Economic Bubble

Following beautiful story tries to answer question on Economic Bubble.

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.

As in the case of land, the above phenomenon applies to stocks as well.

The actual worth of land or stocks depend largely on psychology