The Island of boom and bust by ranfuchs @ 14/02/2010 – 12:41:06

This is a short (and hopefully simple) illustration of what's happening in our economy. In case you are curious. It was the type of game we used to play, when I was first introduced to the concept of money and international trade.

Once there was a little island, it had a piece of land, and two pieces of 1 dollar coins.

Three people were living on the island. A was the land owner, while B and C had 1 dollar each. One day B decided to purchase the land from A for his 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 is 3 dollars.

Now C thought that since there is only one piece of land for three people, its value must definitely go up. So, he borrowed 1 dollar from A, and together with his own 1 dollar, he bought the and from B for 2 dollars. Now 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 value is 1 dollar. Thus, the net asset of the Island is 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) 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 coins. His net asset is also 2 dollars. Therefore the net asset of the Island is 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 coins. 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.

Now the net asset of the Island is 6 dollars, even though the Island still has only one piece of land and 2 1 dollar coins. Yet, everybody had made money and everybody felt happy and prosperous.

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 dollars in circulation, and, I think after all the land that B owns is worth at most only 1 dollar, and no more.' Coincidently, the same thought crossed A's mind, so nobody wanted to buy land anymore.

So now 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.

The net asset of the country is 3 dollars again.

So, who has stolen the 3 dollars from the country? Of course, before the bubble burst B's land was worth 4 dollars, and the net asset of the country was 6 dollars.

B's net asset is still 2 dollars, and he has 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 coins; his net asset is 2 dollars. B is bankrupt; he lost everything and his net asset is 0 dollar. C got no choice but end up with a land worth only 1 dollar. The net asset of the country = 3 dollars.

So we are back to where we started with redistribution of wealth. A is the winner, B is the loser, C has now the land but now money.

This Island is closed economy whereby there was no other country and hence no foreign debt. If foreign debt was involved, everyone could have ended up a loser.