Economic multiplication

In my history book club the other night we got talking about banks, which perform a kind of social magic. A few investors can loan out a lot more money than they invest by borrowing from depositors. Thus the paid in capital of a bank is only a few percent of the bank's loan portfolio. Of course, banks charge more interest on the loans that they make than they give on the money they borrow; the difference covers the risk of loans that they make not being paid back and the profits to the investors.

In the field of development economics it has become clear that one of the problems faced by poor people in poor countries is that they have their capital tied up in economically unproductive assets. Thus they may own a house, the land on which it is sits, and even some land used for agriculture. However, the system for land titling may be poor so that they can not prove that they own that property, the banking system may not serve them so that they can not mortgage that property, and the legal system may be inadequate to allow lenders to be sure that they can appropriate collateral if loans are in default.

In the United States one may own a house, a business and a car with only the investment of a small part of their total value, borrowing the rest of the value from banks. The paid in value generally provides lenders with the guarantee that they can retrieve the money that they loan. If the portfolio owned by the person is well chosen, the income and savings it generates will more than pay for the cost of the borrowed money. Of course, if one borrows unwisely to consume rather than invest, or to purchase property in a bubble only to see it depreciate to less than one owes on the property, one gets into financial trouble.

I suggest that there is a basic similarity between the social mechanism that allows banks to loan more than they have in paid in capital, and the social mechanism that allows individuals to buy more than they can pay for in cash. In both cases, with good management, borrowed funds can be used in such a way as to profit the borrower and produce economic benefits to society. And of course, in both cases unwise management can result in bankruptcy.