Tuesday, October 28, 2008

Deals structured by cows.

Imagine a wealthy landowner (A) who has a herd of 1000 cows. Suppose this landowner was old and pre-occupied and found it difficult to look after his herd. A fellow landowner (B) hearing of his plight offers to borrow and look after his cows and give A 5% of their milk production.

A considers B’s proposition, he is old and tired and can’t look after the cows, by lending the cows out to B he still owns the cows and gets 5% of their milk production without any effort, upon consideration and agrees, except that he wants to be able to slaughter the occasional cow as needs arise and wants B to be able to give it to him on demand, B considers this and they agree.
B is an enterprising fellow. He has no real intention in looking after the cows at all. He is interest in making a buck. The word on the street is that milk is quite profitable and that people are prepared to borrow cows for 9%. Earn 9%, pay 5%, live off the spread. The 4% of the milk is his to sell at the market, its easy money. Now he knows that C is keen on looking after cattle at market rates B however realizes that A may want some of his cattle back on demand, so B lets C borrow 80% of the cattle, keeping 20% in reserve in case A comes a calling. It’s his fractional reserve.
C accepts 9% terms. C however never intended to milk the cattle, rather he wanted to trade them for some farm equipment which he wanted to grow crops with. He thought, if I grow crops I can sell them at market, buy some milk to pay back B and still make a profit. So C swaps his cows for farm equipment which D makes.
D doesn’t know what to do with cows. But he knows that B is paying 5% milk production for the use of cows. He can live off that quite comfortably and still slaughter a few cattle as required. He gives his cows to B by agreement and on the same terms as B is offering to A. B is an enterprising fellow, he realizes lending at 9% and paying at 5% is the path prosperity so he must keep pushing this good thing. B runs around looking for other people interested in borrowing cattle. At the market B finds E, who is willing to accept the same terms at C and so on. After 5 iterations of this scenario, B’s balance sheet looks like this:

Person Liabilities Assets Reserves
A 1000 cows @5% 800 cows @9% 200 Cows
C 800 cows @5% 640 cows @9% 160 Cows
D 640 cows @5% 512 cows @9% 128 Cows
E 512 cows @5% 410 cows @9% 102 Cows
F 410 cows @5% 328 cows @9% 82 Cows

Total: 3362 cows@5% 2690 cows @9% 672 Cows

Questions for budding economists:

1) Does decreasing the amount of amount of cows left in reserve, increase cow supply?
2) What is the cow multiplier when a reserve ratio of 8% is stipulated?
3) Does varying the rates of return, alter the supply of cows?
4) Does fractional reserve cattle banking, increase the number of cows?
5) Are borrowed cows destroyed when loans are paid back?
6) Are cows created by fiat when loans are made?

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