Although the present crisis in United States, Europe and all over the world is much more complicated and difficult to understand, but as each one of the normal person and novice investor/trader wants to know what exactly is happening in the markets around the world, so here is a small story which will give you a basic idea of what has happened and what is happening in the Wall Street and other financial streets:
The story is quite complicated, but you'll clearly understand it at the end :)
Once there was a little island country. The land of this country was the tiny island itself. The total money in circulation was $2 as there were only two pieces of $1 coins circulating round. There were 3 citizens living on this island country.
'A' owned the land. 'B' and 'C' each owned $1. Now the following series of events happen: -
1. B decided to purchase the land from A for $1 . A and C, now each own $1 while B owned a piece of land that is worth $1. The net asset of the country = $3
2. C thought that since there is only one piece of land in the country and land is produce-able asset, its value must definitely go up. So, he borrowed $1 from A and together with his own $1, he bought the land from B for $2.
- A has a loan to C of $1, so his net asset is $1.
- B sold his land and got $2, so his net asset is $2.
- C owned the piece of land worth $2 but with his $1 debt to A, his net asset is $1.
The net asset of the country = $4.
3. A saw that the land he once owned has risen in value. He regretted selling it. Luckily, he has a $1 loan to C. He then borrowed $2 from B and acquired the land back from C for $3. The payment is by $2 cash (which he borrowed) and cancellation of the $1 loan to C.
As a result,
- 'A' now owned a piece of land that is worth $3. But since he owed B $2, his net asset is $1.
- B loaned $2 to A. So his net asset is $2.
- C now has the 2 coins. His net asset is also $2.
The net asset of the country = $5. A bubble is building up.
4. 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. The payment is by borrowing $2 from C and cancellation of his $2 loan to A.
As a result,
- A has got his debt cleared and he got the 2 coins. His net asset is $2.
- B owned a piece of land that is worth $4 but since he has a debt of $2 with C, his net Asset is $2.
- C loaned $2 to B, so his net asset is $2.
The net asset of the country = $6; even though the country has only one piece of land and $2 in circulation.
5. Everybody has made money and everybody felt happy and prosperous.
6. One day a 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 in circulation, I think after all the land that B owns is worth at most $1 only." A also thought the same.
7. Suddenly, nobody wanted to buy land anymore.
In the end,
- A owns the $2 coins, his net asset is $2.
- B owed C $2 and the land he owned which he thought worth $4 is now $1. His net asset became -ve $1.
- C has a loan of $2 to B. But it is a bad debt. Although his net asset is still $2.
- The net asset of the country = $3 again.
8. Who has stolen the $3 from the country? Of course, before the bubble burst B thought his land worth $4 and the net asset of the country was $6 in paper. However, now his net asset is $2.
The net asset of the country = $3 again.
9. B had no choice but to declare bankruptcy. C has to relinquish his $2 bad debt to B but in return he acquired the land which is worth $1 now.
At the end of all this: -
* A owns the 2 coins, his net asset is $2.
* B is bankrupt; his net asset is 0 dollar. (B lost everything )
* C got no choice but end up with a land worth only $1 (C lost one dollar)
* The net asset of the country = $3.
*****************End of Story*****************The net outcome of the above bubble is a redistribution of wealth. A is the winner, B is the loser, C is lucky that he was spared.
Few points worth noting: -
1. When a bubble is building up, the debt of individual in a country to one another is also building up.
2. This story of the island is a close 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.
4. When the bubble burst, the fellow with cash is the winner. The fellows having the land or extending loan to others are the loser. 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 refrain to take part in the game, at the end of the day, he will neither win nor lose. But he will see the value of his money or land go 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. Instead of land, the above applies to stocks as well.
9. The actual worth of land or stocks depends on psychology to a great extent.