Bankruptcy Explained

This showed up in my inbox…

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 1-dollar coins 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 owned 1 dollar each while B owned a piece of land that was worth 1 dollar.

The net assets of the country were now 3 dollars.

Now C thought that since there was only one piece of land in the country, and land is a 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 had a loan to C of 1 dollar, so his net assets were 1 dollar.

B had sold his land and gotten 2 dollars, so his net assets were 2 dollars.

C owned the piece of land worth 2 dollars, but with his 1 dollar debt to A, his net residual assets were 1 dollar. Thus, the net assets of the country were now 4 dollars.

A saw that the land he once owned had risen in value. He regretted having sold it. Luckily, he had 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 consisted of 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 worth 3 dollars. But since he owed B 2 dollars, his net assets were 1 dollar.

B loaned 2 dollars to A. So his net assets were 2 dollars.

C now had the 2 coins. His net assets were also 2 dollars.

The net assets of the country were 5 dollars. A bubble was 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 consisted of 2 dollars borrowed from C, and cancellation of his 2-dollar loan to A.

As a result, A cleared his debt and he got the 2 coins. His net assets were 2 dollars.

B owned a piece of land worth 4 dollars, but since he owed C 2 dollars, his net assets were 2 dollars.

C loaned 2 dollars to B, so his net assets were 2 dollars.

The net assets of the country were 6 dollars even though the country had only one piece of land and 2 dollars in circulation.

Everybody had made money and everybody felt happy and prosperous.

One day, an evil thought came to C’s mind. “Hey, what if the price of land stopped going up? How could B repay my loan? There are only 2 dollars in circulation. 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.

In the end, A owned the 2 dollar coins. His net assets were 2 dollars.

B owed C 2 dollars. The land he owned, which he thought was worth 4 dollars, was now worth 1 dollar. So he had a net liability of 1 dollar.

C had a loan of 2 dollars to B, but it was a bad debt. Although his net assets were 2 dollars, his heart was palpitating.

The net assets of the country were 3 dollars again.

So, who had 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 assets of the country were 6 dollars on paper. B’s heart was palpitating.

B had no choice but to declare bankruptcy. C had to relinquish his 2 dollar bad debt to B, but in return he acquired the land which was worth 1 dollar now.

A owned the 2 coins; his net assets were 2 dollars.

B was bankrupt; his net assets were 0 dollars. (He lost everything)

C had no choice but to end up with land worth only 1 dollar

The net assets of the country were 3 dollars.

This is the end of the story, but there was a redistribution of wealth. A was the winner. B was the loser. C was lucky to be spared.

  1. When a bubble is building up, the debt of individuals to one another in a country is also building up.
  2. This story described a closed system in which there was no other country and hence no foreign debt. The worth of the assets could only be calculated using the island's own currency. Hence, there was no net loss.
  3. An over-damped system can be assumed when a bubble bursts. In this case, the land's value did not go below 1 dollar.
  4. When a bubble bursts, the fellow with cash is the winner. The fellows owning the land or extending loans to others are the losers. Their assets' value could shrink. In the worst case, they go bankrupt.
  5. If there had been another citizen D either holding a dollar or another piece of land, and if D refrained from taking part in the game, he would neither win nor lose, but he would 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. The phenomenon described in the story applies to stocks as well as land.
  9. The actual worth of land (or stocks) depends largely on psychology (or speculation).

Tags: Economics, Fun

Updated at: 20 October 2008 12:10 AM

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