Where has all the money gone?
I got inspired to write this because of the question posted by a friend.
Joju says “Everywhere we see news and discussions about economic slowdown and credit crunch. Analysts say nobody (no banks, mutual funds, general public etc) has enough liquidity. Where have all the money disappeared?”
I would like to share my understanding here with a hypothetical example.
There is a lot of virtual money in the market. This money is only in the books of account and is not physically present. Let us, for example, look at a simple make believe world. This world has only 4 people. One Mr. A, who to start with, has all the money, say $100. One Mr. B has all the land. One Mr. C is a working professional. One Mr. Banker runs a bank.
Mr. A deposits the money that he has in the bank. So bank has deposits worth $100. Bank will be giving interest on the deposited money to Mr. A. So it needs to use this money to make more money. Mr. C wants to buy a house but does not have the money. He goes to the bank and the bank lends $75 to him on interest. Mr. C uses this money to buy the house from Mr. B. Now, Mr. B (the house seller) goes and deposits this money into the bank.
Now, the bank is having $175 as deposits in the Books of Accounts. But note that the world started with only $100. Where has this extra $75 come from? The total money in this world is $100 cash + $75 as a house. Thus, we can say that the total money, is not only the real money but also the assets valued in terms of money.
The bank has $175 deposits as its liability. It has an asset of $75 as loan and $100 as cash. So, by accounting standard, there is no issue as the bank has enough assets to match its liabilities. But, if we take a closer look, we can see that some of the assets that the bank has, if needed, cannot be converted to cash instantly. Thus the liquidity is missing.
If the interest rate falls, or due to any other reason, both Mr A and Mr. B might want the bank to return their money. But the bank does not have that much money as it hold real as well as virtual money. Real money is the $100 as cash that it can return and the virtual money is the assert in form of $75 loan which is not liquid. Thus, leading bank to liquidity problem.
On casual observation, we might feel that $75 though being present in the Books, have suddenly disappeared from the real world.
brilliant! thanks.
Nice, if elementary example. Now add to this soup: Bank decides that instead of trading securities, it’ll also trade on debt. Which basically allows it to trade on $75 that it has got as debt. So it raises more money on the debt. This means that it has now even more money on its accounts, using that $75 as security (hoping that that debt will be paid). So, now the bank has $250 on the books, where one really started off with $100. Now Bank C looks at the first Bank’s portfolio and says, “Hey! You have $250. I can trade more securities with you, uptil $250 since you have the capability to repay until $250″. Now, all of this comes crashing down, if the original guy that owed $75 can’t pay his debt. Which is basically what happened when the housing market in the US went bust.
Nice, simple, clear and easy to understand. Thanks!
Any thoughts on why the situation went (almost)out of control now?
Very good reference, especially for a novice. I second RP’s query, it will be useful if “Why” is explained too.
I received a similar mail today. I am pasting it here:
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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 pieces of 1 dollar coins circulating around.
1) There were 3 citizens living on this island country. A owned the land. B and C each owned 1 dollar.
2) B decided to purchase the land from A for 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 = 3 dollars.
3) Now 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 dollars.
*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 residual asset is 1 dollar.
* Thus, the net asset of the country = 4 dollars.
4) 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.
* The net asset of the country = 5 dollars. A bubble is building up.
(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 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.
* The net asset of the country = 6 dollars; even though, the country has only one piece of land and 2 Dollars in circulation.
(6) Everybody has made money and everybody felt happy and prosperous.
(7) One day an evil wind blew, and 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.”
(8) A also thought the same way.
(9) Nobody wanted to buy land anymore.
* So, in the end, 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, his Heart is palpitating.
* The net asset of the country = 3 dollars again.
(10) So, who has 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 asset of the country was 6 dollars on paper. B’s net asset is still 2 dollars, his heart is palpitating.
(11) B had 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, his net asset is 0 dollar. ( he lost everything )
* C got no choice but end up with a land worth only 1 dollar
* The net asset of the country = 3 dollars.
It answers the question “why”
http://www.hinduonnet.com/thehindu/thscrip/print.pl?file=2008100550010100.htm&date=2008/10/05/&prd=mag&