Debt and Wealth

Here is a thought experiment to understand the relationship between debt and wealth.

Think of a small village where there are only two people — Richie and Poorie. Richie is a rich man who owns everything in the village. Poorie is a poor man who works for Richie.

At the beginning, Poorie gets a salary of $100. His spends all his income on the goods and services sold by Richie. This arrangement continues for some time before Richie becomes greedy.

He reduces the salary of Poorie to $90 so that he can save $10 in salary expenses.

Poorie has no savings. So he has no option other than reduce his expenses to $90. Richie does not like this as his income goes down by $10.

He thinks of a clever idea. How about giving $10 as a loan to Poorie to meet his short fall.

Poorie accepts the loan and buys another $10 worth goods and services. Richie is now happy as his sales is back to $100. He counts the $10 loan as his wealth at a reasonably high interest rate.

This continues for sometime as Poorie amasses more and more debt and Richie becomes wealthy. But it reaches a point where Poorie is unable to repay his debt at current lending rate. Richie has another trick up his sleeve. He reduces the interest rate and gives credit at even more lenient terms.

This works for some more time. Soon Poorie become so indebted that he cannot afford any interest payment and defaults. Richie’s wealth vanishes as his entire wealth was based on Poorie’s ability to repay his debt.

What does this story show? Credit based wealth is nothing but a mirage if the debt cannot be repaid. Unfortunately that is the world we live in. Much of our wealth is based on the assumption that debt will be repaid!

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