Thursday, 16 October 2008

How Banks Work. Or Don't as the Case May Be.

Okay, so this is my attempt to explain the way banks work and if you're not scared by the sheer stupidity of the system after reading this, you've obviously not understood. I read a similar examination to this (using actual money rather than apples - you'll see) yesterday. I'm just trying to point out quite how absurd it all is. So bear with me. Okay. Here goes.

Let's meet Alfie. Alfie is an apple farmer. He grows 10 apples a week. Each week, he pays his 2 workers, Bennie and Charlie, 2 apples each and puts 6 apples in the bank for safe keeping. Bennie and Charlie also put their apples in the bank. The bank, promises to pay back the apples, on demand, whenever anyone wants them. All good so far.

After 5 weeks, this is the situation. Alfie has 30 apples in the bank. Bennie and Charlie each have 10. A total of 50 apples. 10 grown each week for five weeks. All very good.

Now, Bennie decides he wants to but a house from Derek. The house will cost 20 apples, but Bennie only has 10. So the bank lends him 10 apples. He'll pay them back one apple a week for 20 weeks. That's a rate of 100% interest.

This is fine because the bank has 50 apples in their vault for safe keeping (30 from Alfie, and ten each from Charlie and Bennie). So they credit 10 apples to Bennie's account, which he withdraws along with his original 10 (leaving just 30 apples in the bank's vault) and pays to Derek. Derek then pays the money, I mean apples, into the bank.

At this point, there are still only fifty apples in the vault. But now the balances of each customer read :

Alfie : 30, Bennie : 0, Charlie : 10, Derek : 20. Which is a total of 60 apples, even though there are only 50 in the vault.

Bennie also owes the bank 10 apples, a debt which they count as an asset. Making the total value of apples in the system 70.

Because he paid 20 apples for it, Bennie considers his house to be worth 20 apples. But he wouldn't sell it for less than 25, so now there's 95 apples in the 'economy'.

The bank has no real mo... apples of it's own, just the 10 they are owed by Bennie.

Confused yet?

Next week, Alfie grows 10 more apples and pays Bennie and Charlie 2 each, and puts his six left over in the bank. Alfie and Charlie put their apples in the bank, but Bennie can only put one in the bank because he has to use the other to make a repayment to the bank in respect of the apples he borrowed to buy his house (worth 20 apples). Half of the apples goes towards his debt. The other half is kept by the bank. The balances are now :

Alfie : 36 apples, Bennie : 1 apple, Charlie : 12 apples, Derek : 20 apples, The Bank : 0.5 apples.

A total of 69.5 apples worth of value. But there are only 60 apples in the vault.

Bennie still owes the bank 9.5 apples. So the total value of apples in the system is 79.

And the 25 for his house makes it 104.

Now hang on - that's only nine apples more than last week, but we've grown a whole ten apples. Ah, yes - that's inflation. Ten apples last week are now only worth 9 this. Even though there's still ten of them. Clear? No, thought not.

And so it goes on. We can add interest paid to depositors by the bank at a rate of say, 0.05 apples for every ten in your balance. This is paid out of the bank's own money. Or rather, the money they kept when Bennie paid them back.

So the balances are now

A : 36.18, B : 1.05, C : 12.06, D : 20.1, The Bank : 0.11

Plus the 9.5 apple debt the bank has to its credit (and Bennie's debit) and the house worth 25 apples.

There are still 60 apples in the vault. So the bank can give Alfie back his apples if he wants them. And as long as he thinks this is the case, he'll leave them there thinking they are safe.  But if Aflie, Derek and Charlie all want their apples back - the bank doesn't have enough. This is called a "Run on the Bank". The bank runs out of apples and goes bust.

Now, imagine this happening over and over again. Someone borrows apples, so the total value of apples in the system goes up even though the actual number of apples stays the same. And as the apples get paid back, the total value of apples in the system decreases, and the balances in the accounts increase by more than was paid into them. But the apples that have been grown each week are worth less than the apples than were grown the previous week, despite it being the same number of apples.

Now, tell me. Is this a sensible system to base the world economy on? Well, have you got a better idea? If so, please mail it to ;

Gordon Brown, 10 Downing Street, London, England. I'm sure he'll appreciate it. (I'd suggest sending it to the guy in the big white building in Washington but I doubt he'd understand it. And besides, he's moving out soon so you'll only have to explain it to the new guy later on)

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