Here's a very intersting anecdote that describes how an "asset bubble"
builds up and what are its consequences.
ANCEDOTE -
Once there was a little island country. The land of this country was thetiny island itself. The total money in circulation was 2 dollar as therewere only two pieces of 1 dollar coins circulating around.
1) There were 3 citizens living on this island country. A owned the land. Band C each owned 1 dollar.
2) B decided to purchase the land from A for 1 dollar. So, A and C now eachown 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 andland is non produceable asset, its value must definitely go up. So, heborrowed 1 dollar from A and together with his own 1 dollar, he bought theland 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 regrettedselling it. Luckily, he has a 1 dollar loan to C. He then borrowed 2 dollarfrom 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 toC.
As a result, A now owned a piece of land that is worth 3 dollar. But sincehe 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 theland. So he bought the land from A for 4 dollar. The payment is by borrowing2 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 netasset is 2 dollar.
B owned a piece of land that is worth 4 dollar but since he has a debt of 2dollar 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 onlyone piece of land and 2 Dollar in circulation.
6) Everybody has made money and everybody felt happy and prosperous.
(7) One day an evil wind blowed. An evil thought came to C's mind. "Hey,what if the land price stop going up, how could B repay my loan. There isonly 2 dollar in circulation, I think after all the land that B owns isworth at most 1 dollar only."
A also thought the same.
(8) Nobody wanted to buy land anymore. In the end, A owns the 2 dollarcoins, his net asset is 2 dollar. B owed C 2 dollar and the land he ownedwhich he thought worth 4 dollar is now 1 dollar. His net asset become -1dollar.
C has a loan of 2 dollar to B. But it is a bad debt. Although his net assetis still 2 dollar, his Heart is palpitating.
The net asset of the country = 3 dollar again.
Who has stolen the 3 dollar from the country ? Of course, before the bubble burst B thought his land worth 4 dollar.Actually, right before the collapse, the net asset of the country was 6
dollar in paper. 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 2dollar bad debt to B but in return he acquired the land which is worth 1dollar now.
A owns the 2 coins, his net asset is 2 dollar. B is bankrupt, his net assetis 0 dollar. ( B lost everything ) C got no choice but end up with a landworth only 1 dollar (C lost one dollar) The net asset of the country = 3dollar.
****************End of the story***************************
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 oneanother is also building up.
(2) This story of the island is a close system whereby there is no othercountry and hence no foreign debt. The worth of the asset can only becalculated using the island's own currency. Hence, there is no net loss.
(3) An overdamped system is assumed when the bubble burst, meaning theland's value did not go down to below 1 dollar.
(4) When the bubble burst, the fellow with cash is the winner. The fellowshaving the land or extending loan to others are the loser. The asset couldshrink or in worst case, they go bankrupt.
(5) If there is another citizen D either holding a dollar or another pieceof land but refrain to take part in the game. At the end of the day, he willneither win nor lose. But he will see the value of his money or land go upand 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 isworthwhile to borrow money (like A ) and take part in the game. But you mustknow when you should change everything back to cash.
(8) Instead of land, the above applies to stocks as well.
(9) The actual worth of land or stocks depend largely on psychology.
