Circle of Debt- Solution

Circle of Debt- Solution

Question

It’s a rainy day in a distant town secluded from the busy life of Mumbai. Because of very heavy showers, the streets are completely vacant. With the crumbling economy and poor employment, everybody in the town is in debt and everybody lives on credit.

Solution of circle of debt in share market

On one of these days, a tourist from Spain was driving through the town. Due to the heavy showers and minimal visibility, he plans to spend the day in a hotel. He comes inside the hotel front desk and placed a thousand rupees note and mentions that he would first want to inspect the rooms and select the one which he would prefer to stay in.

While the hotel boy took the tourist upstairs for room inspection, the hotel owner takes the note and ran to the butcher to pay off his debt. The butcher quickly took the note and paid off his debt to the poultry farmer. The poultry farmer immediately cleared off his debt by paying the note to the poultry feeder.

Circle of Debt

The poultry feeder rushed to the farmer and paid off his debt by handing over the note. The farmer had dues to his laundry friend for buying grains and paid off the thousand rupees note to him. The laundry guy rushed to the hotel owner and paid him the note for letting him use the garage for keeping his customer’s clothes.

The hotel owner now placed the thousand rupees note back on the front desk. At the very moment, the tourist came down after inspection, picked the note from the counter and told the owner that the rooms are not satisfactory.

The question is very simple – How is it that nobody produced anything or even earn anything throughout the chain of events, however, the whole town managed to get out of debt?

Solution

Perception would drive you to a solution to this intriguing riddle. But, one must understand that all the transactions made no change in any of the party’s Net Wealth. Agree that in the beginning, every party had a liability of thousand rupees; however, each also has an off-setting asset of thousand rupees. To square it off, none has either – asset or liability. Hence, the thousand rupees note acts as a clearing mechanism.

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Let’s use this town as an example for a distinct economy. The foreigner has temporarily increased the town’s cash stock by thousand rupees. To sum it up, the tourist has only induced liquidity by providing a short-term loan for thousand rupees. The thousand rupees note has provided the parties with a medium for exchange that helped them to clear off their off-setting debts.

If you think further in economic lines, the Spanish foreigner’s short-term loan has induced liquidity by elevating the velocity of money. Just in case, the foreigner didn’t offer the money, any of the parties would have derived the same outcome by borrowing thousand rupees from someone else. Also to be noted that no new products or services were produced or rendered, however, borrowing from the foreigner have perhaps cost zero interest than otherwise. Let’s take the above into consideration after discounting the possibility that the hotel owner gets a zero interest loan by embezzlement – using the foreigner’s security deposit without this grant.

On either way, the thousand rupees note from the tourist would have never been required by any of the parties, in case there was a central depository or clearing house. The visible evidence that the hotel owner knew very well that the thousand rupees note would have come back to him pretty quickly as the probability of room selection was a binomial scenario, clearly sums up that all the parties were ready for an informal clearing. In fact, none of the parties in fact needed the money in the first place. The hotel owner could have addressed each of the parties individually and offer to net-off the debt leading to a zero-sum game.

Having given a detailed explanation for this puzzle, it clearly illustrates a point – an increase in efficiency of the Clearing House or System can only reduce the demand for increase in velocity of money. A Clearing & Custody Service is a secure way of providing a channel for exchanging services. At the limit, an efficient system for clearing would be an all encompassing association of computerized exchange, which would negate the requirement for money.

The Spanish foreigner has only been successful in offering monetary services through his short-term loan.

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