Cast Aways: A Thought Experiment

Here is a thought experiment:

Imagine an Island with population for 4 people: Frank Farmer, Charlie Chef, Mike Miner, Sam Smith.

Frank grows grains for all the other three, Charlie bakes and cooks for all the other three, Mike Mines Iron & coal, and Sam makes tools for all the other three. They sleep in caves and live their lives.

Frank saves some grains for that proverbial rainy day. Mike saves some coal and steel, just in case the mine collapses, or if he falls sick. Charlie pickles some vegetables and meat, just incase. Sam keeps few extra tools, just in case he becomes handicapped.

One fine day, Barry Bum washes up the shore of the Island. The islanders welcome Barry. They had an overdose of confidence. Out of the goodness of their heart, they feed Barry the first day. Barry promises that he will pay them back with interest. Next day, Barry eats another meal and gives them an IOU. All of a sudden, Charlie realizes that there is more demand for his cuisines, he starts to serv up his savings. He realize that he needs more utensils, which comes from Sam's savings. Sam suddenly realizes that he needs to replenish his savings, and demands more from Mike's savings. Charlie demands more grain from Frank and that starts to deplete Frank's savings. This goes on for some time as everybody keeps themselves busy. Barry in the mean time takes a vacation to a near by island for a couple of days and comes back ( Home equity extraction ). Once the savings gets depleted, people work harder and produce a little bit more than they used to, to feed the extra person Barry.

Then proverbial rainy day arrives; Charlie falls sick and decides to cash the IOUs he has recieved from Barry. However, Barry has nothing to pay his debts with and hence no way for Charlie to repay his own debts back to Frank or Sam. This causes Sam to realize that he has no way of paying Mike. A credit crunch takes shape. They also realized that there is no need to do the extra work to keep feeding the unproductive Barry. Suddenly Charlie stop producing for Barry, hence he demands less from Frank and Sam.

Ed Empircal Economist comes to the picture and says, there is a lack of confidence. Charlie needs to start feeding Barry as if nothing has happened. He says aggregate demand is going down. See all the idle tools now? Government needs to take over and put these "idle" resources to use.

The reality is, economy was consuming more than it was producing, thus depleting the savings. It was malinvested in unproductive activities. May be, just may be, all the tools and savings allocated to making baking utensils need to re-allocated to some productive activity. May be they need to make pull-carts to transport the produce and iron ore.

If you introduce money into this island's economy, nothing changes. When the farmer produces 100 island dollars worth of grains and produce, converts it to cash and save 10 island dollars, that savings exist as real goods in the economy. Same goes for Mike Miner, Charlie Chef, Sam Smith. When an entreprenuer borrows money to invest, he is actually creating claims against these savings of real resources and putting them to use.

Printing a bunch of money and throwing into the island is not going to make the savings re-appear overnight. The depleted savings have to be rebuilt.

Real life characters are unlikely to lend to Barry the bum to the point of their ruin. Which is the reason why Garry Government, takes away the risk by guaranteeing all the loans, implicitly or explicitly.