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Does Amazon's license agreement allow for that? I don't think so, for what that's worth.
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There have been several libraries (you can Google to find them) which have implemented Kindle loaning. There are blogs of librarians being told that nothing in the Amazon TOS prevent it.
For what it is worth, our local Public library also has a couple of Sony Readers, a couple of iPODS (for audiobooks) and a Wii that you can reserve and borrow if they aren't using it for some Youth Activity. So loaning out Kindles isn't all that unique. They mostly utilize the Sony Readers to get people interested in Overdrive and they hold one back for training. I think that for the Kindle they just keep a list of books that the Library "owns" and then they'll load them onto the Kindle before you take it.
I think they require you to put your Driver's License # on the check-out form and sign an agreement for damages.
Why would Amazon do this? I'm not sure if it is prevalent enough for them to even care right now. Libraries are heavily investing in the Overdrive option right now. But pretty much for the same reason they'll sell a Kindle to anybody else. Sell a Kindle, sell Kindle books. That's what they do.