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We went out for dinner last night with a couple who have a holiday home here. They aren't our favourites, we don't see eye to eye on almost anything but we feel rude turning down invitations so we dragged ourselves along. The husband, when he is disagreed with, tends to raise his voice and so our difference of opinion became unnecessarily heated. The wife tends to go quiet and accused us of becoming aggressive, which we hadn't. Actually we had found the entire episode bewilderingly nonsensical. The husband had stated that when he had asked the bank why he was not receiving the same high interest rates on his savings accounts that he always had in the past, the bank had given him the outrageous response that inflation was not high enough!

We explained that we were in agreement with the bank and the husband went bonkers! As far as he is concerned a bank charges borrowers 5% and pays lenders 3% and the bank lives off the 2% difference and that is that. Nothing whatsoever to do with inflation.

The whole episode bothered me so much I didn't sleep too well and was still mangling it all around in my head this morning. What if he's right? I thought. So I tried to explain to myself in layman's terms how it could possibly work his way, but all I could come up with was the explanation below (read only if, seriously, this stuff interests you). I typed it up with the intention of emailing it to him and then thought better of it. Why not just allow them both to fester in the hope that they never invite us out again?

But having spent so many hours in its preparation it would be a shame to waste it so I decided to blip it instead. Apologies for the hastily thrown together drawing, the brain was too pre-occupied to notice anything camera-worthy.

Basic economics
1 – Businesses and customers
Let's say for the sake of argument that the average cost of living is 10€ per day.
Mr A opens a supermarket, his supplier charges him 1€ per item. Mr A marks up all items by 20% and sells everything for 1.20€. In order to make 10€ per day Mr A has to sell 50 items
Mr B opens a supermarket, his supplier charges him 1€ per item. Mr B marks up all items by 50% and sells everything for 1.50€. In order to make 10€ per day Mr B needs to sell only 20 items.
Customers are not stupid so they all go to Mr A's supermarket where everything is cheaper and Mr B goes out of business. This proves to us that a lower profit margin produces a higher turnover which is better for business. The same is true for banks. A bank charging a high interest to customers (borrowers) will have fewer customers than a bank which charges a lower interest rate to customers (borrowers).

2 – Businesses and suppliers
Mr C opens a supermarket, his supplier charges him 1€ per item. Mr A marks up all items by 10% and sells everything for 1.10€. In order to make 10€ per day Mr C has to sell 100 items. He does this easily because his prices are so cheap and he places a second order with his supplier. He takes too long to pay his supplier and so his supplier doesn't deliver his order. Mr C has no stock to sell and so he goes out of business.
The same is true for banks. If a bank does not pay its suppliers (lenders) fairly they will stop putting money into the bank and so the bank will have no money to lend to its customers (borrowers). A bank paying a higher interest rate to suppliers (lenders) will have more suppliers than a bank which pays a lower interest rate to suppliers (lenders). Therefore a bank must charge borrowers as little as it can afford to and must pay lenders as much as it can afford to, thus keeping profit margins low and turnover high in order to stay in business.

3 – Interest rates and inflation
Let's say for the sake of argument that the bank is charging borrowers 5% per annum, paying lenders 3% and living off the 2% difference, but interest is running so high that you can buy a house for 30,000€ and sell it the following month for 33,000€. If you are a lender and you have 30,000€ in the bank you will take it out of the bank, buy a house, sell it a month later and have made 10% in a month. If you are a borrower you will take out a loan for 30,000€ to buy a house, sell it a month later and even after repaying the bank loan with interest you will have made a profit.
However, if all the lenders take their money out of the bank to buy houses then the bank will have no money to lend to borrowers so the bank will receive no interest payments and it will go out of business.
Alternatively, the bank is charging borrowers 5% per annum, paying lenders 3% and living off the 2% difference, but interest is running so low that house prices remain completely flat over five years. In this instance somebody who does not at the moment have the money to buy a house is better off saving up for one by putting their money into the bank and being paid interest than borrowing money from the bank and paying interest to it. In this way somebody will eventually have enough money to buy a house without having to pay the bank any interest and the bank will go out of business.

Therefore bank interest rates must keep in step with inflation otherwise they will go out of business. If you know of any other way that banking works I would love to hear your explanation.