The Examined Life

Where I torture reality till it confesses the truth

In the Model Village. Part I

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?

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20 Comments

  1. strong stuff!
    totally strong stuff!

  2. Are you saying that it is impossible for a bank to go bankrupt? Because as I understand it, even if the entrepreneur doesn’t return the 900GC the bank can always write off the liability.

    Suppose the bank has exhausted its money creating capacity and the guy who took that 900GC doesn’t return it because he went out of business, what happens to the fractional reserve in the bank. How much can the bank lend out to the next prospective entrepreneur. I’m interested to know. Or was that a stupid question?

  3. hmm.. So AB went ahead and created hyper inflation. Sounds too close a parallel to the dreaded Fed

  4. Gasquet fan, Yes, this is the model village, so I have arranged it so that this bank can never go bankrupt. But barbadkatte, remember that this is the model village and a model bank.

  5. I’d like to hear from people who don’t know economics or accounting if you are with me so far. I’d really like to hear of any doubts or questions.

  6. I am with you. And I have no idea of economics. I watched a video – America: Freedom to Fascism, which talked up the gold standard, but I wondered if rich people decide not to spend their gold they can strangle others into working for them for peanuts. That video made no sense other than giving me another reason to hate America.

  7. Good one. Have some things to discuss about the infinitude of steps required to achieve the money multiplier and its implications but will wait for the series to end.

  8. Ravikiran,

    While this makes for fascinating reading, it is incredibly similar to http://www.relfe.com/plus_5_.html . It might make sense to state this.

    Venkat

  9. The similarity is not intentional… I had not read it earlier. And in any case, the article you’ve linked to is nonsense. My series is intended to help you understand why.

  10. ravikiran,

    sorry i saw this so late. forgive my weak a/c skills but hear me out.

    Once AB invests the 900 gold coins to entrepreneur his asset would look like this

    Asset:

    gold: 100
    A/c Receivable from Entrepreneur 1: 900

    Total: 1000

    Liability

    A/c Payable: 1000

    Total: 1000

    once the gold was given back in exchange for paper, for the first time, paper_count exceeded gold_count. this to me looks odd. While you can account it as the following

    Asset:

    gold: 1000
    A/c Receivable Entrepreneur1: 900

    Total Asset: 1900

    Liability

    A/c Payable To people: 1000
    A/c Payable To Entrepreneur1: 900

    Total Liability: 1900

    I only see the Assets increasing but not the Gold. Gold count never exceeds 1000 Am I right or did I miss something?

  11. You have missed nothing except the main point :) Obviously the gold count cannot increase because one of the assumptions of the model is that the total amount of gold in the system is constant. What has increased is the bank’s assets. If you think that all “paper” should be backed by gold, then this is obviously an odd result. But my intent in providing this example is to illustrate the meaning of money. If you read the second part, you will realise that those assets, though they are indeed “accounting entries” are real. They are real because they monetize the future productive capacity of the village. My point is that, this is what money truly means. Money is not the amount of gold in the system, but the total amount of credit in the system.

  12. i sort of understood it but i am new at this whole topic so am allowed at least 1 stupid question :-). Humor me while I ask one more potentially bad question. I really want to understand this.

    I have one more doubt. What is stopping another citizen of the village, say Ravi banker, from starting his own bank without any gold. Once we have substituted gold with paper. Ravi Banker can start with an asset of 1000 papers (which people give to him) and give out Electronic_paper as paper’s E-substitute. This would allow him to start the whole credit cycle all over again. Then there would be layers of accounting within layers of accounting. And as you say even these Ravi Banker ” assets, though they are indeed “accounting entries” are real. They are real because they monetize the future productive capacity of the village.”

    Have I over-analyzed this or was this what you were getting at? That “total amount of credit in the system” is an aggregate of Arjun Banker, Ravi Banker and all other *.Bankers.

  13. You mean Ravi Bank Inc., or RBI? ;)

    OK, here is the thing. One of the crucial and unrealistic assumptions of my model is that AB is honest and competent (H&C). I made the assumption so that I could abstract out some of the details. I could say that because AB is H&C, it does not matter whether it is gold or something else. It also does not matter that AB is a monopolist.

    But in the real world where bankers will not be fully H&C, gold and competition would matter. So let’s treat your question step by step.

    First, let us assume that RBI provides banking services to another caste in the same village, a caste that has absolutely no interaction with the caste to which AB provides his services. Now the question will be, did RBI treat those pieces of paper with as much sanctity as AB treated gold? If so, then we should expect that RBI’s caste did just as well as AB’s caste, because whether it is paper or gold, what difference does it make?

    On the other hand, if you use “paper” to mean that anyone with a scrap of paper can get an electronic receipt, then yes, it will lead to inflation in that caste.

    Next, let’s relax some assumptions.

  14. Let’s assume that members of the two castes trade with each other, but the two banks don’t. In that case, the exchange rate between the two currencies will depend on the relative value of the goods produced by members of the two castes. Let’s assume that one bank has made some bad loans, i.e. it financed a factory, but the factory turned up a dud and did not produce any goods. It means that it issued some currency without having goods to back it up. So the holders of this currency will experience a fall in the value of their currency. But of course, the way I have structured the model, the bank can make as many bad loans as it wishes without going bankrupt. To remedy that we need to tweak the model further.

  15. Next, let’s assume that the banks too can trade with each other. Now, we cannot continue with the assumption that the gold or paper will never be redeemed. This is because banks have an incentive to redeem it while competing with each other. A customer of AB asks RBI if he can pay back his loans in AB’s currency. RBI says “yes”, and extinguishes its own accounting entry in return for AB’s entry. Then it may hold the currency or ask for it to be redeemed. This will depend on whether RBI thinks that AB’s loans are good. If the AB has been making lots of bad loans, then AB’s currency is likely to depreciate. So obviously there is no point holding it. Let’s say that RBI asks for gold. AB may:
    1) pay back its inhouse gold
    2) or buy gold from the market by securitizing its loans,
    3) or ask RBI to accept the value of gold in RBI’s currency (and try to buy RBI’s currency by securitizing its loans.)
    4) or declare bankruptcy and ask RBI to take ownership of its assets.

  16. Now of course you’d have noticed that the reverse process will not work. If RBI can go bankrupt much faster than AB can. But in a situation where the currency cannot be redeemed for anything (as is the case in the world today), we are back to the situation as of the comment of 11:53.

    What I really really want to convey through my series is the similarity and difference between “making a loan” and “printing money”. Conceptually they are the same. The problem is that “printing money” by the central bank is equivalent to making a bad loan. Money creation by a well-functioning banking system is not a problem.

  17. i’m glad i came up with this idea

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