Tom, Dick, and Harry go to the liquor store together. Each of them purchases a bottle of Dom Perignon champagne. Each of them pays $150. Tom gives his bottle to his boss, as a holiday gift. Dick brings his bottle home and drinks it with his wife. Harry accidentally drops his bottle in the street. It bursts and the champagne flows into the gutter. 1. In which of these scenarios is wealth "destroyed"? 2. Where does destroyed wealth go?
This same question is something I remember struggling with years ago without resolution. Unfortunately, I have been Tivo-ing old episodes of "Lost" and thought it may provide a real back to basics scenario to help get a different perspective. Unlike the television program, the poor folks marooned on this island are living like true hunter gatherers, inexperienced ones at that. The pickings are so meager that they need to think about the energy needed to procure a specified number of calories. I imagine these folks are about as poor, wealth-less, as they come. They may have a few knives, but they have almost zero assets. Then an event occurs which is stranger than fiction They discover what appears to be an essentially endless supply of MRE's. Things change almost overnight. Their gathered berries are now just supplements to the nutritious and delicious MRE's. Strength and vitality are returning to everyone. Personal hygiene has experienced a noticeable uptick. Shelters have been constructed and a raft nearly completed. There is the time and inclination to party and works of art are being created. Rap music can be heard from every shelter. No, lets have a do over and scratch that last part So it appears that this society has, relatively, a good deal more wealth than it had previously. Folks are back to overeating and their newly developed svelte bodies are becoming obese. Unfortunately, it is discovered that the food underlying the top level of MRE's is contaminated with botulism. Sadly, their assets are discovered to be toxic Their actual assets have not changed at all, but their perception of them has. Hopefully the energy derived from the good MRE's have been put to use creating other assets that can be used as a means of production, fishing nets, garden tools etc. Other than the good use they may have made from the nontoxic assets, their life is going to approach what they had known before. I guess what I take from this dumb little story is that actual wealth was not created or destroyed. It was what it was. Perceptions and expectations did however change to a large extent. If you add money and debt and look at wealth by individual the example becomes more interesting and much more complicated. I don't see it changing the big picture too much. Perhaps one could argue that money would have made the small boom period more efficient, but the MRE's remain toxic. I guess this cannot be anything much more than oversimplified, but warm up your flame throwers none-the-less.
Joeski, I'm sure others have/can explain it more succinctly, but that 9 to 1 multiplier effect is the theoretical cumulative effect of the original bank loaning out a portion of the original 1M, then the loan recipient spending the loan on a house, car, etc, then the home seller depositing the proceeds in their bank, who in turn loans out a portion of that deposit, and so on. There is a nice chart explaining this in Wiki. Lets pretend that total financial meltdown occurs, and all banks are consolidated into one bank, starting over with no assets. A newly formed world central bank prints out its first installment of 1M units, which for arguments sake, I end up with. I walk into the bank, deposit the 1M, and the guy behind me in line then borrows .8M. He goes, buys a house and the homebuilder comes into the bank and makes a deposit of .8M. The bank takes the $$ and then loans out .64M. We could continue this process many more times to arrive at that fantastic multiplier touted earlier, but that would get really boring. So lets just review. At this point, the bank owes its two depositors a total of 1.8M. The bank has loaned out and is owed 1.44M. The bank has 360K in reserves to cover any withdrawals. If the homebuyer in my example defaults, what happens when the bank has to resell the house for only 20 cents on the dollar? The bank sells the 800K house for 160K. Now the bank owes 1.8M, and has assets as follows: 520K in reserves and loans for 640K; is there a problem? Yes, the bank owes 1.8M, and only has assets totalling 1.16M. The bank could turn around and loan out the 160K they received from the asset sale and hope they can gather more deposits, and try to ride out the problem. What happens in the example above if the homebuyer doesn't default, but instead I, the bank's largest depositor, hears a rumor that the default will happen. If I run down to the bank and demand to be repaid my 1M, the bank has a problem again. If they can't figure out how to pay me, maybe by getting some cash from that new world central bank, using their loan assets as collateral, they are screwed. What if the home buyer defaults, AND I hear about it and run down to the bank demanding my $$. Every hear of a bank called WaMu? Not sure if any of this helps at all, and obviously, it is a grossly oversimplified example, but I'm really just pointing out that in order to create that the theoretical bank that created 10M in loans from 1M in original "money" actually generated lots of liabilities as well, in the form of depositors. This fractional banking thing works pretty well when MOST of the depositors feel comfortable that the banks are prudent and aren't going belly up, and MOST of the borrowers are actually going to pay back their loans as agreed upon. Hmm, what was your original question? Oh yeah, the bank IS screwed if it were forced to liquidate all its borrowers for 20 cents on the dollar.
===================== It is 9x deposits. PLUS! If you watch all the videos, you'll see that the money mutiplied out by bank one, gets put into another bank, and multiplied again, and again, and again, so you end up with huge leverage. $80-100 of new money created for every dollar (i'm going off memory so I might be off a bit) but you get the idea. In your thought exeriment: If you loan out 10 million, and property values fall 20%, there is a 20$ million equity loss. Since there is only actually $1 million in capital, all parties split the losses, bank take some & property purchaser looses equity. There is less money in they system now overall. When people default or banks take losses, money gets nuetralized. If the home buyer defaults, the bank eats the entire loss (difference between what was lent and what bank could sell for), if buyer continues to hold and pays mortgage, the buyer looses when OTHER people default on their similiar property. Key point - You have to think of this as an overall system = not one individual transaction. It is the net reduction in money and credit in the system that is deflationary. Any one particular buyer and bank may or may not "loose" money, but the reduction in money around in total will be shared, one way or another. Play monoploy game, introduce a banker/player mid game with money from a second game. Watch prices of properties rise on average. Banker slows or withdraws lending, watch property prices go down (ON AVERAGE).
Wealth depends on valuations. When people are willing to pay more for the same quantity, wealth increases. When people are willing to pay less for same quantity, wealth decreases. The use of the term "wealth destruction" is a red herring. Wealth changes value depending on the status of the economy. I'm not talking about the wealth of an individual. I'm talking about aggregate wealth. If the price of a stock falls 50% and someone has x shares then his wealth drops 50%. You cannot destroy wealth the same way you cannot destroy temperature. They are both quantities that measure something. They can go up and down but can never be destroyed.
============================== Respectfully, I don't think it is a red herring. Valuations are comprised of two factors 1)supply and demand of item and 2)amount of money in the system. Assuming the same supply and demand, if the Money/purchasnig power (money + credit) is $400k, share, or the DOW (pick your asset) will sell more than if the average money supply per person is $50k. More money in the system makes prices go up, on average (again assuming equal supply and demand). And I'm not talking about "wealth", I'm talking about money, and money supply. The definition of inflation in increase in the money supply. Deflation is decrease in money supply. Just as money supply increases creating inflation, it can also decrease causing deflation.
You example would be correct if the supply of money is a constant. THen if some one losses, someone else gain equally. And you would be right, money would not be created or destroyed. But money, is NOT constant. The average amount of money per person (on average) fluctuates over long term periods. "Money" = money + credit availability. For instance, note how credit is drying up now, and prices are falling for most goods on average? Less credit = lower prices.
It seems like all the media participants talking about "wealth destruction" must have forgotten or missed the many times my Econ 1A professor pounded on the lectern and declared "money is NOT wealth; you can't EAT IT, you can't WEAR IT, you can't LIVE IN IT!" In that case, they probably also missed all the times my Econ 1A professor stated "there's no such thing as a free lunch". I kept a tally of how many times he said these and a few other such "Econisms"
Many people have explained very well for your question. Unless you know how many bill the fed had printed then we can figure out where the destroyed wealth go. Assuming that the Fed had printed (say $50T) and the 2005 wealth valuation was $75T (of course the $25T excess was virtually coming from the stock/forex markets gain). And now the 2008 wealth valuation is $55T. So man don't worry too much, we still have $5T virtually inflated to lose in order to correctly reflect the physical amount that the fed had printed. PS: The above example was aimed to simplify for easy understanding, it assumed the whole world has a unique currency, the USD. While the real valuation of wealth reflecting the physical money printed from many countries in the world as a whole is far more complex.
you are leaving out confidence. there can be low supply and excess money in the system but if people have no confidence in the future they will not spend and bid up assets.