The Financial bubble

As I was cranking my head over the currency valuations, I was spreading the virus around as well, hoping for some answers. A friend sent me this insightful email that explains the financial bubble in vey simple terms. read on …..

Once there was a little island country. The land of this country was the tiny island itself. The total money in circulation was 2 dollars as there were only two pieces of 1 dollar coins circulating around.

1) There were 3 citizens living on this island country. A owned the land. B and C each owned 1 dollar.

2) B decided to purchase the land from A for 1 dollar. So, now A and C own 1 dollar each while B owned a piece of land that is worth 1 dollar.

* The net asset of the country now = 3 dollars.

3) Now C thought that since there is only one piece of land in the country, and land is non producible asset, its value must definitely go up. So, he borrowed 1 dollar from A, and together with his own 1 dollar, he bought the land from B for 2 dollars.

*A has a loan to C of 1 dollar, so his net asset is 1 dollar.
* B sold his land and got 2 dollars, so his net asset is 2 dollars.
* C owned the piece of land worth 2 dollars but with his 1 dollar debt to A, his net residual asset is 1 dollar.
* Thus, the net asset of the country = 4 dollars.

4) A saw that the land he once owned has risen in value. He regretted having sold it. Luckily, he has a 1 dollar loan to C. He then borrowed 2 dollars from B and acquired the land back from C for 3 dollars. The payment is by 2 dollars cash (which he borrowed) and cancellation of the 1 dollar loan to C. As a result, A now owned a piece of land that is worth 3 dollars. But since he owed B 2 dollars, his net asset is 1 dollar.

* B loaned 2 dollars to A. So his net asset is 2 dollars.
* C now has the 2 coins. His net asset is also 2 dollars.
* The net asset of the country = 5 dollars. A bubble is building up.

(5) B saw that the value of land kept rising. He also wanted to own the land. So he bought the land from A for 4 dollars. The payment is by borrowing 2 dollars from C, and cancellation of his 2 dollars loan to A.

* As a result, A has got his debt cleared and he got the 2 coins. His net asset is 2 dollars.
* B owned a piece of land that is worth 4 dollars, but since he has a debt of 2 dollars with C, his net Asset is 2 dollars.
* C loaned 2 dollars to B, so his net asset is 2 dollars.

* The net asset of the country = 6 dollars; even though, the country has only one piece of land and 2 Dollars in circulation.

(6) Everybody has made money and everybody felt happy and prosperous.

(7) One day an evil wind blew, and an evil thought came to C’s mind. “Hey, what if the land price stop going up, how could B repay my loan. There is only 2 dollars in circulation, and, I think after all the land that B owns is worth at most only 1 dollar, and no more.”

(8) A also thought the same way.

(9) Nobody wanted to buy land anymore.

* So, in the end, A owns the 2 dollar coins, his net asset is 2 dollars.
* B owed C 2 dollars and the land he owned which he thought worth 4 dollars is now 1 dollar. So his net asset is only 1 dollar.
* C has a loan of 2 dollars to B. But it is a bad debt. Although his net asset is still 2 dollars, his Heart is palpitating.
* The net asset of the country = 3 dollars again.

(10) So, who has stolen the 3 dollars from the country? Of course, before the bubble burst B thought his land was worth 4 dollars. Actually, right before the collapse, the net asset of the country was 6 dollars on paper. B’s net asset is still 2 dollars, his heart is palpitating.

(11) B had no choice but to declare bankruptcy. C as to relinquish his 2 dollars bad debt to B, but in return he acquired the land which is worth 1 dollar now.

* A owns the 2 coins; his net asset is 2 dollars.
* B is bankrupt; his net asset is 0 dollar. (He lost everything)
* C got no choice but end up with a land worth only 1 dollar

* the net asset of the country = 3 dollars.

End of the story; BUT 

There is however a redistribution of wealth.
A is the winner, B is the loser, C is lucky that he is spared.
A few points worth noting -

(1) when a bubble is building up, the debt of individuals to one another in a country is also building up.
(2) This story of the island is a closed system whereby there is no other country and hence no foreign debt. The worth of the asset can only be calculated using the island’s own currency. Hence, there is no net loss.
(3) An over-damped system is assumed when the bubble burst, meaning the land’s value did not go down to below 1 dollar.
(4) When the bubble burst, the fellow with cash is the winner. The fellows having the land or extending loan to others are the losers. The asset could shrink or in worst case, they go bankrupt.
(5) If there is another citizen D either holding a dollar or another piece of land but refrains from taking part in the game, he will neither win nor lose. But he will see the value of his money or land goes up and down like a see saw.
(6) When the bubble was in the growing phase, everybody made money.
(7) If you are smart and know that you are living in a growing bubble, it is worthwhile to borrow money (like A) and take part in the game. But you must know when you should change everything back to cash.
(8) As in the case of land, the above phenomenon applies to stocks as well.
(9) The actual worth of land or stocks depends largely on psychology (or speculation) .

Credits : Thanks! Puneet for the e-mail. Should anyone know the source of this e-mail, do let me know.

A world without money ?

Lets assume, hypothetically, a world without the institution of money. If there is no money, then how do we trade ? how do we buy ? how do we sell ?. Lets then reintroduce the good old barter system where we exchange goods directly based on our surpluses and needs. Such a system would be hugely complex under two aspects,

First, the problem of finding a buyer and a seller of the same item. Lets say, I want to buy a shirt and have a camera to sell. The factory selling shirt, would possibly have no need for my camera. Their requirements would be in terms of raw materials such as cotton, synthetic fibers, machines etc. Therefore, in order to source my shirt, I am sucked into a wide chain of activities involving exchanging goods, untill I am rid of my camera and have the raw materials the clothing factory needs. The complexity of an otherwise simple transaction is self evident.

Secondly, the problem of assigning value. Since in a barter system, goods are exchanged and that any two goods can be exchanged, the problem arises in the relative value of goods. We cannot possibly map out every item that can be exchanged and then assign a ratio for exchange .We could then probably have an absolute token, like gold for example, a reference to value the goods. That, is what is money!

I understand. But then, what is the reason we have so many currencies ? Can’t we do with a single global currency ?

Behind the Mint ….

Its tough times, economically, with some even touting the current situation to be the next great depression. The bewildering  maze that money and its associated institutions have spawned takes the whole system of economics outside the grasp of the common man. It is quintessential, an understanding of this macro economics should you believe that “money works for us and we don’t work for money”. I, myself, then am in a no better situation to crack this money mess, but I do hope sincerely get to the bottom of this, for a simple reason that whatever happens at the wall street, I can feel it at the fair price shop at the corner of my street. We as people, both as produces and consumers are intricately woven into this system . As to why a 0.5% rate cut means the world to somebody, as to how a 100 point cut somewhere miraculously generates millions of dollars of money supply, and as to why things have to be this complex. I don’t know. The retoric is endless, and I don’t have the answers for most of the questions. I often like to believe, to any problem, a simple solution exists, the most elegant and also the most effective. Therefore, as I look at the current system, I am puzzled ! is there something fundamendally wrong ?! Maybe, maybe not. It might be a necessary evil afterall .I dont know, but a quest begins to explore economics as we know it.

To start with, is it possible, a world without money ?