The Island

on Monday, April 25, 2011

In response to Steven Landsburg's article, Here is a simple island situation that will make this problem clear. Imagine everyone fishes to eat each day, and that Mr. Kendrick invents a net and a boat and begins accumulating fish in his hut. He saves a lot of fish; everyone else saves a few fish each year. (They salt and smoke the fish so that it lasts indefinitely.)

Soon, people tire of storing their fish and tire of hauling fish around the island to use as money. One man builds a strong stone building and starts a bank. He offers to store fish in his building and give out "fish certificates" in exchange. The certificates are easier to carry and people trade them as if they were fish. When someone needs to eat, they go to the bank and turn in the paper certificate and receive a fish in exchange. The banker cheats a little.  He prints up a few certificates for himself from time to time and spends them, hoping no one notices. He calls this "quantitative easing," and says that it is necessary to keep the value of the fish certificates stable. Most islanders are not convinced.

The banker soon begins accepting other items to store in his vault. He estimates their value compared to fish, takes the cheese, wine or bag of spices, and issues fish certificates in exchange for the new forms of wealth. He also makes loans against homes. If a man wants to spend some of the value of his hut, he goes to the banker.  The banker says "give me your house, and I will give you fish certificates in return. If you wish to live in the house as well, you can pay me a fee (interest) to live there." The islanders agree and begin to finance myriad other forms of wealth, like bigger huts, boats, complex fishing net factories, and so forth.

Soon, some of the biggest men on the island, who have been busy using their spare time to manufacture spears, swords and other weapons and armor, decide that they need more fish so that they can spend more time preparing to defend the island.  They insist that defending the island is something everyone must help them do, and the island agrees to pay the men 20% of fish they harvest from the sea, so that they may focus on defending the island. Some people refuse to pay, and the men take it from them at spear-point.

Mr. Kendrick continues to invent better nets. He accumulates wealth, but loans it to other islanders so that they can spend more time looking for spices, or harvesting salt, or breeding better animals. They pay him a fee for this (interest), and he keeps all of the loan agreements in a vault at the bank. Bored with his life, all he does all day is ride his horses around the island, tying each to a different stable pen each night.

In this situation, what happens when the large men with spears decide that all of Mr. Kendrick's loan agreements (which pay interest), are sitting idle in the bank, and that it would be best for the island if they held up the bank, took the paperwork, and kept the interest payments for themselves? Who would be hurt, and who would benefit?