Once there was a little island country. The land of this country was the tiny island itself. The total money in circulation was 2 dollar 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, A and C now each own 1 dollar while B owned a piece of land that is worth 1 dollar.
The net asset of the country = 3 dollar.
3) C thought that since there is only one piece of land in the country and land is non productive 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 dollar.
A has a loan to C of 1 dollar, so his net asset is 1 dollar.
B sold his land and got 2 dollar, so his net asset is 2 dollar.
C owned the piece of land worth 2 dollar but with his 1 dollar debt to A, his net asset is 1 dollar.
The net asset of the country = 4 dollar.
4) A saw that the land he once owned has risen in value. He regretted selling it. Luckily, he has a 1 dollar loan to C. He then borrowed 2 dollar from B and and acquired the land back from C for 3 dollar. The payment is by 2 dollar 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 dollar. But since he owed B 2 dollar, his net asset is 1 dollar.
B loaned 2 dollar to A. So his net asset is 2 dollar.
C now has the 2 coins. His net asset is also 2 dollar.
The net asset of the country = 5 dollar. 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 dollar. The payment is by borrowing 2 dollar from C and cancellation of his 2 dollar loan to A.
As a result, A has got his debt cleared and he got the 2 coins. His net asset is 2 dollar.
B owned a piece of land that is worth 4 dollar but since he has a debt of 2 dollar with C, his net Asset is 2 dollar.
C loaned 2 dollar to B, so his net asset is 2 dollar.
The net asset of the country = 6 dollar. Even though, the country has only one piece of land and 2 Dollar in circulation.
(6) Everybody has made money and everybody felt happy and prosperous.
(7) One day 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 dollar in circulation, I think after all the land that B owns is worth at most 1 dollar only."
A also thought the same by now.
(8) Nobody wanted to buy land anymore. In the end, A owns the 2 dollar coins, his net asset is 2 dollar. B owed C 2 dollar and the land he owned which he thought worth 4 dollar is now 1 dollar. His net asset become -1 dollar.
C has a loan of 2 dollar to B. But it is a bad debt. Although his net asset is still 2 dollar, his Heart is palpitating.
The net asset of the country = 3 dollar again.
Of course, before the bubble burst B thought his land worth 4 dollar. His net asset is still 2 dollar, his heart is palpitating.
The net asset of the country = 3 dollar again.
(9) B had no choice but to declare bankruptcy. C as to relinquish his 2 dollar 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 dollar. 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 dollar (C lost one dollar) The net asset of the country = 3 dollar.
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 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 overdamped 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 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) In addition of land, the above applies to stocks as well.
(9) The actual worth of land or stocks depend largely on psychology.
Source: Anonymous mail forwards
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, A and C now each own 1 dollar while B owned a piece of land that is worth 1 dollar.
The net asset of the country = 3 dollar.
3) C thought that since there is only one piece of land in the country and land is non productive 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 dollar.
A has a loan to C of 1 dollar, so his net asset is 1 dollar.
B sold his land and got 2 dollar, so his net asset is 2 dollar.
C owned the piece of land worth 2 dollar but with his 1 dollar debt to A, his net asset is 1 dollar.
The net asset of the country = 4 dollar.
4) A saw that the land he once owned has risen in value. He regretted selling it. Luckily, he has a 1 dollar loan to C. He then borrowed 2 dollar from B and and acquired the land back from C for 3 dollar. The payment is by 2 dollar 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 dollar. But since he owed B 2 dollar, his net asset is 1 dollar.
B loaned 2 dollar to A. So his net asset is 2 dollar.
C now has the 2 coins. His net asset is also 2 dollar.
The net asset of the country = 5 dollar. 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 dollar. The payment is by borrowing 2 dollar from C and cancellation of his 2 dollar loan to A.
As a result, A has got his debt cleared and he got the 2 coins. His net asset is 2 dollar.
B owned a piece of land that is worth 4 dollar but since he has a debt of 2 dollar with C, his net Asset is 2 dollar.
C loaned 2 dollar to B, so his net asset is 2 dollar.
The net asset of the country = 6 dollar. Even though, the country has only one piece of land and 2 Dollar in circulation.
(6) Everybody has made money and everybody felt happy and prosperous.
(7) One day 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 dollar in circulation, I think after all the land that B owns is worth at most 1 dollar only."
A also thought the same by now.
(8) Nobody wanted to buy land anymore. In the end, A owns the 2 dollar coins, his net asset is 2 dollar. B owed C 2 dollar and the land he owned which he thought worth 4 dollar is now 1 dollar. His net asset become -1 dollar.
C has a loan of 2 dollar to B. But it is a bad debt. Although his net asset is still 2 dollar, his Heart is palpitating.
The net asset of the country = 3 dollar again.
Of course, before the bubble burst B thought his land worth 4 dollar. His net asset is still 2 dollar, his heart is palpitating.
The net asset of the country = 3 dollar again.
(9) B had no choice but to declare bankruptcy. C as to relinquish his 2 dollar 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 dollar. 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 dollar (C lost one dollar) The net asset of the country = 3 dollar.
******* Story Ends *******
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 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 overdamped 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 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) In addition of land, the above applies to stocks as well.
(9) The actual worth of land or stocks depend largely on psychology.
Source: Anonymous mail forwards
A day back I was going through the blog of Greg Mankiw, an economics professor at Harvard University. His yesterday's post talks about two articles he read giving him two hypothesis:
- Jeff Frankel : High prices of commodities like oil are being driven by low real interest rates.
- Anil Kashyap and Hyun Song Shin : With oil prices so high, Middle Eastern sovereign wealth funds should come to the rescue of Wall Street. (although I wont call it as a rescue but exploiting an opportunity)
What he derives out of these two hypothesis is a a new piece of the monetary transmission mechanism: The Fed's monetary expansion reduces interest rates >> low interest rates drive up commodity prices >> high commodity prices make OPEC rich >> and finally OPEC uses its new wealth to recapitalize our struggling financial institutions.
Jeffery Frankel, a former member of the White House council of economic advisers, points out at a flawed growth explanation. It has been said since 2003 that the growth of Asian countries and new economies have been deriving the resources consumption. As these countries were running full engines to grow at enormous rate so, the resource consumption was too high. More money after fewer resources -> prices rose higher. Now he observes that in its most recent forecast, the IMF World Economic Outlook revised downward the growth rate for virtually every region, including China. The overall global growth rate for 2008 has been marked down by 1.1 percent (from 5.2 percent in July 2007, just before the subprime mortgage crisis hit, to 4.1 percent as of January 29, 2008). And prospects continue to deteriorate. Yet commodity prices have found their second wind over precisely this period. Up some 25 percent or more since August 2007, by a number of indices. So that rebuffs the given justification.
So he comes to a conclusion: real interest rates are an important determinant of real commodity prices. He puts it like this, the monetary expansion temporarily lowers the real interest rate (whether via a fall in the nominal interest rate, a rise in expected inflation, or both — as now). Real commodity prices rise until commodities are widely considered "overvalued" so overvalued that there is an expectation of future depreciation (together with the other costs of carrying inventories: storage costs plus any risk premium) that is sufficient to offset the lower interest rate (and other advantages of holding inventories, namely the "convenience yield"). Only then do firms feel they have high enough inventories despite the low carrying cost. In the long run, the general price level adjusts to the change in the money supply. As a result, the real money supply, real interest rate, and real commodity price eventually return to where they were.
But the events since August 2007 provide a further data point, he observes. As economic growth has slowed sharply, both in the United States and globally, the Fed has reduced interest rates, both nominal and real. Firms and investors have responded by shifting into commodities, not out. This is why commodity prices have resumed their upward march over the last six months, rather than reversing it.
That all brings me to a question, where is the problem exactly? As I see it, the problem entirely lies with the domestic consumers of US. Problem is that this consumption is so high that US consumer is also the world's largest consumer in entirety. So if they decrease consumption, every big nation feels the burnt on fiscal revenue. Also due to the transaction base being dollar, even monetary health suffers for all nations (even though their own currency gets strengthened!). Fed rate cuts brings the liquiidity in the system, which already is facing the inflation. Now how to make sure that the excess money is going in paying off debt rather than higher consumption level? or should it actually go to consumption to make world stable? Shouldn't the FD interest rates be increased to suck off the excess of 'luxury' money?
Jeffery Frankel, a former member of the White House council of economic advisers, points out at a flawed growth explanation. It has been said since 2003 that the growth of Asian countries and new economies have been deriving the resources consumption. As these countries were running full engines to grow at enormous rate so, the resource consumption was too high. More money after fewer resources -> prices rose higher. Now he observes that in its most recent forecast, the IMF World Economic Outlook revised downward the growth rate for virtually every region, including China. The overall global growth rate for 2008 has been marked down by 1.1 percent (from 5.2 percent in July 2007, just before the subprime mortgage crisis hit, to 4.1 percent as of January 29, 2008). And prospects continue to deteriorate. Yet commodity prices have found their second wind over precisely this period. Up some 25 percent or more since August 2007, by a number of indices. So that rebuffs the given justification.
So he comes to a conclusion: real interest rates are an important determinant of real commodity prices. He puts it like this, the monetary expansion temporarily lowers the real interest rate (whether via a fall in the nominal interest rate, a rise in expected inflation, or both — as now). Real commodity prices rise until commodities are widely considered "overvalued" so overvalued that there is an expectation of future depreciation (together with the other costs of carrying inventories: storage costs plus any risk premium) that is sufficient to offset the lower interest rate (and other advantages of holding inventories, namely the "convenience yield"). Only then do firms feel they have high enough inventories despite the low carrying cost. In the long run, the general price level adjusts to the change in the money supply. As a result, the real money supply, real interest rate, and real commodity price eventually return to where they were.
But the events since August 2007 provide a further data point, he observes. As economic growth has slowed sharply, both in the United States and globally, the Fed has reduced interest rates, both nominal and real. Firms and investors have responded by shifting into commodities, not out. This is why commodity prices have resumed their upward march over the last six months, rather than reversing it.
That all brings me to a question, where is the problem exactly? As I see it, the problem entirely lies with the domestic consumers of US. Problem is that this consumption is so high that US consumer is also the world's largest consumer in entirety. So if they decrease consumption, every big nation feels the burnt on fiscal revenue. Also due to the transaction base being dollar, even monetary health suffers for all nations (even though their own currency gets strengthened!). Fed rate cuts brings the liquiidity in the system, which already is facing the inflation. Now how to make sure that the excess money is going in paying off debt rather than higher consumption level? or should it actually go to consumption to make world stable? Shouldn't the FD interest rates be increased to suck off the excess of 'luxury' money?
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