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What's going on here: good or bad?

  1. Jan 10, 2016 #1
    $100 dollar story

    It's a slow day in the small town of Pumphandle and the streets are deserted. Times are tough, everybody is in debt, and everybody is living on credit.

    A tourist visiting the area drives through town, stops at the motel, and lays a $100 bill on the desk saying he wants to inspect the rooms upstairs to pick one for the night.

    As soon as he walks upstairs, the motel owner grabs the bill and runs next door to pay his debt to the butcher.

    (Stay with this.....and pay attention)

    The butcher takes the $100 and runs down the street to retire his debt to the pig farmer.

    The pig farmer takes the $100 and heads off to pay his bill to his supplier, the Co-op.

    The guy at the Co-op takes the $100 and runs to pay his debt to the clothier, who extended credit.

    The clothier rushes to the hotel and pays off his room bill with the hotel owner from his anniversary stay with his wife.

    (Almost done...keep reading)

    The hotel proprietor then places the $100 back on the counter so the traveler will not suspect anything. The traveler comes down the stairs, states that the rooms are not satisfactory, picks up the $100 bill and leaves.

    No one produced anything. No one earned anything. However, the whole town now thinks that they are out of debt and there is a false atmosphere of optimism and glee.

    And that is how a "stimulus package" works!
     
  2. jcsd
  3. Jan 10, 2016 #2

    Borg

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    Sounds more like circular debt. The Net Balance of Zero example is the same as yours.
     
  4. Jan 10, 2016 #3

    Merlin3189

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    So all you need is a generous hotel owner to write off the debt to him.
     
  5. Jan 10, 2016 #4

    Merlin3189

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    Just looked again because someone liked the post and realised I misunderstood it!
    So provided credit is easy, everyone is happy and always should have been
     
  6. Jan 10, 2016 #5
    But that might be a good thing. Even though the town hasn't been any wealthier and may not be out of debt, their opinion of the economy has become more positive and now they're going to be more inclined to start spending again.
     
  7. Jan 10, 2016 #6

    OmCheeto

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    False.
    False.
    They are out of debt.
    Sounds like a very well rounded economy, except for the fact that they are again missing a $100 bill.
    They should print up a $100 bill.
    Or, they could use a special rock. Rocks are pretty cheap. The people on the island of Yap use special rocks, for money.
     
  8. Jan 10, 2016 #7
    It could be I'm missing the point, but how realistic is this situation of "circular debt," though? The story is unrealistically neat, with all parties owing the same amount they have also extended credit for. Also, In the real world I think most people simply owe money without being owed any.
    Only if the $100 was each person's total debt. I can't exactly tell from the story if that's the implication. Generally, I suspect the story of being inapplicable to practical situations.
     
  9. Jan 10, 2016 #8

    OmCheeto

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    I threw out all the middlemen, and "word problem-ish" extra wording, and came up with the following rough draft:

     
  10. Jan 10, 2016 #9
    I agree with your digest of the story. But my question is: is that ever the case in reality?
     
  11. Jan 10, 2016 #10

    OmCheeto

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    If anything, this is an example of "when it's good to buy things on credit".

    The butcher takes the $100 and runs down the street to retire his debt to the pig farmer.

    Before the story started, the butcher was originally penniless, but could turn a pig into a profitable commodity. And the cycle, continued.
     
  12. Jan 10, 2016 #11

    OmCheeto

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    Chicken and the egg, comes to mind.
     
  13. Jan 10, 2016 #12

    Borg

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    I loaned my wife a million dollars and week later she loaned me a million dollars. Now we're two million in debt and I don't know how we'll ever pay it all off. :olduhh:
     
  14. Jan 10, 2016 #13
    According to the story, you should open a hotel and wait for a guy who wants to check out the rooms.
     
  15. Jan 10, 2016 #14

    Merlin3189

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    Most of us are in debt to some extent and most of us are also creditors, eg. we get paid at the end of the month, we pay into pension and life insurance funds. If most people have a reasonable balance of debt and credit, then on average this is an enormous pool of circular debt. So long as people have confidence in this situation and there are plenty of $100 bills around, we're happy.
    The problem in this town was that, although no one was actually in net debt, they had no spare $100 bills and, for some reason I don't quite understand, they were not happy. Why they should be any happier now, is equally difficult to understand.

    It seems to me that most of us are actually worse off than these folk. They have a net debt of zero. Most of us owe more than we are owed and so should be less happy than they. What saves us, is the confidence that we will be owed more in the future - our earnings will continue (and increase) and our investments will increase in value. Why do these folk not have that confidence? Perhaps most of the town are worse off than our heros, so even though they are solvent now, they have no confidence of future income. Has the $100 bill made any difference to that?
     
  16. Jan 12, 2016 #15
    I'm still not sure about the example, but I think Om Cheeto is on the right track for the most part.

    Thanks to Borg for mentioning circular debt....I had never heard the term....I skimmed a few summaries but have not drawn any conclusions so far. I would have thought the 'velocity of money' would be part of the explanation, but I'll have to read something about it. [The velocity of money (also called the velocity of circulation of money) refers to how fast money passes from one holder to the next.]

    An illustration is here:
    https://en.wikipedia.org/wiki/Velocity_of_money#Illustration

    I was hoping someone would explain how or if there was no real net debt to begin with, aka, Borg's post #12.
    A version of this example is called 'net debt'.....where different amounts are owed along the way.

    In the example I posted, as noted, real work was performed so it seems economic activity was what I would call 'real'.

    I'll have to read more about circular debt and it's implications....

    I am currently sidetracked in a two hour Roger Penrose cosmological lecture and that is REALLY complicated!
     
  17. Jan 12, 2016 #16

    collinsmark

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    I'll give it a stab.

    Nobody in the story is in any real debt to begin with, since each person has a total equity of $0.00. We can define a person's "equity" here as the sum of the person's credits and debits. [Edit: where the debits get a negative sign.]

    Let's start with butcher. The butcher has $100 credit attributed to the hotel owner and also $100 debit attributed to the pig farmer.
    Total equity: $100 + [-$100] = $0.00.

    The pig farmer has $100 credit attributed to the butcher and also $100 debit attributed to the co-op supplier.
    Once again, total equity: $100 + [-$100] = $0.00.

    And we can repeat this sort of thing for everybody in the circle.
     
  18. Jan 12, 2016 #17
    I think this is part of the story. They were not happy because they thought they owed money. Once the 'debt' was 'cleared', they no longer had an obligation to others and probably felt they could more safely acquire alternative debt if required.

    Another part of the story has to do with "This is how a stimulus package works."

    I believe there are substantive differences.

    For one thing it appears a government stimulus package actually increases government debt because expenditures exceed revenues. In addition, there are transaction costs, coupled with government inefficiencies,and outright bribery, while private debt is reduced as people/corporations earn money via their labor in exchange for government payment. Think "Solyndra' solar panel scandal.
     
  19. Jan 12, 2016 #18
    Well, that's a conclusion I came to as well...yet the $100 bill seems to have had an effect, even if only psychological.

    A funny variation would have been to start with, say a $1 bill instead, and after passing it around 100 times, voila, same result. THAT seems a tad absurd!
     
  20. Jan 13, 2016 #19

    Merlin3189

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    But only because this is a very simplified situation. In our world there are millions of debts and credits, not all $100, so we need lots of bills for lots of small debts.
    In this town lack of liquidity is causing a problem. Everyone is solvent, but no one can clear his debts and maybe that is affecting sentiment. When someone has confidence and injects some liquidity, it oils the wheels of commerce and sentiment improves.
    If each of these people had had a few $1 bills in their pocket, they could all have been making and receiving payments, all would see themselves as solvent, in a stable situation capable of continuing indefinitely. I guess even if one of them had been in net debt, things would not look too bad, so long as he was making payments and receiving income. (That certainly seems to work for a lot of people.)

    I wonder how they got into this situation? Have all the $ bills ended up in the hands of the (maybe few) net creditors, who now are unwilling to lend?
     
  21. Jan 13, 2016 #20
    I've made some remarks of my own below, but I must state that I do not hold any degree in Economics, nor have I ever formally studied it, so excuse any gross errors.

    I think one should consider the fact that all of these people had no guarantee whether their debtors would eventually repay or not. (You're dealing with people here, not corporations, so there is even less confidence of timely repayment [or any payment at all].)

    Besides, this is a simplified model where there are no interest rates on loans. Steady payment of interest acts as a psychological relief factor to the creditor as it seems to show that the debtor still has the financial capacity to repay at least a fraction of the amount he/she has taken on loan.

    The biggest factor that can sometimes be overlooked in such cases is that, although everyone has a 0 net equity, you cannot be certain whether a person who receives money from a debtor will immediately use it to pay off his/her creditors or consume it first in the hope of future income/profit/repayment from other debtors. Delays in exchanges between debtors and creditors (which is what appears to be the case for Pumphandle) build up stresses in the cycle - the people who give in to their temptations of spending liquid funds upon receiving them after a long time "break" the cycle, and the "stimulus package" fails to come around. (This, of course, assumes that the "consumption" make the funds exit the local system.) Most stimulus packages are usually "injected" into the cycle in a place where the parties which are more likely to spend funds on consumption rather than paying off creditors are the furthest so that the cycle can continue as far as possible.
     
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