13
$\begingroup$

I looked it up online (here), but I find it hard to believe that money literally "disappears". For example, if I buy 10 stocks of a toaster company for \$100 per share, and then the stock value drops to \$10, I've lost \$900, but the entities I bought from have gained \$900 collectively. I understand that money is supposed to be an abstract concept, but we should be able to trace where the dollars go.

So how does money just disappear when the stock market crashes?

$\endgroup$
  • 2
    $\begingroup$ You may need to define "money" first. Your wealth may have fallen, but that is something else. The entities you bought from actually have $\$1000$ from you, though whether that is "money" depends on (a) what they did with it and (b) what "money" is. $\endgroup$ – Henry Sep 7 '16 at 14:43
  • $\begingroup$ That link is a bad description of what happens. $\endgroup$ – Dave Harris Mar 11 '17 at 3:25
  • $\begingroup$ In my professional opinion, the most concise and clear answer that is closest to the facts is the one by user7935, based on the question you wrote. The answers by RegressForward and paj28 were also reasonable, they were just less clear, imho. You do want to distinguish between wealth and money. They are different things. The other posts were descriptions of fractional banking and you did not ask about that. $\endgroup$ – Dave Harris Mar 11 '17 at 3:47
  • $\begingroup$ You buy a painting at a yard sale for \$10. I love it, and would be willing to pay you \$100 for it. Later, my tastes mature, and I tell you that I'd only pay you \$1 for it. Did you just lose \$99? \$90? \$9? Actually, you lost nothing except potential future income. $\endgroup$ – Ask About Monica Mar 17 '17 at 17:36
13
$\begingroup$

Stocks are not money.

The valuation of a company - the market captialisation - is the number of shares multiplied by the share price.

The share price is the price people are willing to trade at right now. It does NOT mean all the shares have been traded at that price.

If a company issues 1 million shares, at a starting price of £10, the market cap is £10 million. They may only sell a few of these shares, so much less than £10 million actually changes hands. If the price rises to £20, only a few of the shares changed hands at that price - but the market cap is reflected in all the shares, and is now £20 million. People have commented on the flaws in this methodology.

The same happens in a crash. Only a fraction of the shares actually change hands, but the media report on the change in the market cap.

If you want an analogy, consider a house burning down. You buy the house for £200,000. Then it sadly burns down (and without insurance). It is now worth £0. However, no money has been created or destroyed; it's a loss of value of an asset.

$\endgroup$
  • 1
    $\begingroup$ You did not answer the question about how money disappears. $\endgroup$ – Mick Sep 7 '16 at 9:29
  • 6
    $\begingroup$ @Mick - The money does not disappear - the OP has a misconception. You should revoke your downvote, it is petty. $\endgroup$ – paj28 Sep 7 '16 at 9:35
  • 1
    $\begingroup$ @Mick - which bit of my answer is factually incorrect? Your answer is talking about the knock-on effects of a crash. You may well be right, but I don't think that's what OP is asking about. It sounds like they have a misconception that market captialisation is actual money, and my answer corrects that. $\endgroup$ – paj28 Sep 7 '16 at 9:40
  • 2
    $\begingroup$ @Mick - You still haven't said where my answer is factually incorrect $\endgroup$ – paj28 Sep 7 '16 at 10:05
  • 2
    $\begingroup$ @Mick - depends how you read "the money". The question refers to loss of market cap $\endgroup$ – paj28 Sep 7 '16 at 10:44
3
$\begingroup$

If I buy 10 stocks of a toaster company for \$100 per share, and then the stock value drops to \$10, I've lost \$900...

You paid \$1000 to some counterparty for some assets worth \$1000 at time $t$, a fair deal. The value of your assets then dropped to \$100, resulting in a return of -90% at time $t+1$. However, the counterparty didn't lose anything, they still have \$1000 in cash and experienced 0% return over the same time period. It's possible that there are second order effects depending on how the trades are financed, but the activity of trading does not destroy or create any wealth.

The entities I bought from have gained $900 collectively.

So this is not quite right. The counterparty gained nothing by trading. This is because the value of the asset was worth the exact same amount as the value of your cash at time $t$. That the price at time $t+1$ would be much lower was unknown to you both. And of course the counterparty was in exactly the same situation when they originally acquired the asset at time $t-1$: the amount of cash that they paid was exactly the same as the value of the assets at $t-1$. Again, no wealth was created or destroyed through trading. Any return the asset generated was due to it being a share of a wealth-generating business.

$\endgroup$
2
$\begingroup$

The assessed value of the stocks goes down.

Non-stock related example: If my prized family portrait is assessed at 1000 dollars, and is later reassessed at 250 dollars. That value is lost, 1000-250=750 dollars lost. No money ever went anywhere, but I, and as result all of society, is now poorer by $750. This loss is because we believed the painting was worth a lot, and we were wrong.

$\endgroup$
  • $\begingroup$ Although I like your analogy, I think it does not create the right impression about how markets work. Any change in market prices is much more likely to be due to changes in the information set than due to corrections of mispricing. For example, if a fire breaks out in company X's factory and the share price of X goes down, it is not because X was wrongly priced and the market was wrong. It is just that previously there was a chance of fire in the factory, and now that fire is certain, so prices must change to reflect this. $\endgroup$ – user7935 Sep 14 '16 at 12:08
  • $\begingroup$ Doesn't that depend on your interpretation of probability? A change in information leads to the conclusion a previous price was wrong (from the omniscient perspective), and the new price is... arguably less wrong. $\endgroup$ – RegressForward Sep 14 '16 at 17:06
  • $\begingroup$ I don't see where the interpretation of probability comes in, and I'd point out that omniscience is a rather extreme requirement in any circumstance. Referring to your own example, I see a clear difference between a change in value due to the reversal of a wrong appraisal, and a value change due to the portrait going up in flames. Don't you? In the first case the appraiser was wrong, in the second they were not. $\endgroup$ – user7935 Sep 15 '16 at 13:37
  • $\begingroup$ Unfortunately, my instincts don't seem to see the situations as different. In the second case, I simply assess that were wrong about it going up in flames. One is a bigger price adjustment than the other, though. $\endgroup$ – RegressForward Sep 15 '16 at 14:17
  • $\begingroup$ Being uncertain about whether some future event is going to happen and then updating beliefs when there is certainty (or new information in general), is not the same thing as being wrong. In fact, it's the opposite. What would be wrong is to not update beliefs when new (or previously unconsidered) information is available. If you still disagree, I would be very interested in hearing the definition of wrong/right with respect to some set of information in your philosophical interpretation of probability. $\endgroup$ – user7935 Sep 15 '16 at 15:13
-1
$\begingroup$

If the stock market lost say 10billion dollars in value, it does not mean that 10billion dollars literally disappears (despite what the poorly written document you linked to suggests). But it is true that some money may have literally disappeared. This is because many shares are purchased with money borrowed from banks ("margin debt"). If the net amount of borrowing for share purchases went down i.e. some money was repaid, then that repaid money did literally disappear. This is all to do with how fractional reserve banking works - "Just as taking out a new loan creates money, the repayment of bank loans destroys money".

EDIT: After the stock market crash of 1929 the money supply fell by about a third. This was because huge amounts of money that had previously been invested in the stock market was in fact borrowed from banks. CORRECTION: I should not have implied that all of the one third reduction in the money supply was caused by a reduction in margin debt, but certainly part of the reduction was.

EDIT: The idea of the money supply falling after an asset price bubble bursts is not widely reported. After the crash of 2007/8 almost no media outlets have discussed any notion of money disappearing. This is because the media and the general public have little clue that it is even possible for the money supply to decrease. But you can read here the governor of the Bank of England telling UK politicians in Jan 2013 that QE was an effort to counteract the falling money supply: "What we were doing [through Quantitative Easing] is injecting money into the economy, and what the banking sector has been doing is destroying money [as existing loans were repaid]." ... "what we were doing was partially to offset what would otherwise have been an even bigger contraction."

$\endgroup$
  • $\begingroup$ The edit is interesting... do you have a link with more info? $\endgroup$ – paj28 Sep 7 '16 at 9:38
  • 1
    $\begingroup$ Sadly the issue is clouded by the fact that fractional reserve banking is so often misunderstood, even in academic textbooks - see here: fractionalreserves.com/?page_id=81 You can find many references that will tell you that the money supply fell after the crash - but very few will correctly tell you why it fell. $\endgroup$ – Mick Sep 7 '16 at 9:41
  • $\begingroup$ I meant a link about "After the stock market crash of 1929 the money supply fell by about a third." $\endgroup$ – paj28 Sep 7 '16 at 9:44
  • 1
    $\begingroup$ wiki.dickinson.edu/index.php/Causes_of_The_Great_Depression - "From 1929 to 1933, the money supply fell by about 30%." $\endgroup$ – Mick Sep 7 '16 at 9:56
  • $\begingroup$ Why does a crash cause the loans to be repaid? I'd expect the opposite - people would default on the loans $\endgroup$ – paj28 Sep 7 '16 at 9:56
-2
$\begingroup$

Here is the narrative that I've arrived at:

1) Banks "create" money by lending recursively. This is called the "Multiplier Effect" which is a consequence of the "Fractional Reserve Banking System".

enter image description here

This artificial money can only exist if we assume that all lenders will pay back their loans.

2) When there is an economic recession the public stop spending as much (why this happens is another discussion), so borrowers stop getting revenue and default on their loans. The asset (a debt security) issued by the lending bank is now worthless and written off. There is a domino effect in that if that lending bank's assets decrease, the entity that this lending bank itself borrowed from also loses assets. The money that remains is equal to the "real" assets in the system (used to be gold) and this is why the economy is said to "reset" during a recession.

This begs the question of why allow a fractional reserve banking system instead of insisting on a full-reserve banking system. I would guess that it just makes for a very limited economy, even if it results in less spectacular market crashes. Apparently no country in the world sticks to a full reserve banking system.

$\endgroup$
  • $\begingroup$ This does not ask the original question. $\endgroup$ – Dave Harris Mar 11 '17 at 3:24
  • $\begingroup$ Explain why not $\endgroup$ – Sridhar Sarnobat Mar 11 '17 at 3:25
  • 1
    $\begingroup$ The question was very specific and was not about fractional reserve banking. While there are, usually trivial, money supply effects from market price changes where margin is present, it is not true that margin is present for all stocks AND it was not assumed in this narrative. The money supply changes constantly and if this is the only security involved the impact would be so trivial nobody would notice. I just made a credit purchase for $50 and in doing so changed the money supply, but that is so trivial that it should be ignored. $\endgroup$ – Dave Harris Mar 11 '17 at 3:34

Your Answer

By clicking “Post Your Answer”, you agree to our terms of service, privacy policy and cookie policy

Not the answer you're looking for? Browse other questions tagged or ask your own question.