Saturday, February 17, 2018

Boat on an Island

Three men are stranded on a desert island. Their names are A, B and C.

They survive by fishing and catching enough fish to survive each day. They lead a substance lifestyle.
A thought that he could have a better life if he owned a boat and net. He knew he could buy them from traders who sailed by occasionally, but they would cost $10,000.

B had $10,000 cash in his pocket that was there when he was marooned. There was nothing he wanted to spend it on. He offered to loan it to A for 10% interest per year. A took the loan and bought the boat and net. He was able to catch enough fish to pay the interest, as well as buy some household goods from the passing traders that made his life much better.

At the end of the year, A had a boat and net, but a debt of $10,000. B now owned a loan of $10,000. C was just subsiding.

B offered a loan of $11000 to C to buy a boat and net. C offered to buy the boat and net from A for $11,000. A accepted the offer and repaid his loan to B. C now had a boat and net. A had $1000 cash which he could use to buy stuff from passing traders.

C could catch enough fish to pay the interest of $1100 to B and to buy some household stuff from passing traders.

A year later, A was feeling the pinch, so he sounded out the possibility of getting a loan from B to re-purchase the boat and net. B offered to lend him $12,000. He kept the additional $100 to buy stuff that he needed.

A bought the boat from C for $12,000. C kept $1000 to buy stuff that he needed from passing traders.

Now A could catch enough fish to eat plus to pay the interest of $1200 to B and to buy some extra household stuff from passing traders.

This goes on for several years in the same way. After buying and selling the boat a number of times, A owns the boat again, but he had to spend $20,000 to buy it. He had to borrow that sum from B, so he has to pay $2000 interest per year. He has a good stock of household goods to make himself comfortable. The problem is that even with a boat, it takes all his efforts to catch enough fish to eat and to sell to pay the interest. He does not get enough to buy any more household goods.

B has been able to buy some household goods. He can still catch enough fish to live on without a boat. He owns a loan of $20,000. Through compound interest, he has doubled his wealth in a few years. The boat is still the same boat, but its price has been inflated by debt financing.

C has some household goods that make his life very pleasant.

In the following couple of years, fishing is really bad. A cannot catch enough to eat and pay his interest.

A now owns the same boat as he bought at the beginning. It is worth twice as much, but it is still the same boat. The big difference is that A has a debt that is twice as large, and his interest payments are double what they were. The person who is better off is B, because he has doubled the value of his wealth (B is for banker).

This demonstrates what has happened in the modern housing market. By buying and selling houses, they have bid up the prices of existing houses using debt until they are more than double what they were. People end up with the same houses, but their debt is much greater and the interest payments are bigger too. The banks who lend the money are the ones who benefit the most.

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