Let's imagine for a few moments that we have a nation that doesn't have banks and doesn't have paper money but instead uses gold coins, etc., for real money in all transactions. Now imagine you have $2,000 in gold coins but no safe place to keep them. A businessman offers to store the coins for you in his secure safe and will only charge you $5 a month for storage fees. Seems pretty fair, you are paying for a service and he's making a little money providing that service. He gives you a receipt so that you can show that he owes you the money if you decide to take it back later on.
Well, word gets out that he provides this service and eventually he has quite a few clients, totaling about 100 people in all and the deposits altogether add up to $100,000 that he is holding. He's charging them each $5, so that's $500 a month, not bad. Or is it...
Enter Dave. Dave doesn't have money to deposit but in fact, has the opposite. Dave needs money to buy a horse. Dave goes to the businessman and asks if he can borrow $2,000 and pay him back over time. The businessman, seeing all the money he's holding, decides he can lend Dave the money. The agreement though is that Dave will pay $200 a month for 12 months, totaling a $2,400 repayment.
Now when you hear about this you become upset because you think the businessman has just given your $2,000 to someone else. You demand your money back. The businessman obliges and gives you your $2,000 in gold coins right there on the spot. Realizing that it isn't your money that he lent out, you feel safe again and re-deposit the money.
After a short while, the businessman realizes that in any given month, his depositors will only transact a few thousand in gold coins a month. The other $90,000 or so doesn't ever really move. It's just sitting there, in his storage. He figures he can safely loan out about $50,000 of it without ever running the risk of everyone demanding their money all at once. Then something unusual happens. The people borrowing money don't want to take the actual gold coins out of storage. They prefer instead to just get paper receipts that they can give to local stores, etc., instead and the stores can come get the gold coins themselves with the paper receipts. Pretty soon everyone is buying goods and services using these paper receipts instead of gold coins. Everyone trusts the paper receipts because they know the businessman has the money in storage to pay the receipt. They trust him. The businessman is happy because he continues to make storage fees and loan interest. So the money is gradually moving from storage into his own pockets.
You didn't think we would end the story there, did you? The plot thickens as the businessman realizes that if he can just give out paper receipts every time someone wanted to borrow money and that so few of the paper receipts come back at any given time he can loan out a lot more paper. He only needs a fraction of gold in his storage for all the paper receipts he "loans" out.
Stay tuned to find out what happens next....
Sunday, December 13, 2009
Posted by Catrina | Duane at 9:50 AM
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