In a recent comment Ashutoshg says:
You might have heard about 7bn$ fraud at Societe Generale in France. As news says, The guy who is responsible didn’t got rich because of the fraud. He just traded badly. Bank lost it and that guy didn’t make it then, where did this money go? Who got rich? Can money just disappear? Please explain.
Indeed, money can simply disappear without a trace. But first, let me tell you a story.
Once upon a time, an Englishman used to visit a certain little island for his annual vacations. The island was a little economy chugging along fine with its own currency, a bit of domestic production, a little bit of foreign trade and a bit of this that and the other. The Englishman would go there, enjoy the sun and sand, spend some of his money and return home refreshed.
One year he did not carry sufficient cash for his needs and ended up paying his hotel bills with a check from his checking account which he held in London. As he was a regular visitor with a reputation for paying his bills, the hotel accepted his check. But instead of submitting the check to a bank on the island, the hotel management used the check as part payment for their grocery bill. The grocer, in turn, used the check to settle his shop rent. The landlord later used the check to pay for some renovations on his property. Months went by while the check circulated among the islanders, and the check was never presented to the London bank for settlement. The Englishman’s checking account balance was never debited by the amount on that check.
The question is: who paid for the Englishman’s hotel stay?
The answer, you might have guessed, is that potentially everybody on that island paid for it. The Englishman by writing that check simply added to the money supply of the island economy. Assuming that the Englishman’s vacation did not increase the total amount of goods and services produced in the economy–that is, he merely consumed a part of the total production which would have anyway occurred regardless of his presence–then his increasing the money supply in effect caused a bit of inflation in the economy. Which means that others’ money after the check went into circulation would buy a fractionally smaller amount of goods and services than before. The Englishman created money out of the blue.
The fact that money can be created out of the blue by simply scribbling something on a piece of paper is important in understanding that money is not a real thing. More accurately, fiat money is not a real thing at all, as opposed to commodity money which is. If you use say pieces of gold as money, it cannot be created or destroyed–it can only be transformed. Stuff is real but money that we normally use is not. It is either pieces of paper or simply digital bits in some computer memory.
Money is one of the most ingenious creations of human creativity. It is a way of keeping an account of who owns what. For that, first there have to be stuff that can be owned. So the stuff that you can own is the real stuff and money just keeps track of who has claims on that stuff. So if there is no stuff, money is worthless. On a deserted island with no stuff on it, sacks of money would be less useful than some stuff that you can use.
The stock market illustrates the idea of money quite well. You buy a share of some stock from me for Rs 100. I spend that Rs 100 to have a meal. Now you have claims to a share of the profits of the firm whose stock you own. Now if the share price increases on the prospects of the firm’s increased profits, and the shares are trading at Rs 120 say, then you of course have the chance of selling your share for a profit of Rs 20. However, there’s another effect. Suppose the firm had 1000 outstanding shares, when the share price moves from Rs 100 to Rs 120, the market capitalization of the firm goes up from Rs 100,000 to Rs 120,000. Suddenly it is as if Rs 20,000 of money was created. It does not mean that someone actually paid Rs 120,000 for all the shares of the company. Some people may have bought and sold shares of that company over a wide range of share prices. Those 1000 shares may have been purchased for much less than Rs 120,000. But just as money magically increases with the rise of the share price, it can equally magically disappear. So if on the news that another company is producing a better gizmo, the shares price of the firm falls, then the valuation disappears–not the firm’s factories or its inventory. Stuff is real, the share price and valuation is only nominal.
So it is that on the aggregate there are no gains when the bank lost $7 billion because on the aggregate no one really lost any stuff. What happened is the distribution of the claims on goods and services merely got reallocated.
Money is magical stuff. That is why people want more of it.
Categories: Random Draws