There was once a beautiful small island in the middle of the ocean. An economy of just 10 islanders lived there and they all had special skills. They bartered goods with each other as a system of payment. One day a banker comes to the island and proposes to them a new system of credit, with fiat paper money. The islanders initially were sceptical and wanted to stick to barter. But the banker eventually convinces the islanders that they will benefit from this system, and they agree to it. So the banker sets up the Island Bank, which is to be the sole issuer of paper currency on the island. He initially lends everyone $10, so that the island as a whole has $100, to kick-start the new economy. But the catch is that he charges everyone 10% interest, to be paid exactly next month to the bank. The islanders seemed quite content with the arrangement and began using the new currency. At first, people set their prices arbitrarily of what they’re selling in terms of dollars. Eventually supply and demand changes the prices of goods to optimum market prices. The islanders are happy and grateful to the banker for facilitating their lives with paper money. All went well.
On the first day of the next month, the interest fell due. Some islanders found themselves in deficit of money on the day, while others were in surplus. The best-case scenario was that they all ended up precisely with the same amount of money, $10, as they were initially given each. But this still added up to $100 in total, and they owed more than this. The islanders go to the banker perplexed. One man asks, “Mr Banker, how can we pay you $110 in interest with only $100?”. The banker smiles and says “Easy – you borrow more money from me!”. The islanders didn’t know what to say, and so they borrowed more. With time, the once happy tribe that lived on this pristine little island found itself beset by unemployment, inflation, poverty and conflict. People were trying in every way to outwit each other for that extra dollar to pay their debts and some even robbed their neighbours. For the first time, crime was seen on the once co-operative island community. Some of the more nostalgic islanders went to the banker, who was happily smoking a cigar in the sun, and to their amazement, saw how he was living in utter splendour while they were all struggling. They asked the banker how he became so rich, but he threatened them to get off his property.
More time passed, and it was eventually realised that while only some prudent islanders benefited individually from this new system, collectively as a community, they were all in loss. Their “public” debt just kept on rising and rising, and they began to feel cheated. It got to a point where they now owed collectively $1000 to the bank while their economy only had $500 worth of money. It got so worse that individual interest debt as a percentage of monthly expenses kept increasing relentlessly until it consumed over 50% of their household budgets. Once that occurred, the islanders and their whole economy became bankrupt. They looked in despair and went to the banker. To their shock, they saw where all the money they lost in interest had ended up: with the banker. By charging interest, he re-distributed wealth from the islanders to himself. He was so rich by now that he had climbed on-board his large new boat, which was constructed by the help of a few embarrassed islanders in desperate need of dollars. Packed to the top with cash and with the best food from the island, the banker sailed off, leaving the island in total devastation, looking forward to his next venture.
And that ladies and gentlemen, is how modern banking works.