Global Financial Crisis (with added comment)


It is August. In a small town on the South Coast of France, holiday season is in full swing, but it is raining so there is not too much business happening. Everyone is heavily in debt. Luckily, a wealthy Russian tourist arrives in the foyer of the small local hotel. He asks for a room and puts a Euro100 note on the reception counter, takes a key and goes to inspect the room located up the stairs on the third floor.

The hotel owner takes the banknote in a hurry and rushes to his meat supplier to whom he owes E100.

The butcher takes the money and races to his supplier to pay his debt.

The wholesaler rushes to the farmer to pay E100 for pigs he purchased some time ago.

The farmer triumphantly gives the E100 note to a local prostitute who gave him her services on credit.

The prostitute goes quickly to the hotel manager to whom she owed E100 for the let of a room to entertain her clients.

At that moment, the wealthy Russian is coming down to reception and informs the hotel owner that the proposed room is unsatisfactory, takes back his E100, and departs. There was no profit or income, but everyone no longer has any debt, and the small townspeople look optimistically towards their future.

[I received the above briliant little satire in an E-mail a couple of days ago from a right wing mailing list. I saw the same story many years ago, although I canít remember when or where, though it may have been pre-Internet. The new version has different characters but the message is the same. Itís a pity that our politicians, including the Chancellor of the Exchequer donít appreciate the wisdon therein, especially at this current time of financial malaise. I have edited the story very minimally - April 26, 2009].

Comment

I always had the feeling there was something not quite right with this, and a few weeks after posting it I realised what it is; the hotel owner loses E100. I should point out that I didnít work this out for myself; I found a comment to that effect on a blog somewhere. I meant to respond to this (perfectly valid) criticism months ago, but never got round to it. Having said that, the objection is not terribly important, provided one bears in mind that this story is only an analogy. So what is the solution?

Simple: add another character to the story - a banker. It must be the banker who loses the E100! The story should actually begin with the banker, who starts the cycle by ďlendingĒ to one of his customers. Let us see what happens here and what happens if someone borrows the money from someone else.

Suppose I come to you and say ďHi SabineĒ - or whatever your name is - ďIíve had a hot tip for a wonder horse at Newmarket; lend me E100, and Iíll pay you back double when I win.Ē

You, being a kind-natured person (or a mug) take this money out of your pocket, and I back the horse, which romps home first in the 3.30. Unfortunately, it was running in the 2.30, so William Hill says thank you very much, I kiss goodbye to your ton, and you delete my name from your address book.

Now, supposing instead I go to the bank; the banker lends me the money, or does he? No, he most certainly does not!

Let us suppose that you are a fairly wealthy sort of person; your net assets prior to your act of rather foolish generosity were E100,000. You write down this E100 as a loss, and your net assets are now E99,900.

The bank, being rather a small bank, has assets of E100,000,000 - that is very small for a bank. But, and here is a very big but, when I borrow this money, the bank writes in its ledger the following:

Current Assets                             E100,000,000
Advanced to A Baron                                E100

Current Assets                             E100,000,000 
Liabilities                                        E100

After my nag trails in last, I leave the country, and at some point, the bank quietly writes off the E100. You have lost your money, William Hill pays it in after the race - ie it goes back to the bank - and the bank has lost precisely nothing.

Of course, this canít go on indefinitely; thatís what the Credit Crunch was about, but it does not hurt the banking system as a whole if the odd million - or billion - simply disappears into the void from which it was created in the first place. Not only does it not hurt the banks, but it benefits the economy as a whole, because this new money has come into circulation debt-free, as it should have done in the first place.


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