Long long ago, nestled among the mountains, there was a village perfectly isolated from the rest of civilization. Its inhabitants led a hand to mouth existence. Because this village always behaved according to our macroeconomic models, it was called “The Model”.
Now, in The Model, villagers used gold coins, and only gold coins for trading. They used gold for nothing else. The total number of gold coins in The Model was fixed.
But gold coins were cumbersome to lug around and exchange with each other. So one day, a wise villager named Arjun Banker (or AB for short) made them an offer. He told them to deposit all their gold coins with him. He would maintain their titles to the gold coins. Whenever they wished to make a transaction, they could inform him and he would transfer the titles to the gold as needed.
The villagers liked the concept of the idea, but they objected to its proposed implementation. “Why should we run to you every time we wish to make a trade? You are an old man. We do not wish to disturb you in the night when we want to make a payment at the local brothel, for example. Why don’t you issue us all paper proof of ownership, so that we can exchange those papers instead of gold?”.
But AB said: “That would be old fashioned. We are a primitive village, but because we are in The Model village, we all have cell phones. I can identify all of you by your phone numbers. I will set up a system so that whenever you wish to make a payment, you can send SMS PAY <AMT> <PAYEE PHONE NUMBER> <PIN> to my number. My systems will automatically handle it without waking me up.”
“What an idea!”* the villagers exclaimed. “But will we be able to redeem our gold if needed?”
“Yes, on demand!” said AB.
So the villagers gave him their gold. The scrupulous banker that he was, AB locked up all the gold in a secure vault with two keys, one key with him and one key with the Panchayat president, and enabled the electronic self-destruct mode, so that any unauthorised attempt to open the vault would destroy the gold and turn it into lead.
AB also created a balance sheet for his bank using Generally Accepted Accounting Principles. On the Assets side was GC 1,000 as cache in hand. On the Liabilities side, he recorded all those people to whom he owed these 1,000 gold coins. Like all good balance sheets, it balanced to the last gold coin.
The Model villagers carried on life more or less as before, but the ability to pay without having to carry coins in their pockets made them a tad more consumerist. On the positive side, they had less to fear from pickpockets now.
Many years passed, and AB realised that The Model villagers had got so used to the system that no villager had ever requested redemption of even part of the gold. That gave him another idea. He decided to keep 10% of his gold coins and lend the rest of them out to anyone with a good business idea. He was still a scrupulous banker, so he vetted the business ideas to ensure that they would generate adequate returns. He also ensured that his balance sheet always balanced.
So when he made a loan of 900 gold coins to an entrepreneur, he made the following entries:
On the assets side
Cache in Hand reduced by GC 900
Loans increased by GC 900.
Net change in assets: 0. The Liabilities side of course, remained unchanged, because those who had deposited their gold coins still had their claims intact.
But when he was about to hand over the 900 gold coins, the entrepreneur looked confused, because he had forgotten what gold coins looked like. “I guess these will go right back into the vault”. He said. A. Banker was delighted at this turn of events. The gold went back into the vault and the following two entries went into his books:
Assets (Cache in Hand) increased by GC 900
Liabilities (deposit by the entrepreneur) increased by GC 900.
The net result of these transactions meant that the total amount of money in The Model was now GC 1,900.
AB now realised that he could do this again and again. His next loan amounted to GC 810. The loan after that was GC 729. If you remember your high school maths, you will realise that when he exhausted his credit, the total amount of money in The Model was 1,000/0.10, i.e. 10,000.
“I am creating money!” AB thought happily. Then he wondered: “Why am I maintaining a fractional reserve at all? No one has ever asked for a return of the gold coins. Why shouldn’t I lend out all my reserves again and again and create an infinite amount of money? Something is wrong. Hey cabbie! If I can have infinite amount of money, you can have a perpetual motion machine. Take me on a never ending trip!”
The cabbie smiled at him.
*Is this the first example of situational advertising in a blog post?