A stranger is staying at a hotel in a small town high up in the mountains for a few days. Shortly after his guest has eaten breakfast and left for the day, the hotel owner notices that he has left his wallet on the table. Business is bad, everyone is in debt, and the baker has refused to sell the hotelier any more bread until he pays the £100 that he owes. The hotelier can see that there are five £20 notes in his guest’s wallet, and after wrestling with his conscience for a short while, steals the money and takes it down the baker, who restores the hotelier’s line of credit.
The baker is particularly grateful to the hotelier as he happens to owe the butcher £100, so he takes the banknotes across to the butcher’s shop and settles his bill. The butcher in turn owes the local garage £100 for repairs to his car, so he uses the money to pay off his bill. The garage owner realises that he can now pay the hotelier the £100 he owes for the meal bought last weekend, so he pops into the hotel and gives the money to the hotelier. Moments later, the guest returns. The hotelier, seeing him come through the door, quickly puts the £100 back in the wallet and hands it back to the guest.
At first sight, there is something odd about this tale. Everyone in the town appears to have paid off their debts and yet, at the end of the day, the stranger still gets his £100 back. How can this work? Where did the money come from?
What is going on here becomes clearer if we forget about the stranger at the hotel, and imagine instead that the hotelier gives the baker a note that states, “I, the hotelier, promise to give the bearer of this note goods or services to the value of £100.” The baker then gives the note to the butcher, and so on until the garage owner returns it to the hotelier. The hotelier has already supplied the bearer with a meal worth £100, so he simply takes back the note and calls it quits.
This can work, but only if everyone concerned actually believes the promise that is written on the note. In a small town, where everybody knows everybody else, this is feasible. However the hotelier would be unlikely to accept such a note from the stranger in payment for the room as he knows nothing about him and has no reason to expect ever to see him again. It’s a matter of trust (something explored in more depth in my post on Games Theory).
Now open your wallet and take a look at a banknote. If it’s British it will say something like “Bank of England” followed by “I promise to pay the bearer on demand the sum of Ten Pounds” and, if you look closely, the signature of the Chief Cashier (most likely one Andrew Bailey). At one time, this did actually mean that you could go to the Bank of England and exchange a £10 note for gold to the equivalent value. This is no longer the case and instead the system relies on trust – trust that the value of these bits of paper in our wallets will be recognised by others, and accepted in exchange for goods and services.