Sunday, August 2, 2009

Is economic recovery so easy?

One of my friends sent me this interesting story on the economic crisis and recovery from it; read the story and my response to it below. I suggest that you read the story, and then think whether the story can be true. With your response in hand, read my response. R

It is the month of August, on the shores of the Black Sea. It is raining, and the little town looks totally deserted. It is tough times, everybody is in debt, and everybody lives on credit.

Suddenly, a rich tourist comes to town. He enters the only hotel, lays a 100 Euro note on the reception counter, and goes to inspect the rooms upstairs in order to choose one.

The hotel proprietor takes the100 Euro note and runs ot pay his debt to the butcher.

The butcher takes the 100 Euro note, and runs to pay his debt to the pig grower.

The pig grower takes the 100 Euro note, and runs to pay his debt to the supplier of his feed and fuel.

The supplier of feed and fuel takes the 100 Euro note and runs to pay his debt to the town's prostitute that in these hard times, gave her "services" on credit.

The hooker runs to the hotel, and pays off her debt with the 100 Euro note to the hotel proprietor to pay for the rooms that she rented when she brought her clients there.

The hotel proprietor then lays the 100 Euro note back on the counter so that the rich tourist will not suspect anything.

At that moment, the tourist comes down after inspecting the rooms, and takes his 100 Euro note, after saying that he did not like any of the rooms, and leaves town.

No one earned anything.

However, the whole town is now without debt, and looks to the future with a lot of optimism.....

And that is how the United States is doing business today.


Is this true? My response is the following:

Assume the Russian is a banker, who gave a 100E zero-interest loan to the hotel owner. Thats all.

This is precisely the economic purpose of credit, of financial intermediation. The story cleverly ends by saying "There was no profit or income." Correct. But there is a loss. When the hotel owner gave the 100 back to the Russian, it is not a no profit-no loss end to the story. The prostitute actually owed the hotel owner 100, and he never got to enjoy it. It continues to be a loss to the hotel owner; technically, he is poorer by 100! The 100 did not disappear; it is very much there!!

Yet, the whole chain has had economic values to certain others. It is this multiplier effect of credit that is important in generating economic activity.

Now when will economic crisis occur? "The Russian came down. But the prostitute hadn't arrived." !!!

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