Mystery of the mortgage financial crisis

The net asset of the country = $6; even though the country has only one piece of land and $2 in circulation.

5. Everybody has made money and everybody felt happy and prosperous.
6. One day a 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 in circulation, I think after all the land that B owns is worth at most $1 only." A also thought the same.
7. Suddenly, nobody wanted to buy land anymore.
In the end,
- A owns the $2 coins, his net asset is $2.
- B owed C $2 and the land he owned which he thought worth $4 is now $1. His net asset became -ve $1.
- C has a loan of $2 to B. But it is a bad debt. Although his net asset is still $2.
- The net asset of the country = $3 again.
8. Who has stolen the $3 from the country? Of course, before the bubble burst B thought his land worth $4 and the net asset of the country was $6 in paper. However, now his net asset is $2.
The net asset of the country = $3 again.
9. B had no choice but to declare bankruptcy. C has to relinquish his $2 bad debt to B but in return he acquired the land which is worth $1 now.

At the end of all this: -

* A owns the 2 coins, his net asset is $2.
* 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 (C lost one dollar)
* The net asset of the country = $3.
*****************End of Story*****************

The net outcome of the above bubble is a redistribution of wealth. A is the winner, B is the loser, C is lucky that he was spared.

Few points worth noting: -

1. When a bubble is building up, the debt of individual in a country to one another is also building up.
2. This story of the island is a close system whereby there is no other country and hence no foreign debt. The worth of the asset can only be calculated using the island's own currency. Hence, there is no net loss.
3. An over-damped system is assumed when the bubble burst, meaning the land's value did not go down to below $1.
4. When the bubble burst, the fellow with cash is the winner. The fellows having the land or extending loan to others are the loser. The asset could shrink or in worst case, they go bankrupt.
5. If there is another citizen D either holding a dollar or another piece of land but refrain to take part in the game, at the end of the day, he will neither win nor lose. But he will 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. Instead of land, the above applies to stocks as well.
9. The actual worth of land or stocks depends on psychology to a great extent.

While this small story does not provide a solution, it does help us to understand what has actually caused the financial crisis. Paper money is not the same as money on paper that never existed in the first place. When inflation is brought into the picture, the paper value of the dollar is increased by psychological manipulation. For just as real estate is considered to have inflated in its value, other corporate businesses and commodities also inflate their values which is the pseudo-value. This pseudo-value makes the country and its people pseudo-rich if they do not convert their money on paper to actual cash or coins at the right moment and hope the coins themselves do not devalue.

What do you think of this and the economic meltdown?

Awesome article...very clear

Awesome article...very clear and simple explanation of the current U.S. situation.