I came across this very interesting analogy of Bubble Economy ... nice read!
The following story is an analogy to a bubble economy. It was sent originally by a Professor of Finance. It was developed to help students understand the Senate testimony by Enron whistle-blower Sherron Watkins. This has been used routinely in an introductory course in financial accounting for MBA students.
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 1-dollar coins in circulation. There were 3 citizens living in this island country. A owned the land while B and C each owned a dollar.
1. B decides to purchase the land from A for $1. So, A and C now own $1 each while B owns a piece of land that is worth $1. The net asset of the country is $3.
2. C thinks that since there is only one piece of land in the country and land is an asset that cannot be produced, its value will definitely go up. So, he borrowed a dollar from A and together with his own dollar, he bought the land from B for $2. A has a loan to C of 1 dollar, so his net asset is $1. B
sold his land and $2, so his net asset is $2. C owns the piece of land worth 2 dollar but with his $1 debt to A, his net asset is $1.
The net assets of the country are $4.
3. A sees that the value of land he once owned has gone up. He regrets selling it. Luckily, he has a $1 loan to C. So he borrows $2 from B and acquires the land back from C for $3. The payment is made by the $2 in cash (which he borrowed) and cancellation of the $1 loan to C. A now owns a piece of land that is worth $3. But since he owes B $2, his net asset is $1. B loaned $2 to A, so his net asset is $2. C now has the two coins. His net asset is also $2. The net
asset of the country is $5. A bubble is building up.
4. B sees that the value of land has continued to rise. He also wants to own the land. So he buys the land from A for $4. The payment is by borrowing $2 from C and cancellation of his $2 loan to A. A has cleared his debt and he has the two coins. His net assets are $2. B owns a piece of land that is worth $4 but since he owes $2 to C, his net assets are $2. C loaned $2 to B, so his net assets are $2. The net assets of the country are $6. Keep in mind, that the country has only one piece of land and 2 dollar in circulation. Everybody has made money and everybody feels happy and prosperous.
5. One day an evil wind began to blow. An evil thought came to C. "Hey, what if the land price stops 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." A also has the same thought.
6. Nobody wants to buy land anymore. In the end, A owns the two 1-dollar coins; and his net assets are $2. B owes C $2. And the land, that he thought was worth $4, is now worth only $1. His net asset becomes a negative $1. C has loaned 2 dollar to B. But it is a bad debt. Although his net asset is still 2 dollar, his pulse is racing. The net assets of the country are $3 again. Who has stolen the $3 from the country's economy?
Of course, before the bubble burst B thought his land was worth $4. Just before the collapse of the country's economy, the net assets of the country were $6 on paper. B's net assets are still $2, his pulse is racing.
B has 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. A owns the two 1-dollar coins; his net assets are $2. B is bankrupt. C has no choice but to end up with land worth only $1; he lost one dollar. The net assets of the country are $3.
The country's wealth has been re-distributed. A is the winner; he has gained a dollar. B is the loser; he has lost a dollar. C is lucky that he somehow managed to end up with land that is worth a dollar.
There are some points worth noting:
A. When a bubble is building up, the debt of individuals to one another is also building up.
B. This story of is built around a "closed system" in which 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.
C. An "over-damped system" is assumed, meaning that the land's value did not go down below $1 when the bubble burst.
D. When the bubble burst, the fellow with cash is the winner. The fellows having the land or extending loan to others are losers. The assets could shrink or worse, they could become bankrupt.
E. Suppose that there is another citizen D that either holds a dollar or another piece of land, but who refrained from taking part in the game. At the end of the day, he will neither win nor lose. But during then bubble, he will see the value of his money or land going up and down like a see saw.
F. When the bubble was in growing, everybody made money.
G. If you are smart and know that you are in a growing bubble, you may make money by borrowing (like A) and taking part in the game, if and only if you change everything back to cash at the right time.
H. You can easily substitute "land" with "stocks" in this story.
I. The market worth of the land or stocks depends largely on market psychology.
None of the transactions in the story involve any productive activity. Instead, wealth was created entirely from accounting entries and financial transactions
