The case of the missing money remains an intriguing one to every one, from the uninitiated to omniscient. First, the puzzle. 3 people went to a restaurant and ordered something to ring up the register to $30, $10 a piece. Taking into account the group's frequency of visit, the owner of the place discounts the bill by $5 and orders his server to split it up evenly among the three. Not known for his modular division skills, the server could not figure out a way to evenly distribute the 5 note among the 3, and so pockets $2 and gives back 3, amounting to $1 a piece. And now the question, if the patrons paid 9 each (with the discount) and the server pocketed 2, where did the $1 go, from the $30 that they initially shelled down? The question is not so much about problem solving skills as it is about teaching perspective. The original problem lies in trying to solve the problem from both the ends, the payer and the paid. At the owner level, he received $30, kept $25 and returned $5. At the server level, he kept $2 and returned $3. From that paid end, owner received 25, server got 2 and the group got 3. From the payer's side, they paid 27 (with the discount), server got 2 and the owner got 25. Call it Creative Accounting 101. If only things were this simple in the real world, particularly in the current economic context, where simple mathematics is making absolutely no sense, and economics, pandits and analysts are trying to balance an equation where the LHS and the RHS appear to be loggerheads and at each others throats. First of all, I am not an economist and don't claim to be any sort of an expert on matters relating to economics, accounting practices and balance sheets, not to mention, trade imbalances, stock markets and market corrections. I am just an average person trying to wrap my mind around the current economic quicksand, that is just sucking in/out the steam in the financial system.
First, the broad statement. X BILLION DOLLARS HAVE VANISHED FROM THE MARKET. This was the statement that had me digging the rabbit hole in the first place. Does that mean that in addition to whatever amounted to economy, the hard cash in circulation in the whole world, an extra X billion dollars are missing from the market? Where did they go? Or the other fundamental question, how did those extra dollars come into being? In a simple transaction involving 2 people, if one sells the other a product at a value greater/lesser to what he got, he is said to have made a profit/loss. So A bought something for $10 and sold it for $11. The profit is clear as a daylight. And A has with him the $1 to show for (the Tax Man). And same goes for a loss transaction. Now when a newspaper report claims that the market sustained X billions in loss, the common sense question would immediately be, who profited by just that much standing on the other side of the transaction equation. There has to be someone balancing the equation out, else the natural laws governing the universe, not just the economics, are at fault, and everybody from Archimedes, with his water displacement theory, and Einstein, with his conservation principle, had it all wrong all this while. So, where did the money go, the billions and trillions all over the world? It is here that the missing dollar puzzle above hits us on the head, reminding that current crisis, like the puzzle, is never about the numbers, it is all about perspective. So, let's look at the question again - where did all the money go - from a different angle, the bank's, the ground zero of the implosion. Banks' operational philosophy is quite simple. Start with a certain capital, lend it out, earn the interest, subtract the costs, and announce the profit/loss for a given financial year. So if a bank A lends $10, from its working capital of $100, to B to buy a house, and as long as B keeps servicing the loan with the prompt payments, at the end of the term, the bank stands to gain on its investment. There are no tricks here, no illusions, no rabbits out of the hat. The working capital is real, the payments are real, and the profit is real. If the loan is defaulted, the bank has $10 of house in its possession to make up to its initial $100 capital. So, technically, if all the banks have in their assets column all the foreclosed homes, adding up to the loans they have disbursed, why are the banks striking out the game left and right? Don't they still have all their capital (assets + currency) in tact? Well, not quite. Because of a little thing called valuation.
That seems to the difference between a tangible value like currency's and a surreal one, like valuation's. Say, a new home was bought for $100. That means, $100 have changed hands between the builder and the buyer. As long as the home never changes hands again, ever, it becomes immaterial what the value of the home, very much like how people buy gold more as an ornamental addition, than as an investment opportunity. The real trouble starts when reality gives way to apparent, perceived and purported "value". Say, the owner wants to take out a loan on his home and approaches the bank. The bank sends an assessor to the place, who valuates it for $200. This is creationism at its best, from here on. The apparent jump in the value from 100 - 200, attributed to several legitimate factors, like demand, growth and neighborhood, is still an apparition. Suddenly an extra $100 has breathed a new life. Say, the bank lends $100 on the $200 property, hoping that even if the loan is defaulted, the bank stands to gain an extra $100 on its investment. And if lent out 10 such loans of $100, depleting its reserves by $1000, waging on a bet that pays of $2000 in the worst case of a default or anything over a $1000 in interest accrued, the business plan sounds solid on paper. When the worst case is indeed realized on all those loans, the bank is now in possession of $2000 worth of assets. Or is it? When one (or the market forces) can decide that a property that was worth 100 before is now worth 200, then it can equally dictate that what was $200 once is 0 zero. So the investment of $100 on the part of the bank has disappeared, with no one to profit from that loss and balance out the equation on the other end. Until the property gets auctioned off at a later point of time for a higher (or, just any) value, the money is stuck in a limbo. So technically all those X billions made by the banks on foreclosed homes are in the twilight zone between the reality and apparentness.
This valuation system has always been the bane of financial industry, where the demarcation between money and wealth is drawn in the sand - clear at times and hazy at some other. In this system, nothing is created, there are no goods (or even services) to show for, just some one sticking their hand in the wind and bringing bastard wealth into circulation. The same thing happened during the internet bubble, when crazy ideas were (over-)valuated and rewarded with ridiculous money, and when the dust settled, there was nothing to show for, but empty promises and unrealized dreams. So how much money is actually in the system, in the wallets, changing hands, and in the bank vaults? Surprisingly far less than one might think. So what does it mean when the government is going to pump in a few trillion dollars into the system - print that much more money? operate on 'I owe you' credit? or creative accounting again? And the answer, a hidden one, is all of the above. So if the there are already $100 in the market, and the government promises to provide a stimulus for another $100, does that mean that there is more money circulating in the market, changing hands. And the mischievous smile on the lips of missing dollar puzzle creeps up again.