The Hindu Business Line : Bubble explained

If you have been wondering how the bubble works, be it in the economy or the stock market, the story of this tiny island which has only three inhabitants, two Re 1 notes in circulation and a piece of land will help. This is what happened to the country between January 1, 2008 and June 30, 2008.

January 1, 2008: Only three citizens lived in that country, Mr A, Mr B and Mr C. Mr A owned the land. Mr B and Mr C owned Re 1 note each. So the country’s total wealth was Rs 3.

Februay 1, 2008: Mr B decided to buy the land from Mr A for Rs 1. So, now Mr A and Mr C have Rs 1 each while Mr B owned the land that’s worth Re 1. The wealth of the country stays at Rs 3.

March 1, 2008: Mr C felt that the price of the land would go up. So, he borrowed Re 1 from Mr A, and with his he bought the land from Mr B for Rs 2.

Mr C is A’s debtor for Re 1. So Mr A’s wealth is Re 1. Mr B had sold the land and picked Rs 2. So Mr B’s wealth is Rs 2. Mr C owns the land worth Rs 2 and with his Re 1 debt to Mr A, his wealth is Re 1. The country’s wealth is now Rs 4; up from Rs 3.

April 1, 2008: Mr A, the original owner of the land, is upset that its price is now Rs 2. He wants it back. So he borrows Rs 2 from Mr B and buys the land from Mr C for Rs 3.

The balance Re 1 is settled by nullifying the Re 1 which was due to Mr A from Mr C. Now Mr A owns the land worth Rs 3. Since he has borrowed Rs 2 from Mr B, his wealth is Re 1. Mr B has given Rs 2 loan to Mr A.

So his wealth is Rs 2. Mr C has Rs 2 with him. So his wealth is Rs 2. The wealth of the country is the total wealth of the three guys, and is Rs 5; up from Rs 4.

May 1, 2008: Mr B decides to get into the act. He buys the land from Mr A for Rs 4. He settles by borrowing Rs 2 from Mr C and by adjusting against the loan of Rs 2 to Mr A. Mr A is free of debt, has the Rs 2 with him and so is worth Rs 2. Mr B owns the land now worth Rs 4 but since he owes Rs 2 to Mr C, his wealth is Rs 2. Mr C has lent Rs 2 to Mr B and so his wealth is Rs 2. The country’s wealth is Rs 6; up from Rs 5.

June 1, 2008: Mr C decides that the land price cannot go up. Ditto is Mr A’s thought. Neither wants to buy the land. So now Mr A has the Rs 2 and his wealth is Rs 2. Mr B owes Mr C Rs 2 and the land which he thought was worth Rs 4 is now only Re 1.

His wealth is Re -1. Mr C has a loan of Rs 2 to Mr. B. But that’s bad debt. Although his wealth is Rs 2, he may not be able to encash it. The wealth of the country is Rs 3; down from Rs 6.

June 30, 2008:Mr B declares bankruptcy. Mr C has to forego his loan to Mr B and in lieu takes the land which is worth Re 1. So Mr A has now Rs 2, Mr B has no wealth and Mr C has the land worth Rs 1. The wealth of the country is Rs 3.

Confused? Good. If you are an accountant, look at each event as a transaction. The changing capital is the wealth of each individual and the sum of the capitals is the wealth of the country.

There are several morals in this. The most important are Mr A won, Mr B lost and Mr C got away. When the bubble bursts, the guy with cash is king.

If you don’t partake in the fun your wealth swings but you don’t lose. Now what we said of this country is true of the stock market.

Caveat: A remarkable story circulating on mail which in part explains the bubble. I have merely tinkered on the margin.

(The writer is a Chennai-based Chartered Accountant)

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