If America is losing money, who’s gaining? Does there have to be balance?

BY busadmin  October 23, 2008 at 2:08 PM EDT

Question/Comment: If the world today has all the same resources it had yesterday and America is losing money there must be someone somewhere gaining from this crisis in order for there to be a balance. Am I right? If I am, who are these countries and how is this happening?

Paul Solman: The idea of balance is a common misunderstanding, Jason, and an important one. In fact, I once got muddled by this myself, and had to be set straight by the great Nobel economist Paul Samuelson.

Think of a stock that you bought for $100 yesterday. Today you need the money, but can only get $99 for it. You sell it to someone for $99 and lose a dollar. He now owns something “worth” $99 and you have one dollar less than you had yesterday. Tomorrow, he can only get $98. He too has lost a dollar. Another dollar. And so it goes, to the point that right now, the total value of stocks in the US is something like $8 trillion dollars less than it was as its peak. That’s pretty much $8 trillion VANISHED DOLLARS. Just like the drop in housing value, which is vanished wealth as well.

True, there are speculators who have bet that prices would go DOWN: the “short sellers,” for example, sometimes blamed for the current crisis because they borrowed stock at a higher price, sold it, and will pay it back by purchasing at a lower price, pocketing the difference. They DO make money when assets turn down in price, and I guess their winnings should be subtracted from the totals. But short seller stock gains are a minuscule fraction of total stock losses. There is no balance.

Other speculators make money too: buyers of options known as puts. But they are making side bets with so-called “counterparties.” For every put that pays off, there’s a bettor on the other side who loses an equal amount.

In the world we inhabit at the moment, MOST asset classes are plummeting in value. That’s vanished wealth, pretty much across the board. Which fits well with the theory that the world was “overleveraged” – had taken on an unsustainable level of debt.

We made promises to each other – “I’ll get richer and pay you back,” “So will I,” etc. – that turned out to be implausible. The lenders started asking for their money back. The borrowers had to start selling their assets, driving down their price. And the race to the bottom was on. As assets went down in price, “value” and “wealth” disappeared.

CORRECTION: I had this response of mine vetted by an eminent finance professor before posting it but he was careless and I was wrong. The paragraph about short selling that begins, “True, there are speculators” is incorrect. Even THOSE bets are part of the vanished value, as was pointed out to me by none other than Nobel laureate financial economist Robert Merton when I made the same mistake in public the other night.

When a stock is “shorted,” it is borrowed and then sold. Eventually, it must be repurchased so that it can be returned. These transactions are reflected in the price movement of the stock, as are “all of the markets for stocks (e.g., the S&P 500) — spot, futures, and options — connected through arbitrage,” writes my frequent guest vetter, Professor Zvi Bodie of Boston University and MIT. “A shift in supply or demand in any of them therefore affects the prices in all of them. The same is true of foreign exchange, interest rates, and commodities.”