Saturday, April 18, 2009

Story of Boom, Growth & Speculation

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 notes circulating around.There were 3 citizens living on this island country.

A owned the land. B and C each owned 1 dollar.

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.

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.

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 from B) 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 notes. His net asset is also 2 dollars.
The net asset of the country = 5 dollars. A bubble is building up.

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 notes. 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.

Everybody has made money and everybody felt happy and prosperous.

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.”

A also thought the same way. 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.

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. 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 notes, 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

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 -
When a bubble is building up, the debt of individuals to one another in a country is also building up.
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.
An over-damped system is assumed when the bubble burst, meaning the land’s value did not go down to below 1 dollar.
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.

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 go up and down like a see saw. When the bubble was in the growing phase, everybody made money.

If you are smart and know that you are living in a growing bubble, it is worthwhile to borrow money (like A ) and participate in the game. But you must know when you should change everything back to cash.

As in the case of land, the above phenomenon applies to stocks as well.


  1. Another story to support the thoughts of companies and the employees specially in India-

    This story is about a man who once upon a time was selling Hotdogs by
    the roadside.
    He was illiterate, so he never read newspapers. He was hard of
    hearing, so he never listened to the radio.
    His eyes were weak, so he never watched television. But
    enthusiastically, he sold lots of hotdogs.

    He was smart enough to offer some attractive schemes to increase his sales.
    His sales and profit went up. He ordered more a more raw material and
    buns and sold more.
    He recruited more supporting staff to serve more customers. He started
    offering home deliveries.
    Eventually he got himself a bigger and better stove.
    As his business was growing, the son, who had recently graduated from
    college, joined his father.

    Then something strange happened.

    The son asked, "Dad, aren't you aware of the great recession that is
    coming our way?"
    The father replied, "No, but tell me about it." The son said, "The
    international situation is terrible.
    The domestic situation is even worse. We should be prepared for the
    coming bad times."

    The man thought that since his son had been to college, read the
    papers, listened to the radio and watched TV.
    He ought to know and his advice should not be taken lightly.
    So the next day onwards, the father cut down the his raw material
    order and buns,
    took down the colorful signboard, removed all the special schemes he
    was offering to the customers
    and was no longer as enthusiastic. He reduced his staff strength by
    giving layoffs.
    Very soon, fewer and fewer people bothered to stop at his Hotdog stand.
    And his sales started coming down rapidly and so did the profit.
    The father said to his son, "Son, you were right". "We are in the
    middle of a recession and crisis.
    I am glad you warned me ahead of time."

    Moral of the Story: It's all in your MIND! And we actually FUEL this
    recession much more than we think.

  2. Nice story to acknowledge the post.

  3. Advancing Layoffs in the Indian IT sector shows how money(read dollar value) controls man, as people were found incompetent to control money!

    Downtime or layoffs may be the only option in USA, but is it required in India. In US, average annual pay rise is about 2~3%. So the chances of a person sticking to a company, even when he doesn't get a pay rise is more. But in India average pay rise is around ~30%. So if you do not give a pay hike, dudes leave the company. In such a situation, not giving hike to let those employees resign themselves might save $ for the company as well as give the employee time to get a job! Also debilitation is more in India. So stopping the hiring will also work!

    My personal opinion(though I was never laid-off, hitherto :)), is that lay-off in India is always a loss for the company. Stop hiring/giving hike should work! I know a company which did lay-off and a year later spent huge huge $$$ to recruit sub-standard people. Total loss :(

    I even doubt that using attrition and stopping pay-hike means no job for the HR dept and managers. So they will look useless to the company. But layoffs mean more work for them! No surprise, it is natural for people to decide which favors them.