What’s Wrong Here?

4 September 2009 at 7:50 am 20 comments

| Lasse Lien |

A rich tourist came to a small town in the middle of the financial crisis. He went into the local hotel, placed a 200-dollar bill on the counter and went upstairs to check out what kind of rooms the hotel had to offer. In the meantime the hotel manager grabbed the bill, walked over to the butcher and used the bill to pay his debt. The butcher then took the bill to the cattle farmer and paid his debt to him. Next, the cattle farmer took the bill to the cattle feed supplier and paid his debt there. The cattle feed supplier then paid his debt to the local prostitute. The local prostitute brought the bill back to the hotel and paid her debt to the hotel manager. The hotel manager put the bill back on the counter. Then the rich tourist returns down the stairs and proclaims that he didn’t like the any of the rooms. He grabs the bill and leaves the city. A pity, but more importantly, the town was now debt free and optimism was back.

Source unknown. HT: Tore Hillestad.

Entry filed under: - Lien -, Bailout / Financial Crisis.

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20 Comments Add your own

  • 1. joshmccabe  |  4 September 2009 at 9:04 am

    Besides the fact that this guy had a 200-dollar bill?

  • 2. Mauro Mello Jr.  |  4 September 2009 at 9:19 am

    Was Bastiat in town?

  • 3. claudio  |  4 September 2009 at 9:29 am

    amazing. There is a Portuguese version of this story. I wrote my own version, in Portuguese, changing this strange story (which occurs without time, transaction costs, etc). In my example (in Portuguese here: http://gustibusgustibus.wordpress.com/2009/08/28/quando-a-moeda-circula-nem-sempre-a-economia-prospera/), the owner of the hotel gains 100% more at the end. And there is no “grabbed money”.

  • 4. Mauro Mello Jr.  |  4 September 2009 at 9:31 am

    … and is it by chance the small town of Mobile, as in Perpetuum Mobile?

  • 5. AGMycroft  |  4 September 2009 at 9:50 am

    F for accounting. Everyone exchanged $200 owed for them for $200 owed TO them; this is a simple settling of outstanding accounts and didn’t affect anyone’s net position.

    Why optimism should return by everyone in town exchanging $200 of accounts receivable for $200 of accounts payable is beyond me! This assertion is like the recent psychological study that shows that taking cash out of the bank, counting it, and then redepositing it makes people happier. If it works, go for it — but it’s hard to claim any deep economic significance to it.

  • 6. Peter Klein  |  4 September 2009 at 9:59 am

    Josh, Lasse must have been thinking of a EUR 200 note. It couldn’t have been Norwegian kroner, as NKK 200 would barely buy a candy bar from the minibar of a Norwegian hotel.

  • 7. Austin  |  4 September 2009 at 10:14 am

    Mycroft,

    Is it irrational that a $200 interest-free loan caused everybody to gain optimism at the end of the day? When everybody was $200 in the hole, there was uncertainty that debts might not be paid back. I think it’s reasonable that the “loan” from the tourist, enabling everybody to clear their debts, brought back optimism; there’s nobody that can renege anymore. Looking at it in accounting terms, like you are, will always be misleading because assets and liabilities always net to zero (short of loan defaults) but explain nothing going on within.

  • 8. David Gerard  |  4 September 2009 at 11:01 am

    A $200 prostitutes in a small town would generally only be available to the likes of Richard Gere and Eliot Spitzer.

  • 9. srikanth thunga  |  4 September 2009 at 12:19 pm

    2 things are not captured/wrong in the story
    1. the story is so simple that transaction costs seem ridiculous (as someone has already commented above)
    2. the story ignores a fundamental concept of money/finance.. time value of money.. money needs to keep appreciating.. if you assume that the same process takes 15 days, someone lost interest on those 15 days OR the inflation would have reduced the purchasing power of 200..

  • 10. srikanth thunga  |  4 September 2009 at 12:25 pm

    what if we change the story a little?

    assume the hotel mgr borrowed 200 from someone saying that he will give it back when the prostitute gives it back to him.. assuming a zero inflation economy where no interest is paid on money, …

    what if I include a small interest rate? will it be carried throughout the system?

  • 11. David G. Hoopes  |  4 September 2009 at 8:11 pm

    Everyone owed $200 and was owed $200. Having a currency with which to settle accounts allowed people with varying needs and talents to carry out exchange. Seems like a story that explains why having a currency is more efficient than having a barter system.

  • 12. Mauro Mello Jr.  |  5 September 2009 at 6:09 am

    The tourist might as well have left his hat on the counter, on which the hotel manager could have scrawled “US$200” and used it to start the quasi-circular debt-canceling exercise.

    No hat? Make it a $200 check. The hotel manager would have to accept it (or the hat) from the prostitute, knowing that he could be obliged to return it to the tourist — and return to the initial state.

    The city is not debt-free.

    There is no exchange of anything between the hotel manager and the tourist! (Hence one cannot even consider transaction costs in this argument as there is no exchange of anything across a technologically-separable interface.)

  • 13. James Boudreau  |  5 September 2009 at 11:27 am

    What’s wrong is the closed cycle of obligations. That is what makes the $200 bill (or check, or hat, etc.) irrelevant. The puzzle breaks down as soon as one of the agents involved is owed but does not owe anyone else.

  • 14. ßadaßing  |  5 September 2009 at 1:06 pm

    the funniest thing about that is story seems to be that its meaning/flaws are seriously discussed here…

  • 15. Amit Gal  |  5 September 2009 at 8:35 pm

    What is an interesting question for me in this story is how such debt cycles are revealed. I have no problems with interest and inflation free markets and with 0 transaction costs, and I can even accept the assumption that there is no uncertainty about debts eventually being paid. Given these, the only problem is inforational. How can people detect such cycles so they can eliminate debt. Here the 200 bill carries no value in money, but serves as an information carrier.

  • 16. Lasse  |  6 September 2009 at 12:22 pm

    Hey Josh, who said it was a US-bill?

    Anyway, the story didn’t come with a definitive answer. So anyones guess is as good as mine. My interpretation, though, is that apart from the credit risk being eliminated, the town is not any more well off than before. So perhaps comment # 14 is the appropriate one :-)

  • 17. Michael Ling  |  7 September 2009 at 4:53 am

    Hi Peter,

    Each person in the town has a net position of $0 and, as a result, the net position of the town is $0. It might have a cashflow problem if the due date of the money he/she owed to someone is sooner than the date money is due back from his/her debtor. In one scenario, if they all come together and net out their positions, then they surely can declare their town debt free.

    What the tourist has done is creating the opportunity for the town to initiate the debt recovery/collection, which is analogous to netting out each one’s position.

    Regards
    Michael

  • 18. AGMycroft  |  7 September 2009 at 1:31 pm

    Voluntariy paying off these non-interest-bearing debts is irrational. You still bear the credit risk from those who owe you, but are giving a gift (equal to the probability you default time s the size of the debt) to those you pay — effectively converting their risky asset to a risk-free one without discounting the principal. There ought to be a discount applied to the settlement of these debts that can overcome the lack of liquidity in the economy.

    The way the story SHOULD go is,

    The customer negotiates a cash discount of 5% by paying up-front, but the hotelier doesn’t have change for the $200 bill. While the customer is looking at the rooms, the hotelier takes the bill out to pay his debt. The hotelier negotiated to pay his $200 debt for $190 and received $10 back in change in consideration for his extinguishing the debt. So did the others in turn (passing the $200 bill along in each case, paying out $10 when they take the bill and receiving $10 when they pass it on.) Then when the courtesan returns the bill to the hotelier, he gives her the $10 in change he was intending to give to the guest. Good thing the guest doesn’t want the room; he receives the $200 bill back “unchanged.” Note how the temporary availability of the $200 allows the transactions to proceed!

  • 19. E=mc2butCrash=cdo2  |  10 September 2009 at 7:44 am

    Yes, it’s funny how all those recycling this old chestnut think it somehow proves that a temporary money expansion works in restoring prosperity (which to the mainstream only needs ‘optimism’ to return), when all that was actually needed was a clearing house. The adjunct to this is the other fallacy that for every monetary loser (say, a stock investor) there must be a corresponding winner (the guy who sold to him) so no aggregate loss can ever appear in a closed system.

  • 20. A parable of how to solve a financial crisis | Medianism.Org  |  25 September 2015 at 11:22 am

    […] Lien posted a simple story about how a change in the money supply can reduce transactions costs and eliminate debt.  When the […]

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