# Can wealth be destroyed or merely transferred?



## darkhorse70 (22 July 2014)

For example if the stock market crashes, and billions or trillions vanish does wealth simply vanish or is just transferred from one hand to another. For example wealth is created in a bull market for person A and wealth is lost in a bear market for person B so its essentially equal? Is that correct or incorrect.


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## minwa (22 July 2014)

Transferred.

If a share goes to zero the stockholder loses and whoever sold it to him last gained the cash. The "wealth" that's transferred is in the form of that cash which that person may have invested into other things or taken out as cash to spend on other things. If a share to went to 0 you can bet that the people who short sold the share or held puts will want to get their cash. 

Maybe in a total collapse of the stock exchange system or financial system and the exchange does not honor/sort out counter party risk then is wealth destroyed. Then again, in that case the exchange gains the wealth by paying less than they owed.


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## cynic (22 July 2014)

A further aspect needs to be considered, namely the illusion of wealth creation/destruction that is caused by the process of "marking to market".

e.g. if 10 traders start their portfolio by buying equal quantities of all floated shares of XYZ for $10ps and the only subsequent trade for that day was one of those traders selling his/her XYZ shares for $11ps, then how would one account for the entirety of the 10% paper profit that would be deemed to have appeared on the remaining 9 shareholders' portfolios when only 1/10 of 10% (i.e. 1%) of real wealth was added to the total shares on issue?


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## Value Collector (22 July 2014)

Companies can destroy wealth, 

If a company builds a $1billion oil rig, and it blows up and sinks to the ocean floor, that $1billion asset is gone, the loss might be spread around by insurance, but still our economy has lost a $1billion asset


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## Knobby22 (22 July 2014)

I agree. Wealth is not like entropy. it is continually created and destroyed.

In a stockmarket crash, not every share is shorted so wealth is destroyed.
If a person buys a share at $1 and sells at 10c, then he is undergoing wealth destruction. True the person who sold the share at $1 still retains the $1 and the person who buys the share at 10c still has the share but the person in he middle of the transaction has lost 90% of his wealth due to that company.

Growth has made us all wealthier, we are far wealthier due to advances in technology, efficiency of services, supply chains and manufacturing. If oil say went to $100 a litre we would all be poorer in today's world as food etc. would be more expensive.


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## darkhorse70 (22 July 2014)

Thanks for the reply guys.  Im goung to assume it can be created and destroyed then. The illusion is to mind boggling for me to grasp haha. I had to ask this qs or I couldnt go to sleep. The example im going to use is that if I bought a vehicle off a car maker then I recieve an asset and he recieves money. If I crash the vehicle then I have lost wealth (no insurance). Its vanished? Disregard depreciation etc. In reality the wealth of that asset was consumed into thin air. Haha I wonder if this subjectis debatable by economusts. Watching a doco yesterday about economists who argue that humans are rational investors vs they are not.


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## So_Cynical (22 July 2014)

I think there is a creation and destruction cycle going on with an element of transference.


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## minwa (22 July 2014)

Value Collector said:


> Companies can destroy wealth,
> 
> If a company builds a $1billion oil rig, and it blows up and sinks to the ocean floor, that $1billion asset is gone, the loss might be spread around by insurance, but still our economy has lost a $1billion asset




We're talking about the stock market. Obviously in the real world wealth can be destroyed.



Knobby22 said:


> I agree. Wealth is not like entropy. it is continually created and destroyed.
> 
> In a stockmarket crash, not every share is shorted so wealth is destroyed.
> If a person buys a share at $1 and sells at 10c, then he is undergoing wealth destruction. True the person who sold the share at $1 still retains the $1 and the person who buys the share at 10c still has the share but the person in he middle of the transaction has lost 90% of his wealth due to that company.




Every share IS SHORTED. For shares to start trading they must be SOLD to the market. The company retains the short position until they buyback the shares. For 100 shares to begin trading on the market, the company has to sell 100 shares to the market. There has to be a seller for there to be a buyer. The 100 issued shares to be traded on the exchange DOES NOT CHANGE unless split/buyback occurs. There has to be a -100 position/+100 position for the shares to continue trading. It is then traded around by the market participants.

In your example of a crash assuming the company initially started trading at $1, $1 of cash is gained by the company. Price goes to 10c, stockholder(the shares traded on the market) lost 90c. So what happens here ?

Company gains 90c of wealth. (+$1 cash minus 10c of liability (current share price) = +90c.
Stockholder loses 90c of wealth. (-$1 cash minus 10c of asset (the shares)) = -90c.

You might say in a stock market crash the company loses wealth too as well as investors. Has it really ? 
Before a crash the company:
-holds $2 of cash
-holds $4 in real assets
-owes $1 to shareholders
total $5

After the crash the company:
-holds $2 of cash
-holds $4 in real assets
-owes $0.10 to shareholders
total $5.90

Where did the extra 90c come from ? Sentiment only affects stock market prices NOT real assets. Your tractor can can carry 100kgs of coal today. It will also carry 100kgs of coal tomorrow after a stock market crash.

Wealth is simply transferred WITHIN the stock market. Zero sum. 1 + 1 has to = 2.

Whatever happens in the middle does not matter. It might've been traded 100 or 1000 times, spread made by market makers, commissions made by brokers - wealth is simply transferred within there.




Knobby22 said:


> Growth has made us all wealthier, we are far wealthier due to advances in technology, efficiency of services, supply chains and manufacturing. If oil say went to $100 a litre we would all be poorer in today's world as food etc. would be more expensive.




True, outside the stock market. Although if oil went to $100 a litre we wouldn't ALL be poorer. The Arabs and oil investors will be laughing again. But you are right, real growth in the real world made us all wealthier.


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## Value Collector (22 July 2014)

minwa said:


> We're talking about the stock market. Obviously in the real world wealth can be destroyed.




The stock market is just a list of real world companies. Any wealth destroyed In the "real world" is going to affect the stock market.

Eg. If that Oil rig I described is owned by BHP or Insured By QBE it will affect those shares.


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## Knobby22 (22 July 2014)

minwa said:


> In your example of a crash assuming the company initially started trading at $1, $1 of cash is gained by the company. Price goes to 10c, stockholder(the shares traded on the market) lost 90c. So what happens here ?
> 
> Company gains 90c of wealth. (+$1 cash minus 10c of liability (current share price) = +90c.
> Stockholder loses 90c of wealth. (-$1 cash minus 10c of asset (the shares)) = -90c.
> ...




I disagree. The purpose of a company is to make profits, not collect assets. There are plenty of companies with little in the ways of assets that are worth heaps.

Let's take a real world example, Fortescue.

If the iron ore price drops to $50, suddenly Fortescue is not profitable. It's assets are worth less. The share price drops. The company may even go broke. 

Then you have high asset companies like Qantas. Sure they own planes and airport terminal rights but if they go broke, selling the planes is not going to cover the losses.   

Flight Centre, a highly successful company that's only decent asset is its recognised name. If there is a change in consumer behaviour and their profit drops by half, then the share price will similarly fall.

Summarising

Before a crash the company:
-holds $2 of debt   (most companies are leveraged)
-holds $5 in real assets
-owes $0 to shareholders (not true, the company doesn't owe anything to the shareholders, you are buying a share of a company.)
total $3

After the crash the company:
-holds $2 of debt
-holds $3 in real assets (assets devalue due to lower profits/crashing values)

total $1   the company is in danger of going broke if they start making losses.


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## Knobby22 (22 July 2014)

minwa said:


> In your example of a crash assuming the company initially started trading at $1, $1 of cash is gained by the company. Price goes to 10c, stockholder(the shares traded on the market) lost 90c. So what happens here ?
> 
> Company gains 90c of wealth. (+$1 cash minus 10c of liability (current share price) = +90c.
> Stockholder loses 90c of wealth. (-$1 cash minus 10c of asset (the shares)) = -90c.
> ...




I disagree. The purpose of a company is to make profits, not collect assets. There are plenty of companies with little in the ways of assets that are worth heaps.

Let's take a real world example, Fortescue.

If the iron ore price drops to $50, suddenly Fortescue is not profitable. It's assets are worth less. The share price drops. The company may even go broke. 

Then you have high asset companies like Qantas. Sure they own planes and airport terminal rights but if they go broke, selling the planes is not going to cover the losses.   

Flight Centre, a highly successful company that's only decent asset is its recognised name. If there is a change in consumer behaviour and their profit drops by half, then the share price will similarly fall.

Summarising

Before a crash the company:
-holds $2 of debt   (most companies are leveraged)
-holds $5 in real assets
-owes $0 to shareholders (the company doesn't owe anything to the shareholders, you are buying a share of a company.)
makes healthy profits
total $3  but this is not true, invstors buy on profits so say P/E ratio is 14 and the company is providing eps of 50c then price is $7

After the crash the company (and recession):
-holds $2 of debt
-holds $3 in real assets (assets devalue due to lower profits/crashing values)
Profit drops to 10c eps, Assuming P/E vale remains at 14 Sp is $1.40 however if the company starts losing money, then the banks may foreclose.


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## Value Collector (22 July 2014)

darkhorse70 said:


> For example if the stock market crashes, and billions or trillions vanish does wealth simply vanish or is just transferred from one hand to another. For example wealth is created in a bull market for person A and wealth is lost in a bear market for person B so its essentially equal? Is that correct or incorrect.




I suppose you could ask the question "Did the wealth exist"

for example if a companies shares are trading at $10, and there are 1million shares, the company is worth $10Million dollars.

But if I buy the last share traded that day, and I by it for $100, Suddenly the company will be quoted as being worth $100Million, Did me buying one share for $100 really create $90,000,000 in value? and if tomorrow some one sells a share for $5 was $95,000,000 really lost


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## minwa (22 July 2014)

Value Collector said:


> The stock market is just a list of real world companies. Any wealth destroyed In the "real world" is going to affect the stock market.
> 
> Eg. If that Oil rig I described is owned by BHP or Insured By QBE it will affect those shares.




Not true. If oil rig blows up and no one except BHP knows about it and they decide to go fraud route and clean it up quietly and not disclose it, stock market is NOT affected. Real wealth destroyed yes, stock not affected. Fradulent accountants prove this by cooking the books - company is doing bad in the real world, real wealth decrease, but on paper it's going great, stock market not affected as market participants have no knowledge of the fraud. Stock price is affected by SENTIMENT not real wealth. ONLY if the real wealth causes the sentiment to shift does it cause the movement, but not always the case.



Knobby22 said:


> I disagree. The purpose of a company is to make profits, not collect assets. There are plenty of companies with little in the ways of assets that are worth heaps.
> 
> Let's take a real world example, Fortescue.
> 
> ...




I did not state the purpose of the company is to collect assets. Accounting equation: Assets = Liabilities + Owner's Equity. The company owes the shares to the shareholders in basic accounting terms - you can call it debt, owing, equity, whatever - it falls under the same side on the accounting equation. For assets to increase when they raise cash from issue stocks - the owner's equity/liability side has to increase.

You automatically link stock market crash = real assets devalued/profits drop. Not true. As above, you are missing that investor sentiment decides share prices. A company can be making big profits in the real world and have its share price drop.


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## darkhorse70 (22 July 2014)

Haha value collector. Im just going to assume that wealth is transferred in the stock markets but can be destroyed in real life scenarios? The real question is does understanding this concept make me a better trader haha


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## Wysiwyg (22 July 2014)

darkhorse70 said:


> The real question is does understanding this concept make me a better trader haha



That depends on how you apply this understanding. Manage the risk.


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## Knobby22 (22 July 2014)

minwa said:


> You automatically link stock market crash = real assets devalued/profits drop. Not true. As above, you are missing that investor sentiment decides share prices. A company can be making big profits in the real world and have its share price drop.




True, sentiment is one of the factors that decides share prices. What I don't like about this argument is that if the price falls then it must be a bargain. It equally could be that the fundamentals have changed within the business and only the insiders know or the macroeconomics have changed and everyone hasn't realised it yet.

Fundamentals decide share prices and though the price is connected by the elastic band that is sentiment, fundamentals ultimately set the anchor.


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## minwa (22 July 2014)

Knobby22 said:


> True, sentiment is one of the factors that decides share prices. What I don't like about this argument is that if the price falls then it must be a bargain. It equally could be that the fundamentals have changed within the business and only the insiders know or the macroeconomics have changed and everyone hasn't realised it yet.
> 
> Fundamentals decide share prices and though the price is connected by the elastic band that is sentiment, fundamentals ultimately set the anchor.




Fundamentals decide prices in the future or not is a neverending discussion..but for TODAY's price, fundamental does not decide the price otherwise there would no bid & ask, no trading, just one price, THE price.



darkhorse70 said:


> Haha value collector. Im just going to assume that wealth is transferred in the stock markets but can be destroyed in real life scenarios? The real question is does understanding this concept make me a better trader haha




If you understand the zero sum concept of trading it may cause you to think more before you enter a position. Why does the person taking your other side of the trade have enough conviction to take that position against you ? We all have the same fundamental reports/price data charts..it's how differently we interpret those information and willing to risk money to speculate those views that makes the market. 

We all know to buy low sell high or sell high buy low. To enter a order with a good chance of getting filled you have to buy closer to the ask and sell closer to the bid. That goes against buy low/sell high principle. So you must have a pretty strong view to execute the trade against the principle of making money. Think about that view and know that there is someone else with the opposite of that view.


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## Klogg (22 July 2014)

darkhorse70 said:


> For example if the stock market crashes, and billions or trillions vanish does wealth simply vanish or is just transferred from one hand to another. For example wealth is created in a bull market for person A and wealth is lost in a bear market for person B so its essentially equal? Is that correct or incorrect.




In the context of only a market in its purest sense, then yes, its transfered. But it's never that simple. Consider the effects of margin lending (and interest paid), trading costs, dividends, etc. If you consider these to be separate from 'the market', then yes, it's a transfer of wealth.

For example:
Person A buys Company A for $100. Holds for 1 year, receives $20 in dividends, sells for $80 to Person B.
Each paid $1 in trading costs

Net change in wealth for Person A = $20 (dividend received) - $1 cost = $19
Net change in wealth for Person B = $0 ($80 in cash to $80 in shares) - $1 cost = -$1
Change in total wealth = $18

To really understand it, I'd suggest reading up on the fractional reserve banking system, as this ultimately dictates the total money supply (i.e. total amount of 'wealth')


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## minwa (22 July 2014)

Klogg said:


> For example:
> Person A buys Company A for $100. Holds for 1 year, receives $20 in dividends, sells for $80 to Person B.
> Each paid $1 in trading costs
> 
> ...




You have to subtract the loss for buying for $100 and selling for $80 for Person A ? Person A = -$1 from trading costs, same as Person B. Change in total wealth for the traders = -$2, just trading costs "wealth" which is transferred to the broker who +$2.


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## Smurf1976 (22 July 2014)

Stock market crash = "paper" wealth is destroyed and to some extent transferred. A portfolio worth $100K is now worth $50K - the paper wealth has disappeared. 

Real, tangible wealth hasn't changed however - if the company owns a coal mine with 100 million tonnes of coal in the ground and associated mining equipment etc then they've still got the mine, coal and machinery whether the share price is $1 or $100. Who owns the shares and their market value has changed, but the physical assets are still there.

Oil rig sinks etc - real wealth has been lost regardless of what happens to the share price. We had a working oil rig, now we don't. It's gone.

If real estate crashes then the "paper" value of my house will be reduced. But it has no impact at all on the utility function of the house - I can still live in it just the same whether it's worth $350K or just $350. But if it burns down then wealth has been destroyed no matter who incurs the cost - me or the insurer.


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## darkhorse70 (22 July 2014)

Wysiwyg part of my risk management concept is to have an understanding of the bigger picture of the economy as a whole just to aid my technical decisions. The problem is figuring out what is important and what is junk haha.
Minwa well when I look at a chart it is my hope that im seeing some thing others arent. Im also hoping the guy on the other side of the trade is the chump and not me haha. Klogg ive sort of read the fraction reserve banking system in my finance subject I think. Ill look it up again however. I feel like ill never be a successful trader if I dont understand the sinplest of subjects and the over all financial system.


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## Value Collector (23 July 2014)

Knobby22 said:


> I disagree. The purpose of a company is to make profits, not collect assets. There are plenty of companies with little in the ways of assets that are worth heaps.




The purpose of a company is to make profits, and if it can, use those profits to collect more high returning assets.

Look at Berkshire Hathaway, collecting assets is what it does, and its share price has gone from $9 to over $192,000 per share.


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## qldfrog (23 July 2014)

My own view:
It could be argued that buffettt has not "created" any wealth, merely extracted $ from others pockets;
In my opinion, it is always back to the basic:
a company/business/person only create wealth if it add "value":
ie gather berries, create jam-> result product jam as more value than the raw berries;
so only the wealth creation come from 

manufacturing and a small amount in service(the physical work attached: coffee maker, cook), 
agriculture (ie sun working for you),
 mining

 (well maybe  just as long as you consider as in australia that a mining company can steal resource from a country citizen at barely any cost: no iron/coal get created on our timeline, and the processing adding value pick it up and put it in a truck is actually quite low)

financial wealth creation (interest, market(shares), etc) is justtransfer and vapourware on the grand scheme of things.
but I am happy with the system and do not reject my TD interest or the RE capital gain...


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## DeepState (23 July 2014)

qldfrog said:


> It could be argued that buffettt has not "created" any wealth, merely extracted $ from others pockets...
> 
> ...financial wealth creation (interest, market(shares), etc) is justtransfer and vapourware on the grand scheme of things. but I am happy with the system and do not reject my TD interest or the RE capital gain...




In relation to the above, please consider the net wealth of society that we have vs the one which would exist without the presence of banking and capital markets.  The difference is vast and that difference is the value add from financial markets given a set of primary production activity.  The alternative is a strict barter economy.

The question of wealth creation and destruction is actually one of relativity. Either case, destruction/transference, can be reasonably argued.  We are used to seeing this from the perspective of immediate monetary mark to market value. We generally frame our thinking in this way. But this is just one perspective and one definition of wealth.  It is not the only valid one. Change your definition of wealth to another very reasonable one and your answer changes.  Secondly, within the most common framework we use, there is the definition of mark to market wealth and underlying, intrinsic wealth.  It is possible to destroy both or each individually. Indeed, they can move in opposing directions.


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## Value Collector (23 July 2014)

> My own view:
> It could be argued that buffettt has not "created" any wealth, merely extracted $ from others pockets;








My comment was relating to one someone made saying the point of a company was to make profit not collect assets, My point was that the two go hand in hand. 




> In my opinion, it is always back to the basic:
> a company/business/person only create wealth if it add "value":
> ie gather berries, create jam-> result product jam as more value than the raw berries;
> so only the wealth creation come from




Don't you think many companies inside warrens Berkshire Hathaway do just that, eg, coca cola company turns raw aluminium and corn syrup into cans of coke, he has many manufacturing businesses inside his company



> (well maybe  just as long as you consider as in australia that a mining company can steal resource from a country citizen at barely any cost: no iron/coal get created on our timeline, and the processing adding value pick it up and put it in a truck is actually quite low)




I think a tonne of coal sitting at the gate of a power station is more valueable that one buried 100M below the surface, and one we have found sitting 100M below the service is more value than one we haven't found yet.

So I think mining companies generate value all the way through exploration and production process, Not to mention the manufacturing industries can not exist without raw material. So the primary ( mining farming etc)industries are the ultimate 



> financial wealth creation (interest, market(shares), etc) is justtransfer and vapourware on the grand scheme of things.
> but I am happy with the system and do not reject my TD interest or the RE capital gain...




I don't agree, The financial and investment industry does help generate real value, If you took out all the loans and investor capital out of the mining, farming, Transport, Infrastructure and manufacturing industries there would be almost none of the projects in existence that you say generate value.


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## qldfrog (23 July 2014)

Sure money is an enabler: a loan enables the farmer to buy atractor and then create wealth, without that money I do not deny the wealth would decrease as the field would not be harvested, but is the financial system (aka loan generating wealth ? not in my view)
idem Buffet, yes he "owns" factories etc and yes these generate real wealth but the Berkshier share increasing in value does not add wealth, it is just a reflection of the underlying assets productivity(when it is linked ->usually a very elastic link! as per PE variation along cycles)


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## Smurf1976 (23 July 2014)

Value Collector said:


> I don't agree, The financial and investment industry does help generate real value, If you took out all the loans and investor capital out of the mining, farming, Transport, Infrastructure and manufacturing industries there would be almost none of the projects in existence that you say generate value.




Agreed that finance is an enabler certainly.

But if the share market drops 50% then that is a loss of "paper" wealth only. The mines, farms, trucks and so on are still exactly the same as they were when the share price was higher. Nothing has happened to that "real" wealth, it's only the "paper" aspect that has changed.

A dam, canal, penstocks and power station is a real, physical asset. It takes something of little or no value "as is" (water) and turns it into something of real use (ie electricity). You can see and touch those physical assets, they are absolutely real and relatively permanent. On the other hand, simply speculating on the price of electricity is transferring wealth - a megawatt hour is still a megawatt hour whether it sells for $10 or $10,000 (and both those extremes are reached from time to time in the electricity market).

Lending money to build the dam or coal mine and the power station etc is certainly enabling the physical production of electricity. Speculating on the price of the product isn't - it's just transferring wealth from one party to another. Same with anything from steel to soft drinks.


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## luutzu (23 July 2014)

qldfrog said:


> Sure money is an enabler: a loan enables the farmer to buy atractor and then create wealth, without that money I do not deny the wealth would decrease as the field would not be harvested, but is the financial system (aka loan generating wealth ? not in my view)
> idem Buffet, yes he "owns" factories etc and yes these generate real wealth but the Berkshier share increasing in value does not add wealth, it is just a reflection of the underlying assets productivity(when it is linked ->usually a very elastic link! as per PE variation along cycles)




Wouldn't that make the loan a two bird with one stone value creator?  That it enable value to the farmer AND it brings value (in terms of interests) for the lender.

Without money, nothing will get done - no one would work for free, and the entrepreneur that does do so in hope of getting a big return in the future.

Without money and a good mind behind it, things can get done, but done badly and often wastefully - destroying both the capital, the opportunity that that capital would otherwise have been employed and waste the potential value on projects that a good capitalist would have demanded more research or planning before investing in. 

I mean, what sane investor would fund a recent Chinese water cannon that shoots water vapour 300m into the air to soak up air pollution. But it was done at a cost of some $US160K each - and then realised the water droplets are too large to soak up air particles, and we all know a super vacuum cleaner would do a better job.


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## DeepState (24 July 2014)

qldfrog said:


> Sure money is an enabler: a loan enables the farmer to buy atractor and then create wealth, without that money I do not deny the wealth would decrease as the field would not be harvested, but is the financial system (aka loan generating wealth ? not in my view)




When the farm produce is created but stays at the farm to rot, was value actually created?

If not, then if there was transport to get to a market where produce could be bartered, is the transportation merely enabling, or is it value creating?

What if, the watermelons go to market by magic, but just rot?  Was value ever created?

When the watermelon actually is exchanged for something the producer values, value is created.  Somewhere between the thing just rotting in the market and being sold, value was created.  That transaction required effort.  The person doing it produced a transaction.  The same way that his Dad produced a watermelon.  Without both, there is no value creation.

If not, then is the person who made hats to protect the farmer whilst tilling the fields really adding value, or just enabling?

Where does the border of production end and enabling begin?

If buying and selling goods is production, is buying and selling a service just enabling or is it value accretive? Services represent far more of the economy now than primary production.

If a service like examining the fields and offering advice on which way to hoe it is a value accretive service, and/or transport is a value accretive service then money exchange, securitisation, deposit taking and lending are also services as they are essentially the transport of money. The loan involved securing deposits, checking ability to pay...this could also take place in a barter economy and would require the 'services' of some guy running around trying to barter goods for everything else and excess watermelons for the promise of a woollen coat in 3 months (which is the barter equivalent of bond issuance).  He is engaging in banking.


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## DeepState (24 July 2014)

Smurf1976 said:


> Speculating on the price of the product isn't - it's just transferring wealth from one party to another. Same with anything from steel to soft drinks.




Without the process of subsequent price discovery, how will the primary markets function?  Their presence creates economic value by fostering more efficient uses of capital and providing liquidity as well as offering a price discovery mechanism.  Without these, there would be a primary market consisting of buy and hold to maturity assets. Producers of steel would not be able to hedge their production or cost inputs, making them far more risk averse and dropping the ROA. The absence of a secondary market would also greatly increase cost of capital and, in combination, reduce economic production.


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## qldfrog (24 July 2014)

I never argued against $/finance system, just different view as to whether finance actually create wealth which I bring down to value  as for me, it is only by creating value that wealth can increase and not be just transfered.
knowledge can be a created value (was discussed in both exploration in mining/actual loan check etc in finance industry) but still find it hard to see a major value creation in the finance industry /system;
there are some good point:
easier to transport/transfer via netbank $1000 than giving a few tonnes of carrots to pay your electricity bill;
money is lighter will save time/fuel/wear and tears on your vehicle..yes there is so value on top of the enabling facility, but is any financial tool or exchange (it is called exchange BTW) creating any real world value.
I am still unconvinced
and my apologies for the typos, always typing in a rush last few days
have all a great day, an interesting thread indeed


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## DeepState (24 July 2014)

qldfrog said:


> I never argued against $/finance system, just different view as to whether finance actually create wealth which I bring down to value  as for me, it is only by creating value that wealth can increase and not be just transfered.
> 
> ...I am still unconvinced
> 
> ...an interesting thread indeed




Fascinating how an ostensibly simple question can lead to this.  There is actually no correct answer, in my view.  Per previous post, it depends on your definition of wealth.  Yours is perfectly reasonable. Primary production. All other activity is housed within it.  It just differs from the way the National Accounts are structured and how some others think about it.  Who says they are right?  It's just an opinion. There are much wilder but possibly more accurate definitions out there. 

If I inferred you said that finance does not add value in some way as an enabler, then I withdraw whatever statement led to that belief.  I do not believe that you ever said that.


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## qldfrog (24 July 2014)

DeepState said:


> If I inferred you said that finance does not add value in some way as an enabler, then I withdraw whatever statement led to that belief.  I do not believe that you ever said that.



no worries there, we are all probably all on the same page.
The further I dig in the less black and white the answer becomes, at least as I see thing;
I is also interesting to see how Smurf and I share so many views, I would say probably as we both have an engineering background [only guessing by the history in various thread].
It is good to have these exchanges.


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## Smurf1976 (24 July 2014)

DeepState said:


> Without the process of subsequent price discovery, how will the primary markets function?



No argument that there's a need for markets etc.

I could perhaps refine my point to distinguish markets in terms of speculation and non-speculative activity. Lending money, hedging and so on all enables production. But if the price of BHP shares drops 10% tomorrow, nothing physically has been lost. Some numbers changed on a computer, that's it really. The iron ore etc is still in the ground and still being mined just as it was today. 

As a practical example, they've been mining brown coal and using it to generate power at Yallourn (Vic) since 1924. It was 1995, 71 years later, when the concept of a financial market for the product (ie electricity) emerged and even today there is still no financial market at all for the coal itself. 

That lack of ability to speculate didn't in any way stop the physical assets being built and operated, indeed the maximum rate of production (early 1980's) was long before the concept of a trading market had been thought of.

So using the Yallourn example, yes you need a financial market to provide capital for construction etc but you sure don't need the ability to speculate upon the price of the product in order to produce it.


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## John H2O (24 July 2014)

Stock market crashes are a great income earner for the US. Mum and Dad from Australia, UK, or wherever invest $100K in the latest dot.com that money is paid mainly to US citizens who build houses etc. The dot.com goes bust and the money is lost to Mum and Dad in Australia etc and stays in the US. Same deal with sub-prime.

Maybe this is the reason why the US and UK don't regulate their financial markets like many would like to see. 



darkhorse70 said:


> For example if the stock market crashes, and billions or trillions vanish does wealth simply vanish or is just transferred from one hand to another. For example wealth is created in a bull market for person A and wealth is lost in a bear market for person B so its essentially equal? Is that correct or incorrect.


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## DeepState (24 July 2014)

Smurf1976 said:


> 1. Lending money, hedging and so on all enables production. But if the price of BHP shares drops 10% tomorrow, nothing physically has been lost. Some numbers changed on a computer, that's it really. The iron ore etc is still in the ground and still being mined just as it was today.
> 
> 2. As a practical example, they've been mining brown coal and using it to generate power at Yallourn (Vic) since 1924. It was 1995, 71 years later, when the concept of a financial market for the product (ie electricity) emerged and even today there is still no financial market at all for the coal itself.
> 
> ...




Since we're chatting....

1. The price we pay for BHP shares is a best guess at the value of residual income to shareholders.  A guess can fail to truly reflect the unobservable value.  It may be that the 10% fall does not reflect the reality of a, say, stable underlying intrinsic value as you have illustrated. In this example, the underlying intrinsic value of BHP is largely unchanged.  We will still see wealth effects flow through to consumption and investment and the economy will shrink at the margin. Perception is, actually, reality.  

2. You do not need a futures market to produce.  But it sure helps. So you can have a coal producer doing its thing without a futures market for coal (one may exist in swaps: http://www.westpac.com.au/docs/pdf/pb/Energy_Swap_PDS.pdf) and coal futures trade on CME.

A gazillion years ago, they took corn off the cob in the wild.  Then agriculture came along and farmed it...without a derivatives market over the top.  But one was formed about 1,000 yrs ago.  The natural position for producers is to hedge. Selling their expected corn production at a forward rate.  This provides certainty and ability to plan.  Having this reduces risk and encourages behavior to extract more value from available investment.  The only people in the other side of the natural position are speculators.  Without them, the futures market cannot exist.  The process by which price discovery is achieved is value additive. All subsequent trade is as per our previous exchange on the value of a secondary market.

Speculators are actually necessary for a functional market and their presence is value creating for an economy as a whole.  That's until they blow a hole though the balance sheet of every investment bank on the planet at one time.  But that's just a blip and we can ignore it as an outlier.....


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## DeepState (24 July 2014)

qldfrog said:


> no worries there, we are all probably all on the same page.
> The further I dig in the less black and white the answer becomes, at least as I see thing;
> I is also interesting to see how Smurf and I share so many views, I would say probably as we both have an engineering background [only guessing by the history in various thread].
> It is good to have these exchanges.




I can understand the perception and perspective you have.  

"What the heck do those finance guys do anyway?" is a very common perspective for people who make stuff.


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## Smurf1976 (24 July 2014)

DeepState said:


> "What the heck do those finance guys do anyway?" is a very common perspective for people who make stuff.




Another one is "it's always the financial people who mess up" and a general thought that "banks ought to be properly regulated".

In terms of regulation etc, the general thought goes along the lines that "finance people" at the global level don't manage risks well enough. Engineering 101 - to the greatest extent possible, no single failure should in any way threaten the whole system. 

That's not always practical, eg if a wing falls off a plane then a crash is inevitable, but there's a good reason why commercial airliners have two or more engines and a lot of redundant systems. Most individual parts can suffer a failure without causing the plane to crash. And wings don't generally fall off planes, they're built such that it's a very unlikely scenario. 

In contrast, the banks etc seem to have all sorts of incredibly complex derivative contracts etc that nobody seems able to fully explain. Nobody seems able to state with confidence that if, to pick a random example, HSBC or JP Morgan goes broke then it won't cause any other bank to also go broke. The thinking is that one bank going bust may well bring the others down too - and that's a completely unacceptable risk in terms of how engineers think. If one bank goes bust, then that should be it. One bank is gone, but the others should be able to carry on without disruption, no one part of the system should threaten the whole in the event that it fails. 

So the perception is that at the global level, "financial people" are doing something with very high consequences in the event of failure, but don't seem to have properly assessed what could go wrong and put in place measures to contain any problem that occurs.


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## DeepState (24 July 2014)

Smurf1976 said:


> Another one is "it's always the financial people who mess up" and a general thought that "banks ought to be properly regulated".
> 
> In terms of regulation etc, the general thought goes along the lines that "finance people" at the global level don't manage risks well enough. Engineering 101 - to the greatest extent possible, no single failure should in any way threaten the whole system.
> 
> ...




There's a pretty big difference between laws of engineering and the laws of capital markets.  A plane engine doesn't change its basic characteristics and is unaware of what is happening in seat 17A. In financial markets, the 'effective agents', which may be organisations or certain groups/people change their connections and alter their perceptions all the time.  This keeps morphing the system behavior.  Large connective hubs get formed and this makes them seriously important organs through which finance is channeled. The bigger you are, the bigger you become because you are big (at least in some key parts). Incentives are such that any law that gets made will be largely circumvented in some form of regulatory arbitrage (hedge funds are replacing trading desks and essentially taking up that behavior and they are exempt from capital requirements).  Individuals are simply doing what they are incented to do.  That often leads to situations where it is in no-one's particular interests (at least no-one who actually calls the shots) to contain systemic risk. 

Financial crisis is not a new feature on our society.  Things like the introduction of central banks, separation of trading from deposit taking institutions, capital requirements, deposit insurance, licensing....have all been added as stabilisers. Yet it keeps happening and more stuff gets added.  You can see the cycles, there is rhythm. It's in the nature of the beast. Do you kill it? Harness it? Cage it? ... do whatever, just don't neuter it.


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## Value Collector (25 July 2014)

The central banking system is meant to beable to step in and stop the whole system from collapsing, and that is what they did, and they would have done it quicker if it wasn't for congress playing chicken to win political points.


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## DeepState (25 July 2014)

Value Collector said:


> The central banking system is meant to beable to step in and stop the whole system from collapsing, and that is what they did, and they would have done it quicker if it wasn't for congress playing chicken to win political points.




It is also strongly argued that CBs contributed to the latest crisis by maintaining interest rates at levels below what, in hindsight, was appropriate and not taking into account growing systemic risk.  Systemic risk was very visible in certain types of credit creation and the implications were actually known.  It was a form of shadow financing in the interbank and corporate short-term financing market together with high leverage against RMBS and CDO still on balance sheet.  It was visible, but the view from the Greenspan Fed was that self-interest would keep the risks contained.  It did not turn out to be so.

Banking systems prior to the advent of central banking did not see the collapse of the entire system either, although the severity and frequency of these stress points was higher than in the time after the creation of central banking at least in the US.  Central banking more generally is the arm through which monetary assets are created and the excess use of seignorage to finance war or other profligate expenditure can collapse economies and monetary systems. This has happened many times in history. Hence confidence in central banking as an independent arm separate from the Treasury is seen to be important.

The Fed was quick and aggressive in taking steps to contain the crisis as facts became available.  Treasury is, however, an arm of government and subject to the usual political process.  Hence initiatives relating to fiscal elements via shoring up of balance sheets via high quality loans from the government etc. were helpful...when they came.  A more troublesome copy of this occurred in Europe where initiatives had to be approved by all countries in the union, each of which has parliaments.  How they did that remains pretty amazing to me, but crisis focusses the mind.  The importance of these actions was very important and separate to those of the central banks.  If these were not forthcoming, the massive destruction of asset value meant that the financial system had actually collapsed.  The banking system was, under consensus belief, insolvent in aggregate.  Sending interest rates to zero or negative and QE could not save the system on its own. Such was the severity of this crisis. The initiatives from Paulson (Treasury Secretary at the time), working in concert with Geithner (who worked in the New York Fed at the time) basically refinanced the banking system and kept it alive long enough for it to return to sufficient health.


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## darkhorse70 (25 July 2014)

So in simple words is there a correct answer haja, my brains cooked


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## skyQuake (25 July 2014)

darkhorse70 said:


> So in simple words is there a correct answer haja, my brains cooked




Take out a $50 and light it on fire = wealth destroyed (personal)


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## DeepState (25 July 2014)

darkhorse70 said:


> So in simple words is there a correct answer haja, my brains cooked




What correct answer?  There isn't one. They are just answers to impossible questions. Some problems don't have answers other than to try and keep the worst from happening as you go.  This is one of them.


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## qldfrog (25 July 2014)

darkhorse70 said:


> So in simple words is there a correct answer haja, my brains cooked



I am afraid there is no "single answer" once you leave Academia and hit the real world, black and white tends to merge into a greyish mush.
Individual will have their own more or less tinted glasses:
yes wealth can be destroyed : a fire, eathquake, a missile in a jet, wars etc
No one denies this
But the  question was asked in the context of financial tools/markets.
Would a share market crash destroy wealth?..
Several way of seing that: "only paper loss with all financial engineering being seen as vapourware overall",
 but if you deepen a bit you quickly see too many examples breaking the nice ideology.

Have I summarised it well gents (and ladies)?


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## Value Collector (25 July 2014)

skyQuake said:


> Take out a $50 and light it on fire = wealth destroyed (personal)




Or have you just increased the value of the remaining notes by the same amount you just destroyed.


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## DeepState (25 July 2014)

Value Collector said:


> Or have you just increased the value of the remaining notes by the same amount you just destroyed.




Gosh this is an interesting thread.

...Only if the money multiplier remains fixed and production is unchanged following this event, or something proportionate to this. This is theoretically possible, but not observed in vivo.


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## darkhorse70 (25 July 2014)

Value Collector said:


> Or have you just increased the value of the remaining notes by the same amount you just destroyed.




Hahaha, I guess I was just asking to get a better understanding of how it could possibly effect the general economic condition if there was a large paper loss or just because it might make me a more intelligent trader.its a bit more clear now. Thanks fellas


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## tech/a (25 July 2014)

Read this book if you have an interest in this topic.

http://www.penguin.com.au/products/9781921880131/extreme-money-masters-universe-and-cult-risk


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## darkhorse70 (25 July 2014)

Thanks tech. Will definitely do.


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## Smurf1976 (25 July 2014)

DeepState said:


> Large connective hubs get formed and this makes them seriously important organs through which finance is channeled. The bigger you are, the bigger you become because you are big (at least in some key parts).




Therein lies the problem. "Too big to fail" is "too big to allow" from a risk management perspective.

To me, it seems that the financial system has gradually changed over the past 40 or so years from being a means of facilitating the "real" economy into a parallel world in its' own right, failure of which seems reasonably possible and involves catastrophic consequences for the "real" economy in addition to the financial world.

As an example, over 1 billion barrels of oil are traded "on paper" every day and yet the world produces only about 90 million actual, real barrels of oil that you can see and touch. That level of trading goes far beyond anything reasonably necessary to enable the buying and selling of real, physical oil and has primarily become an exercise in money shuffling. Go back to 1970 and most oil was sold under long term contract - that's one trade not per barrel but for the entire oil field. And suffice to say that there was plenty of oil being used in 1970, the lack of money shuffling didn't stop the geologists, drilling rigs, pipelines, ships, refineries etc from working.


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## DeepState (25 July 2014)

Smurf1976 said:


> Therein lies the problem. "Too big to fail" is "too big to allow" from a risk management perspective.
> 
> To me, it seems that the financial system has gradually changed over the past 40 or so years from being a means of facilitating the "real" economy into a parallel world in its' own right, failure of which seems reasonably possible and involves catastrophic consequences for the "real" economy in addition to the financial world.
> 
> As an example, over 1 billion barrels of oil are traded "on paper" every day and yet the world produces only about 90 million actual, real barrels of oil that you can see and touch. That level of trading goes far beyond anything reasonably necessary to enable the buying and selling of real, physical oil and has primarily become an exercise in money shuffling. Go back to 1970 and most oil was sold under long term contract - that's one trade not per barrel but for the entire oil field. And suffice to say that there was plenty of oil being used in 1970, the lack of money shuffling didn't stop the geologists, drilling rigs, pipelines, ships, refineries etc from working.




Yep, agreed on both fronts.  

So the powers that be are trying to ensure that no node is important enough to take out the system.  Furthermore, they are working to ensure that no group of interlinked nodes can take out the system.  They are also trying to stabilize it by ensuring that banks have more regulatory capital with Basel III and all its variants.  Principal risk has become so expensive in terms of capital requirements that the major investment banks have largely shut these down, becoming brokers in a purer sense.  Risk taking activity has moved more towards funds management and hedge fund management.  Perhaps they'll be in a better position to take it and are more transparent in terms of credit provision for leverage.  There are also moves to centralize OTC derivatives and have them cleared and collateralized.  If achievable, all of these will reduce systemic risk.

What you describe in terms of derivative activity relative to actual underlying activity is crazy isn't it.  But it is symptomatic to sharing the burden of risk across several counterparties and increasing interlinkage and 'complexity'.  It's partly for the same reason that FFX activity vastly outstrips world trade.  However, it is also symptomatic of excess speculation.

Today deals like the Chinese purchase of Russian oil are also multi-decade arrangements which are akin to your oil example.  However, the volume is contracted but price fluctuations probably appear somewhere. Same deal with Japanese long term contracts for our LNG. Some of this will still need to be hedged by gas fired generators in Japan or bulk consumers of electricity.  Risk sharing, liquidity and securitization are important.  Whilst things can happen without it, much more happens with it....except some of it is bad.  How do you sort out the wheat from the chaff?  It's pretty tough when the system seems to want to find a way to turn into chaff when there is a buck to make. Still, you gotta try and restrain it. However, dragging it back twenty or forty years would very probably squash our standard of living quite a bit more than the GFC did.

Interestingly, part of the problem is that finance is becoming very 'complex'.  Everything is linked to everything.  No-one knows how the whole thing works.  Prod here, something, somewhere pokes out.  But you don't know where.

This is happening to the world production economy.  Production chains are getting longer and longer as various productivity enhancements are sought around the world.  As a result there are an ever increasing number of parts generated all over the place to produce a single product.  When one link goes, the whole production line stops.  This happened to car production around the world for certain makes when the Japanese tsumani occurred.  It was an indication of the vulnerability of our production chains. Similarly oil is too big to fail.

It's all a very delicate dance and it is unstable (on the border of chaos and complexity) in nature.


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