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Mar 27

Bank Loans need Trust, Growth needs Credit

Example 1 – Loans require Trust:

  • For most of history per capita production remained the same

  • In 1500, global production of goods and services was equal to about $250 billion – today it hovers around $60 trillion

  • A bank opens in Hitchin

  • A builder finishes a job and is paid £1 million – he deposits this money in the bank – the bank now has £1m in capital

  • At the same time, an entrepreneur sees a new business opportunity and wants to open a new bakery in the city – she doesn’t have enough money to buy the property and extras needed so she presents her business plan to the bank manager and asks for a loan of £1m – he agrees and lends her the money

  • She then hires the builder to build and furnish the new bakery – his price is £1m

  • She pays him, with a cheque drawn on her bank account

  • The builder deposits it in his account with the same bank

  • The builder now has £2m in his bank account

  • But the bank only has £1m in its safe

  • Then, two months later, the builder informs the baker that, due to unforeseen problems and expenses, the final bill for the bakery will actually be £2m

  • The baker is not pleased but it’s too late to stop now so she asks for another £1m loan be put into her account

  • She then transfers this money to the builder’s account

  • The builder now has £3m in his account

  • But the bank still has just the original  £1m

  • The discrepancy is the bakery – the bank put its money into the bakery trusting that one day it would be profitable – it hasn’t baked a loaf yet but anticipates it will be selling thousands of loaves, cakes and cookies soon, at a handsome profit, whereupon it will be able to repay the loan, with interest – and if, at that point, the builder decides to withdraw his savings, the bank will be able to come up with the cash

  • The entire enterprise is thus founded on trust in an imaginary future – the trust that the entrepreneur and banker have in the bakery of their dreams, along with the builder’s trust in the future solvency of the bank

  • Current banking laws permit banks to repeat this exercise and loan £10 for every pound they actually possess in their vaults

  • This means 90% of all the money in our bank accounts is not covered by actual coins and notes

  • So if all account holders at your local bank suddenly demand their money, it would promptly collapse – unless the government stepped in to save it as they did with Northern Rock

 

Example 2 – Growth needs Credit:

  • In the above bakery example, what if the entrepreneur had many dreams but no tangible resources – the only way she could get her bakery built was to find a builder willing to work today and receive a payment in a few year’s time if and when the bakery starts to make money

  • But such builders are rare so the entrepreneur is in a bind – without a bakery she can’t bake cakes, so she can’t make money, so she can’t hire a builder, so he loses demand and she has no bakery

  • For this reason, humankind was stuck for thousands of years – up until the modern era when a new system based on trust in the future was established where people agreed to represent imaginary goods with a special kind of money called ‘credit’

  • Credit enables us to build the present at the expense of the future – it assumes our future resources will be far more abundant than at present

  • Credit was not a new idea but up till then people thought the total amount of wealth was not growing – even dwindling – so offering credit was a bad bet

  • Business was seen to be a zero-sum game – if one company did well, another did badly – the wealth pie never grew by much if at all, so why extend credit

  • Hence any loans offered were usually small, short term and subject to high interest rates

  • Entrepreneurs thus found it difficult to open up new businesses – bakeries etc. – so economies didn’t grow – so people assumed they never would – so the expectation of stagnation fulfilled itself

  • But then came the idea of progress, trust in a better future founded on proven results of geographical and technological discoveries and organisational developments which increased the sum total of human production, trade and wealth

  • New stuff didn’t just replace old as in the past, it added to it – a new bakery might produce loaves, another specialise in chocolate cakes and croissants – consumers would develop new tastes for the latter and, overall, eat more – one bakery owner could become rich, but so could the other

  • This led to more and more people putting more and more of their trust in the future – this created a climate for credit which brought real economic growth, which strengthened the trust in the future, which brought even more credit – a virtuous growth spiral indeed

  • Hence, nowadays, governments, business and individuals can easily obtain large, long-term and low-interest loans that far exceed their current income

  • One just has to be optimistic and expect the future will always be better than now

N.B. The essence of the above examples was extracted from a splendid book, Sapiens, written by Dr Yuval Noah Harari

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