Posted: Wed 08 Apr , 2009 9:44 pm
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And the supportive responses of Yovargas to CG have become so predictable that you could do the same with those.

CG - if none of those things mean anything to your points - why did YOU bring them up in the first place to support your position? Wind tunnels - brought up by you in response to a discussion about loan practices. Chemical labs brought up by you in response to a discussion about loan practices.

And then, when called on it, we get the usual Steve Urkel response where you look all sheepish and deny that you did anything. You should really change your signature to "did I do that????"

Your latest post is an excellent illustration. You make a statement and when called on it you then pretend it actually means something other than the obvious.
Quote:
Who said they do?

Who said they don't?
Go back to your "all things being equal. Every statement I made was designed to show how "all things" are not equal at all. But I guess you missed that for some reason.

And then we get this statement


Quote:
Since I'm going to get condemned whether or not I respond to him I feel that once in a while (every one to two weeks) I can respond to some of his more absurd points.
Gosh CG - why woud anyone on a message board condemn any of your responses or posts? Now there is the question you realy should take a long and hard look at.

from CG aping me... yet again
Quote:
This is this. This is not something else.
Creativity was never your strong suit.

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There are two novels that can change a bookish fourteen-year old's life: The Lord of the Rings and Atlas Shrugged. One is a childish fantasy that often engenders a lifelong obsession with its unbelievable heroes, leading to an emotionally stunted, socially crippled adulthood, unable to deal with the real world. The other, of course, involves orcs. - John Rogers


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sauronsfinger
Post subject: Re: The Inevitable Crash
Posted: Wed 08 Apr , 2009 10:23 pm
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CG - today - April 8 - you saw fit to respond to something I posted on March 13 when I asked a question of Lidless. That is three and one half weeks later over something that was pretty much gone with the wind.

So please, do not do the Steve Urkel thing and pretend that you are not an active participant in all this.

If you crave honesty - here is some for you: that is the one area I am in total agreement with you when I read your responses to people who complain about it. If they do not want to partake, its a free country.

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There are two novels that can change a bookish fourteen-year old's life: The Lord of the Rings and Atlas Shrugged. One is a childish fantasy that often engenders a lifelong obsession with its unbelievable heroes, leading to an emotionally stunted, socially crippled adulthood, unable to deal with the real world. The other, of course, involves orcs. - John Rogers


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Cenedril_Gildinaur
Post subject: Re: The Inevitable Crash
Posted: Wed 08 Apr , 2009 10:26 pm
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Very well, since you crave my attention so much I'll respond one more time.

(You really ought to find someone else to have such a crush on. :P I'm married.)
sauronsfinger wrote:
Cenedril_Gildinaur wrote:
Since I'm going to get condemned for responding to him whether or not I respond to him I feel that once in a while (every one to two weeks) I can respond to some of his more absurd points.
Gosh CG - why woud anyone on a message board condemn any of your responses or posts? Now there is the question you realy should take a long and hard look at.
You know as well as I do that they dislike the "tedious" back and forth sessions where I try vainly to get you to honestly address the topic and you dodge every point and argue tangents instead, pretending I wrote something I didn't so we can argue that instead.

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It is a myth that coercion is necessary in order to force people to get along together, but it is a persistent myth because it feeds a desire many people have. That desire is to be able to justify hurting people who have done nothing other than offend them in some way.

Last edited by Cenedril_Gildinaur on Tue Feb 30, 2026 13:61 am; edited 426 times in total


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sauronsfinger
Post subject: Re: The Inevitable Crash
Posted: Wed 08 Apr , 2009 10:41 pm
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Now there is an honest response. Its not your fault--- its my fault.

Was I the one who invented a quote from you and placed it in a quote box with your name attached in a blatant example of dishonesty that I have otherwise never seen on any internet discussion board anywhere?

Or maybe I "made you" do that?

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There are two novels that can change a bookish fourteen-year old's life: The Lord of the Rings and Atlas Shrugged. One is a childish fantasy that often engenders a lifelong obsession with its unbelievable heroes, leading to an emotionally stunted, socially crippled adulthood, unable to deal with the real world. The other, of course, involves orcs. - John Rogers


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Cenedril_Gildinaur
Post subject: Re: The Inevitable Crash
Posted: Wed 08 Apr , 2009 10:45 pm
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Nope, sorry, you've used up this week's allotment of responses. You aren't getting any more.

Whoops, I just responded. I guess that means you get a freebie with this one. Enjoy it. :heya:

(Really, you should remember that I'm married. :P )

Last edited by Cenedril_Gildinaur on Wed 08 Apr , 2009 10:47 pm, edited 1 time in total.

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It is a myth that coercion is necessary in order to force people to get along together, but it is a persistent myth because it feeds a desire many people have. That desire is to be able to justify hurting people who have done nothing other than offend them in some way.

Last edited by Cenedril_Gildinaur on Tue Feb 30, 2026 13:61 am; edited 426 times in total


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