What's going on here: good or bad?

[alw34]

$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!

 

[Borg]

Sounds more like circular debt. The Net Balance of Zero example is the same as yours.

 

[Merlin3189]

So all you need is a generous hotel owner to write off the debt to him.

 

[Merlin3189]

Just looked again because someone liked the post and realized I misunderstood it!
So provided credit is easy, everyone is happy and always should have been

 

[jack476]

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!

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.

 

[OmCheeto]

...
No one produced anything.

False.

No one earned anything.

False.

However, the whole town now thinks that they are out of debt

They are out of debt.

and there is a false atmosphere of optimism and glee.
...

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.

 

[zoobyshoe]

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.

They are out of debt.

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.

 

[OmCheeto]

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.

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

$100 dollar story

A tourist gives a $100 bill to the motel owner

the motel owner uses the bill to pay his debt to the butcher.
[middlemen removed]
The butcher pays off his room bill with the hotel owner

The hotel owner gives $100 bill back to the traveler, and the traveler leaves.

No one produced anything. [false. everyone produced something.]
No one earned anything. [false]
However, the whole town now thinks that they are out of debt and there is a false atmosphere of optimism and glee.[false. no one in town was in debt to begin with.]

 

[zoobyshoe]

I threw out all the middlemen, and "word problem-ish" extra wording, and came up with the following rough draft:... ...no one in town was in debt to begin with.

I agree with your digest of the story. But my question is: is that ever the case in reality?

 

[OmCheeto]

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.

 

[OmCheeto]

I agree with your digest of the story. But my question is: is that ever the case in reality?

Chicken and the egg, comes to mind.

 

[Borg]

Chicken and the egg, comes to mind.

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.

 

[zoobyshoe]

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.

According to the story, you should open a hotel and wait for a guy who wants to check out the rooms.

 

[Merlin3189]

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?

 

[alw34]

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!

 

[collinsmark]

I was hoping someone would explain how or if there was no real net debt to begin with, [...]

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.

 

[alw34]

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.

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.

 

[alw34]

Nobody in the story is in any real debt to begin with, since each person has a total equity of $0.00.

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!

 

[Merlin3189]

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!

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?

 

[PWiz]

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.

Well, that's a conclusion I came to as well...yet the $100 bill seems to have had an effect, even if only psychological.

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 into 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.

 

[alw34]

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'm in the same boat.

so there is even less confidence of timely repayment [or any payment at all]

Not sure I agree here: What freed up economic activity here was people honoring their debts, presumably to valued neighbors, acquaintances and business associates. An interesting outcome: If just one person said, "hey, time to party with my hundred", instead of paying their 'debt', the apparent outcome might have been very different.

the debtor still has the financial capacity to repay at least a fraction of the amount

Brings up another interesting point: Apparently in the story, people did not have this capacity. Or were not exercising it.

Maybe we should have an economics forum? Or maybe not, as I think that runs into the same problems as 'man made climate change'...and politics...there seem to be widely divergent views on 'the science'...in economics it might still be supply siders versus Keynesians... ??

.

 

[Intrastellar]

Well, that's a conclusion I came to as well...yet the $100 bill seems to have had an effect, even if only psychological.

What happens if, before the story starts, the pig farmer suddenly dies?

 

[alw34]

What happens if, before the story starts, the pig farmer suddenly dies?

The butcher[that owed the pig farmer] feels guilty...but goes out to 'party'?? Unless there was an ironclad loan agreement.

 

[OmCheeto]

What happens if, before the story starts, the pig farmer suddenly dies?

Since, in this simplified scenario, there is no government, and hence, there are no laws, the butcher would simply go down and collect all the pigs.
I believe this is, in real life, called an "extraction industry".
He would then turn them into pork roasts and bacon.
Since bacon is so tasty, the butcher would end up with a huge yacht.

But only after a yacht builder was found, of course.

 

[Intrastellar]

Since, in this simplified scenario, there is no government, and hence, there are no laws, the butcher would simply go down and collect all the pigs.
I believe this is, in real life, called an "extraction industry".
He would then turn them into pork roasts and bacon.
Since bacon is so tasty, the butcher would end up with a huge yacht.

But only after a yacht builder was found, of course.

This is why I was very tempted to make the butcher die, no one will dare to take his knives!

The butcher[that owed the pig farmer] feels guilty...but goes out to 'party'?? Unless there was an ironclad loan agreement.

Or something like this
But that is not the problem, the problem is what will happen to the Co-op owner?? Now he can never get his money from the pig farmer! And he is still indebted to the clothier. He is now in actual debt, it seems! The motel owner is now in debt as well! He has to return the money to the tourist!
Or at least, that is what it seems to my untrained eyes
Real life is complicated, and many things can happen that are not the fault of anyone. If no one owed or was owed by anyone then none of this would have happened.

Of course, the conventional wisdom of the village dictates the opposite; everyone should owe and be owed by everyone else, everyone should help at the time of need and be helped when in need. In that kind of village, what will happen is that everyone will know about everyone else's debt, and they will meet and agree to reset the debt of everyone, or work out some other solution.

Edit: Views may be influenced by thoughts that the grass is greener on the other side (although I am quite sure the grass in greener on the village)