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 their barter system. But the banker eventually convinced the islanders that they would benefit from this system, and they agreed to it. So the banker set up the Island Bank, sole issuer of paper currency on the island. He initially lent everyone $10, so that the island as a whole had a money supply of $100 to kick-start the new economy. But the catch was that he charged everyone 10% interest for that $10, 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 were selling in terms of dollars. Eventually supply and demand changed the prices of goods to optimum market prices. The islanders were 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 the banker $110. The islanders went to the banker perplexed. One man asked, “Mr Banker, how can we pay you $110 with only $100 principal?”. The banker smiled and said “Easy – you borrow more money from me!”. The islanders did not know what to say, so they borrowed some more. With time, the once happy tribe that lived on the pristine island found themselves 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 neighbors. 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 splendor while they were all struggling. They asked the banker how he became so rich, but he told them to get off his property.
More time passed and it was eventually realized 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 owed collectively $1000 to the bank while their economy only had $500 worth of money. This forced them to start pledging their real land, properties and businesses as collateral to the banker. It became so bad that individual interest debt as a percentage of monthly expenses kept increasing relentlessly until it consumed over 50% of their household budgets. 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. By charging interest, he re-distributed wealth from the islanders to himself. He was so wealthy, that he climbed aboard his large new boat, constructed with the help of a few islanders in desperate need of dollars. Stuffed with cash, exotic goods and the freshest produce from the island, the banker sailed off, leaving the island in total devastation, looking forward to his next venture.
That, dear friends, is how modern banking works.