Where is the money gone?

We have an economic crisis. Nobody has money, many starve, lost their homes etc. But where did the money go? On the blog http://scienceblogs.com/goodmath/2009/03/bad_bailouts.php#more the question was raised and some partial answers given. I will try here an explanation:

There is some confusion on terminology: By money I mean the abstract rights which are described with amounts of a currency (Dollar, Euro). By value, I will describe real things which can be used and produce benefits (e.g. my home, my car, a company with its tangible and intangible assets).

The real confusion starts when newspapers report 'today x billions were lost on the stock exchange' (or even worse 'x billions were destroyed'). Who did destroy the money? Where did it go when it was lost? - The answer is simply 'the illusion of value went away'. Here is why:

In the morning I hold 1000 shares of, say Ford Motor company; this means I own a (small piece) of the company with all its assets. They were traded for $16 the evening before and my banker things my net value is 16,000. In the evening I still have the same 1000 shares of the same company, but they are traded now for only $12. What have I lost? Obviously no value was lost, but in the view of my banker, my net value is reduced by $4000. When the stock prices came down, the stock was not representing less real value in terms of assets behind it. What came down was the market value of the stocks.

Before I look why people really lost money, let me discuss what happened when the stock prices were rising:

I bought recently 1000 shares of a company owning large buildings in Vienna for Euro 0.70. These shares are now traded for 1.30. Have I earned now 600 Eros? Not yet. If I sell the stock then I have earned 600, which I can use to invite my friends to a sumptuous dinner. Likewise, I would have realized my loss of holding Ford stock only if I sell it. A gain or a loss in money terms is associated with an action, converting money to an other asset and then back. The same is true for buying a home – there is no gain or loss as long as I hold on to it. The transactions produce a gain or loss, or better an increase or decrease in my net value as seen by my banker.

So – where is the money gone?

If I buy stock or a home but do not pay all with my own money, but ask the bank for a loan, guaranteed by the stock or a mortgage on the home, I can buy more than I could pay cash for. If the stock is traded later higher, I sell it, pay back the loan and pocket the difference. The percentage I can earn in this form is higher than if I buy with cash. Consider the above example: instead of using my 700 Euro to pay for 1000 shares, I buy 4000 and ask the bank to loan me 2100 Euro which together with my 700 pay for the 2800 total (I disregard fees etc.). If I sell at 1.30 I get 5200, pay back the 2800 and get 2400; my net value has increased by 1700 in a few weeks. My gain, expressed in percentage per annum is perhaps 250%. This is aptly called 'leverage'.

Where is the catch?

If the stock trades now lower, say 60 cents, then the bank fears for its loan and ask me to reduce the loan by giving them cash – and if I do not send it promptly, they will sell the stock for whatever price, say 55 cents. This gives 2200 of which the bank takes 2100 to pay back the loan and 100 remains for me – that is what I have left from my 700 Europa I had initially! Now I have really lost 600 Euro (compared to not having bought and sold the stock).

If many buy stock or homes paid partly by loans and market prices are sliding down such that banks see their loans not covered anymore and force the owners to sell, then prices will go further down and more owners may be forced by their banks to sell and thus pushing the market prices further down, as happened last year.

Reading Galbraith' [The Great Crash of 1929] and Krugman's [The Return of Depression Economics and the Crisis of 2008] accounts of the economic crisis indicate that the economic downturn – which is an event happening regularly every 7-15 years – started in every crisis before the crisis broke out (e.g. fall 2007) – but the crisis itself is the product of leveraged buying, which is multiplying the effects of normal economic ups and downs. We had many years of ups and some people benefited from leveraged buying, now we had the downturn and many got caught.

Still, where is the money gone?

When the market values of homes, stocks, companies etc. all increased regularly and leveraged buying of these valuable things was a good deal. People were able to sell and realize the gains in money (or were just increasing their net value in money). They used the money appearing in their bank accounts to buy real value things – like cars, dinners, massages, ships, companies – keeping the real economy going.

The non-intuitive aspect is the account is that the gains were realized first and the losses were occurring later. The bubble economy was giving credits to the ones willing to run risks. When everybody else jumped on the band-wagon, it started sliding backwards. The clever ones had left (i. e. realized) the gains and moved it to other more stable form of assets, the late comers lost their investment.

Now: who benefited from the bubble? Certainly the ones that cashed the big bonus, realized the big gains, but also all the ones which bought and sold homes and used the money for this and that – meaning a little bit everybody (including state employees, benefiting from increased taxes used to pay salaries... me included).

The figures reported in the press are the figures describing Ponzi schemes built on top of the simple examples used above: one can leverage the leveraged investment in stocks, do leverage buy-outs and translate this in stocks; one can produce securities from risky mortgages – and then create leveraged investment in these securities. For example the loss in Madoff's investment vehicle – a classic Ponzi scheme – is reported in the 50 billions; actual investment of real (?) money from outside is closer to 15 – 20 billions – the rest are gains appearing in the books but never realized.

The billions necessary to keep the system relevant banks afloat – a classic scheme of privatizing gains and sharing publicly the losses as Stiglitz has pointed out – are inflated by the leverage schemes used to create the investment vehicles now appearing n their books as toxic assets. I see not enough analysis of the causes of the crisis to believe that the bailout is using the best (least public cost) medication to overcome the current illness of the finance system.