Finding symmetries in an unsymmetrical world ..

Where does money go in recession?

Posted on: February 2, 2009

We have probably overheard (and overrated) the rising bubble and the bubble bust.


So what is it that happens when the bubble busts, where does all the money go? Was it converted from some tangible form to an intangible form? What happened of the overall paper money?



There is this interesting article that I caught up, which describes how the asset of any country disappears in thin air. And what is that huge investment banks which draw lineages for over a century, fall back over the blink of an eye?


Clearly something is fundamentally wrong somewhere, So who is it who is making money ?


Well actually No body. Money just changes hands in any bubble bust.The thing about money are that the money that is perceived to be there, never was there. Its valuation in terms of the assets that represent a “quote” is the basis of the evaluation. This again is based on the universal principle of Supply and Demand.


When the bubble is building, there is an excess demand, which leads to shooting up of the prices, and virtual money is created, which fools the economy into believing that Money is created. This money is JUST a result of OVERVALUATION based on the perceived returns.



When the supply gets lower, i.e. when there is a risk associated with the value of the returns vis a vis the investment incurred to acquire these assests, the bubble starts to prepare itself to bust.


Here is an example reproduces from the article I talked about earlier here :

 

Once upon a time far far away, 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 which had no inherent value. B and C each owned 1 dollar. 

 

Citizen A

Citizen B

Citizen C

Total Capital of country

Land

$ 1

$ 1

$ 2

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.

Citizen A

Citizen B

Citizen C

Nett Assets of country

$ 1

Land ( worth 1 Dollar)

$ 1

$ 3

3. 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 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.

 

Citizen A

Citizen B

Citizen C

Nett Assets of country

Loan to Citizen C of $ 1

$ 2

Land (worth 2 dollars) less Debt of $1 to A= Nett of $1

$ 4

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 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.

Citizen A

Citizen B

Citizen C

Nett Assets of country

Land (worth 3 dollars) less Debt of $2 to B= Nett of $1

  Loan to Citizen A of $ 2

$ 2

$ 5

 

 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.

 

Citizen A

Citizen B

Citizen C

Nett Assets of country

$ 2

  Land (worth 4 dollars) less Debt of $2 to C= Nett of $2

Loan to Citizen B of $ 2

$ 6

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

7. One day an evil wind blew. 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.

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 becomes -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.

 

Citizen A

Citizen B

Citizen C

Nett Assets of country

$ 2

  Land (worth 1 dollars) less Debt of $2 to C= Nett of -$1

Loan to Citizen B of $ 2

$ 3

 Who has stolen the 3 dollar from the country?

Of course, before the bubble burst Everyone thought B’s land was worth 4 dollar. Actually, right before the collapse, the net asset of the country was 6 dollar in paper.  

What must be kept in mind is though C’s net asset is still 2 dollar, his heart is palpitating about the inherent value of the land owned by B used as collateral for the loan so he calls in his loan to B. 

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.

 

Citizen A

Citizen B

Citizen C

Nett Assets of country

$ 2

  $ 0 (bankrupt)

Land (worth 1 dollars) (loss of $ 1 on bad debt of Citizen B) = Nett of $1

$ 3


 


Reccession as per wiki is ” generally describes the reduction of a country’s gross domestic product (GDP) for at least two quarters. The usual dictionary definition is “a period of reduced economic activity”, a business cycle contraction. “


This being a period where the overall sentiment is negative, people prefer to hold paper money to protect their assets from being undervalued. They quickly convert their market valuation based assets (like stocks, land, debts,bonds,and other investment instruments etc.) into tangible ones, paper money. This further creates a heightened sense of overall pervasive risk, and afraid that they would end up losing all they have, they pull out money from the market. Now with even lesser money to circulate, and lesser credit and liquidity, the fear heightens up even more.


Afraid, the consumers say a temporary no to the consumerism, thus there is further loss of demand. When this continues, there are job cuts, because now nobody wants these products or services. Thus bringing down the entire structure on which the economy is based.No demand ,and hence the money circulation is further monitored in an unhealthy way.


All of it, because the risk and fear grips people badly.Greed and fear are two basic feelings controlling our economy today.


Fight them ,Guard yourself against them ! Don’t follow the herd,make your own informed decisions.

 

Here’s an awesome video On the crisis of credit ! Hope you like it as much as I did ..

 

 

~

ek

People demand freedom of speech to make up for the freedom of thought which they avoid.

-Soren Aabye Kierkegaard

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2 Responses to "Where does money go in recession?"

[…] flashy money “generating instruments” like credit instruments, we have more and more of virtual money which is effectually giving us the impression of money that is just “perceived to have some […]

[…] “what to fund- and an easy availability of loans .This gives extra incentives and red signals of what happened with the housing bubble – plethora of loans – in this case – to distribute the stocked otherwise […]

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