The Theory of Money, Part 35

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The last few weeks, we’ve been processing the changes that happened in our fictitious society after President instituted 0% backed fiat money by breaking his country’s currency from its gold backing. As a reminder, this change allowed banks to start using debt as reserves, which means there is no limit anymore to how much additional money can be created. It also enabled the government to take additional Labor Units from the people whenever it wants because it can direct First Bank to print new money to give to it.

There are several minor details that have accumulated as I’ve been thinking about all these issues, so let’s go through those this week.

I’d like to define some terminology for the two different kinds of loans we have seen. I believe clarifying these terms will be useful for helping us think clearly about these ideas.

The first type is an assentive loan, which is when the person lending the money has the assent of the actual owner of the money to lend it. If the person directly lends their own money, obviously that’s assentive. But also a bank can lend someone else’s money if they have the assent from the owner of the money. We typically call that a certificate of deposit (CD)–the person who owns the money knows that their money has been lent out, so they can’t get access to it until the term of the CD ends.

The other type of loan is an exploitative loan. This is done without the assent of the actual owner(s) of the money, which means the owners are being exploited. This is what happens when a bank lends out money through the process of fractional reserve banking. This is also what happens when the government borrows money by having their money-creating central bank create new money in return for a government bond.

How is it exploiting anyone though? Because, technically, the money being lent out in these situations is newly created money, so it wasn’t anybody’s money. Remember that really we care about the wealth (measured in Labor Units) people own. When a bank creates new money, that money carries value, which comes from diluting the value of all the pre-existing money. So, people’s Labor Units are getting taken from them for lending without their assent through inflation.

I also have been thinking more about this fictitious society’s gold coins. From near the beginning, I’ve been saying that the government has been printing them to a standardized shape and weight and quality, but there’s really no reason it has to be the government. As preface, this idea may sound drastic since it’s so different than what we’re used to today. But if a society is truly using only commodity money in the form of gold, I don’t see why a market for coining gold couldn’t spring up. As long as each company printing coins makes them in a desirable way, they will flourish in the market. Typically this would mean the coins are printed in a way that makes them difficult to counterfeit, they’re convenient sizes, and they are ultra exact in their actual weight relative to their stated weight. This would mean that there could be a variety of different weights and types of coins made by different coining companies that people are using for exchange. Soon enough, some standardization would naturally arise as people find the preferred weights in the market. And any coining companies that prove to be unreliable in their coins’ actual weights will quickly be forced by the market to change or go out of business.

This would allow as many coins to be made as there is gold, and that’s fine. We’ve already talked about this earlier in the series, so I won’t rehash it here. But, to briefly describe how it would actually work, anyone would be able to take raw lumps of gold (or even other coins) to any coiner and have them melted and stamped into new coins. The coiner would charge a competitively priced fee for doing this, so maybe you give them 50 grams of gold and they give you 49 1-gram coins in return.

I’ve also never actually named the currency in our fictitious society. And, at this point of having 100% unbacked fiat money, I guess the currency would need a name. Unofficially, I’ve been calling it gold coins, so I’ll stick with that.

If the society had stayed with gold as the foundation of its money supply, then it might be simpler to just refer to prices in the weight of gold. So, instead of saying the cook pot is worth 1 gold coin, we could say that the cook pot is worth 2 grams of gold.

I’ve also never explained token coins. Most modern societies still use metal as money, but the stated value on the metal coins is much higher than the intrinsic value of the metal by weight. So, they’re not real coins that have full intrinsic value like the gold coins of our fictitious society, which is why we call them “token coins.”

I’d also like to review the three different ways the government and First Bank can manipulate the money supply.

First, it can change the required reserve ratio, which of course alters the money multiplier.

Second, it can change the discount rate. Increasing the discount rate makes banks more conservative in how much money they lend out because it will be more expensive for them to go below their required reserve, so increasing the discount rate decreases the amount of money. And you see the opposite effect when the discount rate is increased.

Third, it can create new money for lending to the government.

Generally the money creation mechanism is used according to government spending policies, so this one isn’t as free to be used as a mechanism for purposefully manipulating the money supply. But the other two are much more free for the use in money supply manipulation.

So, with those two tools in hand, the government has control over the value of money because they can deliberately inducing inflation or deflation. This allows them to start leveraging this ability to try to stimulate the economy by increasing the money supply when the country is facing a hard economic time, or they can carefully induce deflation whenever inflation is getting out of hand. That’s why we hear about the Fed changing the discount rate or the required reserve ratio in their efforts to beneficially tinker. I think this topic bears further discussion next week.

The Theory of Money, Part 34

Last week was a longer post explaining the implications of (1) now having a money-creating central bank and (2) shifting from the type of fractional reserve banking that only uses assets as reserves to the type that can also use debt as reserves.

This week, we’ll keep this fairly short (but really interesting). Let’s talk about the U.S. government debt!

Now that we understand that any government with a money-creating central bank at its disposal has three ways to get money (tax, borrow, create) and that the usual method of creating money involves the government giving the central bank an IOU in return, we now have all the tools we need to understand modern government debt.

So, how much of our U.S. government debt is owned by actual people who lent money that already existed, and how much is owned by the Federal Reserve (which means it was created for the purpose of lending to the government)?

According to, the U.S. government’s debt is currently at approximately $31,460,000,000,000. For simplicity, let’s round down to a cool $31 trillion.

The way the debt breakdown is reported, there are two categories: “intragovernmental holdings” (20%) and “the public” (80%). Intragovernmental holdings refers to money that was created by the Federal Financing Bank, which is a money-creating central bank that only lends to specific government agencies (you can read about it here), and all of the debt owned by it was bought with created money.

But what about the Federal Reserve’s holdings? I guess the people creating the report didn’t want to include those in the intragovernmental holdings category because it’s technically not part of the government, so the Fed’s holdings are totally misleadingly lumped into the public category. The Fed holds 20% of the total debt, which, when added to the intragovernmental holdings, means about 40% of the total debt ($13 trillion) is from created money. I kind of expected it to be worse!

I can’t help but share one other detail from this website. Remember when I talked about societal defaults, and the big contributors to that were bank leverage, government leverage, and individual leverage? With our current required reserve ratio of 0% (as of 2020), the federal government’s debt to income ratio at 124%, and our average household debt to income ratio of 145%, this appears scary. Should we be worried about a societal default (i.e., another great depression)?

The reserve ratio is certainly scary, but the debt to income ratio alone doesn’t tell the full story of the government and individual debt burden. There’s a reason banks giving loans worry most about what your monthly debt payment will be as a percentage of your total monthly income because this is probably the most predictive indicator of whether you will be able to afford making your monthly loan payments.

With interest rates being so low right now, debt payments are also low in spite of the high total debt burden, so the federal government is only spending 12% of its income on debt payments, and the average individual is only spending about 10% of their after-tax income on their debt payments.

So, there’s no reason to panic yet. These debt payments don’t strongly predict a societal default, but that doesn’t mean the banking leverage alone can’t trigger one. Except that, like we discussed in the last few posts, bank runs are easier to deal with when the thing being used as reserves can be created at will, so that seems unlikely to trigger a societal default right now as well. Not impossible, mind you, but unlikely.

And if that last paragraph sounds like an argument in favor of 0% backed fiat money, you now understand why people who haven’t read 34 blog posts about the theory of money can be persuaded that 0% backed fiat money is an amazing idea and that using gold as reserves only causes problems!

The Theory of Money, Part 33

Image credit: Bill Watterson

When I started this series, I never expected to get up to this many parts! Apparently I had more thoughts on money than I expected. But we are nearing the end of the series. There are still some more things to process with the change to 0% backed fiat money, and, of course, I will probably have a few things to say about crypto before the series ends. And then at the end I want to take a look back at how far we’ve come and discuss possibilities for improving our monetary policy. But diagnosis first, then treatment.

Last week, I introduced discount window lending into our fictitious society’s banking system. Discount window lending allows First Bank to create money to lend to banks who are still short on reserves even after they’ve gone through the reserve-sharing process with each other (through their “reserve-sharing central bank”). The fact that First Bank can now create money for lending means it has morphed into the kind of central bank people are usually talking about when they use that term. Specifically, it’s now what I call a “money-creating central bank.” I use that term to distinguish it from a reserve-sharing central bank.

Quick sidenote: First Bank could now be referred to as the “lender of last resort.” The first resort was the other banks, but if they don’t have enough excess reserves, then you move on to the last resort by borrowing through this discount window process.

Creating new money is a completely different beast from merely multiplying money through fractional reserve banking. You see, regular banks are limited in how much money they add to a society by (1) the amount of money people store in them and (2) their minimum reserve ratio. Money-creating central banks, on the other hand, have no limits; they can create new money as much as they need and whenever necessary. And, of course, if that money ends up in a bank using fractional reserve banking, then that newly created money can also be multiplied.

I have described how First Bank became a money-creating central bank for the sake of lending to banks any time they are short on collective reserves, but First Bank can lend newly created money to the government as well, and this is probably the more important aspect of its new power. So let’s talk about that.

First, though, why would the government want to borrow newly created money from First Bank? Why not just have First Bank create new First Bank Notes and give them to the government?

I think the issue is that it would be unpopular. If people start to wonder why suddenly inflation is skyrocketing, it wouldn’t take much investigation for them to figure out that the government is simply having First Bank print money and give it to them.

So, instead, the government will borrow this money. This is how they do it: Any time the government wants more money, it can put some government bonds up for sale. If people buy them with real money, it’s great! The government has borrowed money without causing inflation. But if there aren’t enough people with real money to buy all of them, then First Bank has an ongoing commitment to simply create the money necessary to buy all the rest of them.

This is easy to do with a computer, no printing necessary! Some entry-level First bank employee is assigned the task of checking at the end of each day to see if there are any unpurchased government bonds from that day. If he sees that there are 200 government bonds still up for sale from that morning, each one with a face value of 1,000 First Bank Notes, he will go into the special money creation account and adjust the balance from 0 First Bank Notes to 200,000 First Bank Notes. He then uses that account’s balance to purchase the 200 government bonds. Voila! Money was created and lent to the government with a few simple keystrokes!

The government likes this system because it can get all the money it wants anytime. It doesn’t even have to pay back the money it’s borrowing until it’s ready to do so! For example, if bonds mature before the government has the money to pay the face value back to the purchaser, it can simply issue new bonds to replace the maturing ones and use the sale price of the new ones to pay off the old ones. And it’s always guaranteed that all the new bonds it issues will be purchased because of the ongoing commitment from First Bank to buy whatever bonds are not bought by anyone else.

The bankers are pretty happy with this arrangement as well–they get to create new money and then earn interest on the bonds they bought with it!

But President, he’s extra generous to the bankers because he wants to thank them for helping him out like this. So what does he do? The answer is a short statement with a big implication: He says they can use those bonds as reserves.

Yes, this means President has allowed banks to use government debt as reserves. Let’s process this.

Remember when banks originally only used specie (i.e., cash assets) as reserves? And that they eventually expanded to using non-cash assets as well? That was all the way back in Part 22, and I explained how it increased the total amount of money quite a bit.

Let me run through the math of this briefly before we see how this expansion to using debt as reserves changes things.

Let’s pretend that a society has a total of 500,000 Labor Units worth of wealth, 20% of which (100,000 LUs) are stored in cash assets and 80% of which (400,000 LUs) are stored in non-cash assets. And let’s further pretend that currently they only directly use gold coins as money, and each gold coin is worth 1 LU.

Now let’s instantly introduce receipt money and fractional reserve banking into the society. All 100,000 gold coins will be placed into the bank’s vault, and we’ll set the reserve ratio at 0.2, which means the money multiplier will be 5.

Almost instantly, the 100,000 gold coins got multiplied into 500,000 bank notes. That’s a huge dilution of the value of their money (which is another way of saying that we just caused terrible inflation). But now let’s allow banks to use non-cash assets as reserves too. If banks only own 10% of society’s non-cash assets, that’s still 40,000 LUs worth of additional reserves, which in turn creates 200,000 more bank notes.

So, in a very short period of time, they went from 100,000 gold coins to 700,000 bank notes. This means that, once prices adjust to this new amount of money, each bank note will be worth approximately 1/7 as much as gold coins originally were. Or, said another way, each person just lost 6/7 of their cash wealth.

This was a huge amount of inflation, right? But even so, there is an anchor limiting how much inflation you can create when the system still requires some form of assets as reserves. Even if you lower the reserve ratio, there is still an anchor.

But what if you do away with requiring only assets as reserves and also allow government bonds to be used as reserves? To what extent can inflation occur now? If your answer was “infinity,” you were correct, because the only thing limiting more inflation is the government not wanting more money quite yet.

(Ahem, okay, technically, if the government overuses this power and causes too much inflation too fast, it may lead to a loss of confidence in the currency, which could lead to a collapse of the entire currency. But, short of that, if it uses this power carefully so as not to kill the goose that is laying the golden eggs, it could induce inflation indefinitely.)

Continuing with the example now that debt as reserves has been added into the mix, if the government decides to sell 10,000 gold coins worth of bonds, and the central bank buys all of them, then 10,000 additional new bank notes were immediately created. If all of those end up being stored in banks, then really 50,000 new bank notes were added to circulation after accounting for the money multiplier. But don’t forget that the central bank is allowed to use those bonds worth 10,000 as reserves, which leads to another 50,000 new bank notes circulating.

All told, that’s 100,000 new bank notes being added to circulation when the government borrowed 10,000. It’s like the money multiplier that applies (in an oversimplified world) when the government borrows created money is double the usual money multiplier.

So, let’s track the total number of circulating bank notes with each step:

Originally: 100,000 gold coins

Using only cash assets as reserves (reserve ratio 0.2): 500,000 bank notes

Using cash and non-cash assets as reserves: 700,000 bank notes

Using assets and now debt as reserves: 800,000 bank notes

And that final increase to 800,000 was only after a single round of borrowing. They could do that every month and increase the total number of circulating bank notes by 1,200,000 every year, forever. This dwarfs the inflationary effects that the only-assets-as-reserves type of fractional reserve banking can achieve.

Let’s end this post by looking at the implications of this.

Previously, President was stuck only getting money in two ways: taxes and borrowing. He didn’t like increasing taxes because it made him unpopular, but he didn’t like borrowing money either because ultimately he would have to increase taxes or cut spending to pay the loans back. Then he invested in a bank, which has been generating some income for him. That helped a little bit, but now he has the ultimate unlimited source of money. Any time the government needs to borrow money, it can put some bonds on the market and be assured that they will be bought. And it can keep reissuing bonds as long as it wants until it’s ready to pay back the money.

Ignoring the investment income from the bank, from now on let’s be clear about the three ways government can get more money: taxing, borrowing (from people with real money), and creating.

I have two main arguments against the government using this new creation power to get more money:

First, creating money causes inflation, which means everyone’s cash wealth comes to be worth fewer Labor Units. In short, the Labor Units the government is spending are being taken from all people who own First Bank Notes, which I explained in Part 6. (Remember that this effect is limited to cash assets because non-cash assets’ prices rise with inflation, so they are generally immune to inflation, as I explained in Part 7.) I’ve also detailed all the other issues that inflation causes in Part 15 and Part 16.

A couple other things related to this first point. One is that people whose wealth is being taken from them through inflation usually don’t even know it’s happening, so that’s why inflation (when caused like this by governments creating money for spending) is sometimes called a “hidden tax.” Another thing worth mentioning is that since people with less wealth generally have a higher percentage of their wealth stored in the form of cash assets, that means this hidden tax hurts the poor even more than the rich from a percentage-of-wealth-taxed standpoint. For example, if I am poor and 30% of my wealth is stored in cash sitting in my bank account, and inflation is 100% one year, I lost 15% of my wealth. If my rich neighbour only has 1% of his wealth stored in cash (and the rest is in non-cash assets like a large investment portfolio), then he only lost 0.5% of his wealth.

Second, when government subsidizes its spending through this hidden tax, we are blind to the full extent of its expenditures. For example, if citizens hear that their country’s entry into an ongoing war will cost each family about $20,000/year in additional taxes, they may still support that policy. But if they hear that this war will cost them $20,000/year in additional taxes PLUS another $20,000/year through the hidden tax of inflation, suddenly many of them will be much more critical of the decision to enter that war because they will be questioning whether it’s really worth $40,000/year to them. I suspect we end up supporting many government policies out of sheer ignorance of their full cost.

This was a heavier post, but I wanted all this information to be in one place, and I hope you see now why I have come to dislike money-creating central banks! By the way, we do have a money-creating central bank in the United States, and it’s called the Federal Reserve. They probably chose not to call it a bank due to the history of other unpopular central banks from earlier in our history. It took us 33 posts to get here, so don’t be surprised if almost nobody you talk to knows this stuff about central banks.

The Theory of Money, Part 32

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Last week, I used an example to explain how the true number of Labor Units in the world did not increase when President liberated all the gold coins (i.e., when he turned their money into 0% backed fiat money). I also explained how the people won’t bear the cost of him taking those gold coins from them until (or, if ever) they decide to get back to commodity money/100%-backed receipt money. I will soon show why that may be a worthwhile effort, but first there are some other changes to process now that gold isn’t in the picture anymore.

First, what changes with banks’ reserves now that they’re not using gold for reserves anymore?

If you will recall, when President created First Bank and gave it a monopoly on the issue of bank notes, it required First Bank to store all the banks’ gold coin reserves in its own vault. I explained all this in Part 28. Basically, if First Bank is the only one allowed to print bank notes, then it has to be the only bank where people can go to exchange those notes for gold coins, so all the gold coins needed to be stored there. This is actually how it happened historically, at least in some countries.

Well, now that there are no more gold coin exchanges happening, that means there’s no reason banks have to store their reserves at First Bank anymore.

So, after President passes the no-more-gold-backing law, First Bank sends each bank’s reserves back to them. Sure, the banks originally sent giant piles of gold to First Bank, and now they’re getting back (generations later) giant piles of pieces of paper. But the banks don’t care too much because they can earn the same amount of money off the pieces of paper as they ever could off the gold coins.

Now when the government audits banks, it’s a simple process of counting the number of First Bank Notes in the bank’s vault and then adding up the total value of the bank’s customers’ accounts. If the accounts add up to less than 7x the number of First Bank Notes in their vault, then the bank is good–it has adequate reserves. If the accounts add up to more than 7x their reserves, then the bank will have to borrow some reserves from the collective reserves (from the reserve-sharing central bank agreement, remember) and pay interest on that money.

This can all work automatically if everything is electronic. The bank just needs a method of tracking exactly how much money is in the vault at all times, and then, each day when the bank closes, the total amount in the vault and the total value of all accounts is sent to a centralized system. If a bank is short some reserves, it automatically is allocated some of the shared reserves and pays interest on it until the bank is back to having the minimum required reserves. And if a bank has extra reserves, it automatically will have some of its excess reserves allocated to the banks that are short and it will receive interest from those banks.

The system could be very equitable in how it shares excess reserves. If our fictitious society’s original 5 banks are the ones participating in this reserve-sharing central bank, and one bank (say, Story Bank) is short 10,000 First Bank Notes one day at the close of business, then the 10,000 notes are borrowed equally from the other four banks that have excess reserves. That would mean each of the other four banks would electronically have 2,500 of their excess notes allocated to Story Bank and get paid interest from Story Bank automatically each day. And if one of the banks only has 2,000 excess notes, the other 500 notes Story Bank needs could be borrowed from the remaining three banks equally. Simple and automatic.

But what if there aren’t enough excess reserves to meet the needs of all the banks that are short on reserves? This could be catastrophic if suddenly lots of people in society are all wanting to withdraw lots of money all at the same time and there aren’t enough shared reserves anywhere.

Ah, that’s when First Bank can step in and work some magic. President has anticipated this problem, and his solution is to allow First Bank to allocate as much money as is needed to any bank that is still short on reserves after going through the reserve-sharing process. There’s no limit to how much First Bank can lend, because it’s all electronically allocating made-up money anyway. And if the financial situation gets dire enough that bank vaults are actually truly empty of First Bank Notes, it wouldn’t be difficult for First Bank to actually print the First Bank Notes that are being allocated to those banks and physically deliver them.

Banks love this. Now they’re essentially bank-run-proof! The only remaining risk is that they have such a huge mass withdrawal of money from their bank that they go bankrupt from all the interest they have to pay to the other banks (for borrowing their reserves) and to First Bank (for lending them the rest).

A mass withdrawal like this could happen, but it’s exceedingly unlikely, so bankers feel like they have entered a new era of banking system security.

I know I’ve been describing this all as happening automatically electronically, but I think it’s helpful to drop back and look at how it would have happened before the digital age. So let’s picture the process of how this could all go down at the end of each business day.

Let’s say all the banks are all located on a single street. Each banker locks his doors after the last customer leaves and immediately checks the total number of First Bank Notes in his vault and the total accounts balance. He then determines how above or below his required reserve he is, prints out the number on an official-looking sheet of paper, and walks down the street to the reserve-sharing central bank office. The bankers all arrive at generally the same time submit their pieces of paper.

The office employee quickly tabulates the numbers and figures out how much of each bank’s excess reserves go to each bank that is short. He then prints out a receipt for each bank. For the ones that had excess reserves, the receipt states which banks are borrowing some of their excess reserves that night and how much each of those banks will owe them tomorrow. For the ones that were short on reserves, it says how much they’re getting from each bank that had excess reserves, and how much interest they will owe each one of those banks tomorrow.

If the situation occurs where there aren’t enough excess reserves to meet the needs of the banks that are short, the sheet also states how much more the banker needs to go get from First Bank.

So the banker takes that sheet and walks down the street to First Bank, which has built a window into the side of the building for just this purpose. The banker taps on the window and an employee opens it. The banker gives his sheet to the employee, and, while the employee looks the sheet over, probably says something like, “So what’s the rate tonight?” He’s asking what the interest rate will be on the money he’s borrowing. Sometimes this rate is called the “discount rate,” which is why this window is called the “discount window.”

The employee gives the banker a receipt stating how much money First Bank is allocating to him that night (which the banker already knew anyway) and how much interest he’ll owe on that money tomorrow.

From now on, this process of banks borrowing from First Bank at the discount window will be called discount window lending. And we’ll work through the implications of this process starting next week.

But what we have now, finally, is what people are usually referring to when they say “central bank.” It’s not just a reserve-sharing central bank like we’ve seen in this fictitious society for quite a while; it’s a “money-creating central bank,” the defining feature of which is that it can create extra money to lend out any time it wants!

The Theory of Money, Part 31

Image credit: fran_kie

Last week, we finally arrived at a fully unbacked fiat money. Wasn’t that exciting? Let’s process some of the impacts of that major change.

First, let’s talk about how this changes the money supply from an aggregate perspective.

Assuming the reserve ratio when this change happened was all the way down to a little less than 15%, that puts the money multiplier at 7. So, if there were 100,000 total gold coins being stored at First Bank, then there were 700,000 total gold coins worth of currency in the society. 100,000 of those were gold coins stored in First Bank, and 600,000 of those were First Bank Notes.

I think it’s important here to mention that whether those 600,000 First Bank Notes were physically in people’s wallets or whether they were credits in their bank accounts, it’s all the same because, either way, people act generally the same, whether the money is in a bank account balance or in a stack under their mattress, they still perceive that they have that money, and they act accordingly. If the blacksmith buys a new furnace, whether he does it by handing over physical First Bank Notes or by writing a cheque that transfers them from his account to the seller’s account directly, the amount of money he had and is giving to someone is the same. I felt that this is worth mentioning because, in the 1900s, some politicians wanted to limit inflation in their countries, so they tried to keep the reserve ratios higher by making laws limiting the number of physical bank notes that banks could print and lend out. How did banks respond? They kept lending out just as much money as before but simply distributed those loans as account balances (and had their customers write cheques) instead of handing out physical bank notes. The laws were completely ineffectual, and only after watching this play out did the politicians realize their oversight.

Anyway, when President made the change to pure unbacked fiat money, basically all he did was take those 100,000 gold coins out of the First Bank vault and then print 100,000 new First Bank Notes to put in their place. So, there are still 700,000 gold coins worth of currency in society, it’s just that all 700,000 of them are now First Bank Notes.

What does President do with all those gold coins then? Anything he wants! They’re his to spend however he wants, no strings attached. Nobody else has any claim to them anymore. It’s like a magic trick. If a single gold coin represents, say, 4 Labor Units, that means he just created an extra 400,000 Labor Units out of thin air, right? Because nobody lost any of their cash wealth when he made this change, but suddenly he has 400,000 more LUs.

By now, it should be clear that Labor Units (i.e., wealth) don’t come out of thin air; no accounting gimmick or banking trick, no matter how clever or convoluted, can create more wealth. So let’s see if I can clarify what’s going on with this apparent doubling of Labor Units with an example.

Let’s say a society is using exclusively receipt money (bank notes), but it’s 100% backed by gold coins being stored in the society’s single bank. Nobody ever exchanges a bank note for a gold coin, they only use bank notes every time they are transacting. If they have an aggregate of 40,000 bank notes, there are 40,000 gold coins sitting there in that bank’s vault. And, for simplicity, let’s say that 1 gold coin = 1 Labor Unit. So there are 40,000 LUs worth of wealth sitting in his vault. But because nobody ever actually exchanges a bank note for a gold coin, the banker never even opens his vault.

And then something terrible happens. In the middle of the night, a burglar digs a tunnel under the bank, drills into the bottom of the vault, and empties out all 40,000 gold coins, which he takes to a foreign country, melts down, and sells for 40,000 LUs worth of the local currency.

Meanwhile, society continues on as usual. They have no idea that all their gold is gone. Overnight, they went from using 100% backed receipt money to using 0% backed receipt money. But nothing changes, and they continue transacting as they always have with bank notes.

Has the perceived number of Labor Units temporarily doubled? Yes. The people still have all their 40,000 LUs worth of cash wealth in the form of bank notes, and the burglar now has 40,000 LUs worth of gold coins.

Then a missionary comes along and converts the entire society to a new religion that believes that using paper is a sin, so they decide they will all shift to using exclusively gold coins again. They hold a big ceremony in the middle of the town. Each person counts out the total number of bank notes they own and the banker makes a note of it, and then they all throw their bank notes into a big bonfire and go together to distribute the gold coins from the vault according to the records the banker kept during the ceremony.

To their horror, they find the vault empty, with a big hole in the bottom that makes it clear that they were burgled. Suddenly, their perceived cash wealth is now 0 LUs, so the total number of Labor Units arising from those gold coins is back to 40,000–the burglar has all of them, and the people have none of them. (Fortunately, the people in this society have plenty of non-cash wealth, so it’s not like they are instantly poverty stricken.)

And so the people are faced with a choice. Do they print all new bank notes (out of synthetic paper this time) and go back to how they were, using intrinsically worthless bank notes to conduct their business? Or do they want to get back to using an intrinsically valuable commodity as their money?

For them to be willing to choose to start using gold or some other intrinsically valuable commodity again, it would cost them a lot because the moment they decide not to use unbacked bank notes anymore, they lose all their cash wealth. For them to be willing to do this, the benefits of shifting back to using commodity money again would really have to be significant! Otherwise, it makes a lot more sense for them to simply keep using unbacked paper/paper substitutes as their money and just keep pretending they’re worth something. And as long as everyone keeps pretending and treating those worthless pieces of paper as if each one is worth 1 LU, they will continue to work as a means of storing and exchanging wealth just fine.

I hope that clarifies how the number of Labor Units wasn’t truly doubled when President converted the monetary system to unbacked fiat money and got all that gold for himself. It’s just that the perceived number of LUs in the world is doubled because half of them are imaginary. If that shared illusion goes away, the imaginary Labor Units immediately disappear as well, and the true number of Labor Units in the world goes back to what it was.

But there’s no harm in continuing to live this shared money illusion is there? Yes there is. There is great harm, which I will show in subsequent weeks. The question is, is the harm great enough that it is worth the cost of getting us back to commodity money? About that, I’m honestly not sure yet.

The Theory of Money, Part 30

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In Part 29, we saw our fictitious society shift from interchangeably using commodity money (gold coins) and receipt money (First Bank Notes) to exclusively using receipt money. People had mostly forgotten that they used to own gold coins that have intrinsic worth and that they believed that those little pieces of paper were merely a stand-in for the real thing. Instead, those little pieces of paper are so convenient and they’ve been using them for so long that they didn’t even want to deal in gold coins anymore due to their additional weight and inconvenience storing them and the difficulty finding someone who will accept them directly anymore.

Additionally, because First Bank Notes had been used for so long and were so reliable, they became a worldwide commodity in their own right. Thus, even international exchange no longer requires the use of specie directly if First Bank Notes are being used.

President, who apparently has a lifelong term in office, regularly stops by First Bank and looks in at the piles of gold coins in the vault. More and more, he feels like they’re just sitting there doing nothing (we’ve heard that before, right?). People don’t need or even want to use gold coins anymore. He realizes that very few would care or even notice if he stops guaranteeing a gold coin in exchange for a First Bank Note. After all, they’ve leveled up their form of money to something more modern–these very convenient pieces of paper–and it’s working perfectly well as a common medium of exchange.

All these thoughts lie dormant in President’s mind until, sooner or later, some financial challenge occurs. Maybe the weather will cause another bad crop. Or maybe there will be another war. Let’s say it’s another war. And now President is forced to come up with a lot more money to be able to pay for it. He has to pay other countries for some of his war supplies, and he has to pay his soldiers.

That’s when he makes a very important decision: He decides he will no longer guarantee a gold coin in exchange for a First Bank Note. And he can finally do this without causing too much (if any) public outcry. So he quietly changes the law to say that a gold coin will no longer be given in exchange for a First Bank Note. This helps him pay for this new war in two ways.

First, he can take all those gold coins that were “just sitting there doing nothing” and spend them. It’s like the government has just received a large inheritance! This is the perfect way to pay all of his international suppliers for various war supplies.

Second, he is no longer restricted by a silly minimum required reserve ratio that says how many First Bank Notes he can print. If he needs more money, he can simply print it, and he can do that without any risk of a bank run because the ultimate form of money in society is now First Bank Notes, not gold.

But he needs to be strategic in how he decides to print all these extra First Bank Notes. If he simply prints them directly, people might catch on to the fact that the inflation they’re experiencing is a direct result of President doing that. And people don’t like inflation if they know that it’s directly caused by the government printing money and thereby taking a portion of their cash wealth without their consent.

So this is what he does. To pay for his war, he first imposes whatever war taxes he can get away with. People don’t like taxes, so he is pretty limited in this regard. And then, to cover the rest of his war expenses, any time he needs more money, he puts some government bonds up for sale. If he needs another 500,000 gold coins worth of value, he puts 500 bonds for sale, each one being worth 1,000 gold coins. If the general public only buys 300 of them, then he will have First Bank buy the other 200. And how is First Bank going to pay for those bonds, which are worth a total of 200,000 gold coins/First Bank Notes? They will print them of course! And now the inflation caused by First Bank printing this money is hidden in the complexities of banking, which the general public can’t be expected to understand. They will see that inflation and just know that this is a fact of the world. Inflation happens. Especially during a war. (Ahem, or a pandemic.)

And voila! With this one simple change, President can be assured that he will always get all the money his government needs to pay for any financial challenge.

Next week, we will analyze the effects of this. But we have, finally, after 30 weeks of writing about money, gotten to the usual final evolved state of money: fiat money. Well, technically, we got to fiat money when President passed the legal tender law. But now we are at the type of fiat money that is normally thought of when the term is used. It’s the kind that is not backed by anything of intrinsic value, which gives the government full power to print as much as it needs. And now we have seen the whole process of how money evolves from commodity money all the way to unbacked fiat money, and why people in our modern day use as money these nearly worthless pieces of paper.

The Theory of Money, Part 29

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Last week, I clarified some details about how exactly President achieved a uniform currency with the new First Bank Notes. Now all the specie of all the banks is housed at First Bank, and all banks are limited to having outstanding loans amount to five times the number of gold coins in their First Bank account (calculated based on the current required reserve ratio of 20%).

One thing I didn’t mention last week is how a reserve-sharing central bank would work with this new system. It is much easier to share reserves if a bank goes below their 20% reserve requirement since all the specie is stored in the same place, but now that First Bank is controlling the dispensing of receipt money, is it even possible for a bank to lend out more than 5 times their gold coin reserve? Yes. Yes it is. Here’s brief example to show how.

Verity Bank lends 5,000 First Bank Notes to an entrepreneur. Instead of handing the entrepreneur a giant duffel bag with 5,000 First Bank Notes in it (not wise due to risk of it getting stolen), Verity Bank credits the entrepreneur’s Verity Bank account with 5,000 First Bank Notes. Then, whenever the entrepreneur wants to pay a supplier, he can simply write a cheque (or do the same thing electronically with a fancy plastic card issued by the bank) that allows the supplier to get the First Bank Notes directly from Verity Bank.

So we see that if banks have account balances for customers, it wouldn’t be too difficult for them to cross over that reserve ratio requirement, especially if they are aggressive at trying to stay as close to that 20% reserve ratio as possible. For example, if Verity Bank starts working through the process of originating that loan for 5,000 First Bank Notes one week before they actually have the money to give the entrepreneur, then they can sign all the paperwork in advance with a promise to give him the loan money in one week, which would be right after they have 5,000 to lend because they’re expecting several large loan payments to come in on that very day. But if, on that day, even one large loan holder doesn’t make their payment on time, Verity Bank may not actually have the money they promised the entrepreneur. But they will still credit his account for the 5,000, thereby crossing below the 20% reserve ratio requirement.

Fortunately, President accounted for this possibility by setting the reserve-sharing interest rate relatively high, so most banks will be discouraged from having loan policies that are that aggressive because they know that, on average, it will cost them more in interest paid to First Bank (the first-line reserve-sharing institution) than it will earn them.

All right, now with those details out of the way, let’s see what happens next.

Society seems to be growing wealthier. The inflation they initially faced as more and more banks shifted to fractional reserve banking has settled out now, and the efficiencies gained by having a uniform and predictably valued form of money is showing its benefits.

In fact, First Bank Notes are universally accepted domestically (thanks to the legal tender law) and have proven so reliable in their convertibility to gold coins–but are so much more convenient than gold coins–that people are using First Bank Notes almost exclusively. The only time people end up exchanging notes for specie is if they are conducting international trade, which is usually only businesses rather than individuals. And even when individuals go to other countries, First Bank Notes have become so well trusted and well regarded that merchants in other countries often accept them. Or, if someone travels to a place where merchants don’t accept First Bank notes, at least money exchange stores are always available to trade First Bank Notes for the local currency. Pretty soon, nobody is using gold coins directly anymore. Maybe every once in a while, someone will go to a First Bank branch to request to exchange a First Bank note for a gold coin, but this is mostly just to satisfy their curiosity about whether they can still do that.

Thus, within a decade or two, First Bank notes have functionally become the only currency. Even merchants don’t usually have an easy means of accepting gold coins anymore. Meanwhile, the number of gold coin withdrawals has steadily dropped, which has allowed President to slowly lower the required reserve ratio in an effort to earn more interest. Not that increasing the amount of money being lent out will automatically earn more interest for the bank–there are multiple factors involved that determine that. But, for simplicity, let’s assume that President has lowered the required reserve ratio to 10% and is earning even more interest for the government through First Bank.

Let’s stop there this week. We have transitioned from a system where commodity money and receipt money are being used interchangeably to a system where receipt money is exclusively being used. In other words, people have started thinking of these little pieces of paper that they call First Bank Notes as real money rather than think of them as a receipt for the real money, which is intrinsically valuable gold coins. We’ll see how President takes advantage of this next week.

The Theory of Money, Part 28

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Ok, for those following along, last week I pointed out some issues that didn’t make sense with some of these recent changes I said President made. It’s time to clarify them. I may go back and just do that in the original posts later on for the sake of avoiding confusion for future readers, but we’ll see.

As an aside, what a fun journey to be on, right? Figuring out money and banking, and also figuring out how to explain it in a comprehensible format! If you haven’t ever read anything on money and banking, you should. Try, for example, reading these speeches (PDF) made by some Ph.D. economists during a congressional hearing on fractional reserve banking in 2012. If you already understand what they’re talking about, their statements make sense. But if you don’t, man is it befuddling. I’m sure I fail sometimes at making it completely comprehensible as well, but I hope a deliberate stepwise approach to this information (plus some simplifications that don’t alter the underlying mechanics) helps.

Anyway, here’s a quick summary of the issue needing to be clarified: The confusion was about exactly how we transition from our current system with a bunch of different banks offering their own version of Goldnotes to this new system of exclusively using First Bank Notes.

I originally said that we could phase out all the other banks’ banknotes by having First Bank give each bank enough First Bank Notes to directly buy back all their circulating Goldnotes, and that you could take a First Bank Note to any bank and exchange it for specie. But I identified some problems with that method last week–the biggest problem was that, since anyone could get specie in exchange for a First Bank Note from any bank, it basically converted all banks into a single huge bank with a single shared reserve. And that means any bank could get away with lending out a lot more (draining the collective reserve) and earning more money than the rest, which would soon lead to all the others following suit, and then the reserves would be depleted and a banking collapse would occur.

My challenges with getting our fictitious society to make this transition arise from the difficulty I’ve had in finding more details on the specifics of how a government-run bank’s monopoly on the issue of banknotes actually gets enacted. So let’s do this in a different way that makes a little more sense to me.

We’ll start by clarifying that First Bank Notes are good for one gold coin, but you can only make that exchange at First Bank itself. It’s First Bank guaranteeing this receipt money can be converted back into commodity money at any time, so it makes sense for that to be the only place someone can make that exchange.

And if First Bank notes are the only ones that are going to be used in all of society, and anyone can go to First Bank to request a note be exchanged for a gold coin, then all the gold reserves also have to be in First Bank.

So, these are the steps I think President could take to make this transition:

First, he will have each bank send all their gold coins to First Bank, and those gold coins will be deposited into each bank’s account. Yes, this means every bank now has a bank account at First Bank.

In return, he will give them First Bank Notes. Since the established reserve ratio is 0.2 right now, that means the money multiplier is 5, so he will give them 5 times the number of First Bank Notes than they gave in gold coins, which they will then have to use to trade in all their circulating Goldnotes.

All contracts will also need to be converted into First Bank notes or gold coins. So, if a contract is currently denominated in Story Bank Goldnotes, which are trading at 0.9 of their stated value, the conversion would be simple. If a contract is worth 1,000 Story Bank Goldnotes, then it will immediately get switched to be worth 900 First Bank Notes to retain its current market value.

I think that’s it. Ultimately, the exact process of how this works is less important than the fact that people are only using First Bank Notes now. And when banks are lending out money, it’s First Bank Notes that they are giving out, which they are getting from First Bank in return for the specie that they’re storing in their account at First Bank.

From what I can tell, historically the phase-out of other bank notes was done by charging a higher and higher tax on any non-government bank notes, which made them worth so much less that they became no longer viable as a low-cost means of using as a common medium of exchange. But information on the exact details of how that went down is not readily available based on my searching and reading.

All right, next week we’ll resume our more rapid progress through the last few changes our fictitious society’s money needs to make.

The Theory of Money, Part 27

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In Part 26, our fictitious society finally transitioned to a uniform currency. To be clear, their money is still backed by gold, but their receipt money is now uniformly First Bank Notes.

Since that transition, transacting has become easier because now everyone is using the same notes, and they are each worth the same as a gold coin, which is much simpler than what they had to do before when they were trying to account for discounted Goldnotes from many different banks.

But a question arises about this system.

What happens if a bank has a ton of people come and request specie in exchange for First Bank Notes? Aren’t we risking banks running out of specie since there are many times more First Bank Notes than there are gold coins in any one bank?

The answer is that if a bank has to give up a ton of its specie, it is getting First Bank Notes in return, which it can then take and get specie from any other bank.

But this brings up another question.

What’s the point of a reserve-sharing central bank if any bank can get reserves from another bank simply by giving a bunch of First Bank Notes that it has on hand? It seems like all bank reserves have become shared since the receipt money now in use entitles a person to a gold coin at any bank.

This is true, and it means I haven’t perfectly thought through the exact steps that a banking system takes to get from there to here. Sure, these steps are just transitional steps, but I think it’s important to understand each one thoroughly nonetheless.

So this is what I’m going to do. I’ll stop here this week and do some more reading and thinking by next week. This is a great reminder of an important point: my knowledge is imperfect. I hope that’s not a surprise to anyone. I’ve written before about academic integrity, and I just re-read that post and still completely agree with everything I wrote. I recommend taking a look at it. It applies to my knowledge of money and banking just as much as any other topic.

The Theory of Money, Part 26

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Last week, we saw President get his government into the banking business by shifting all his government money into a newly created government-run bank that we are calling First Bank. President also implemented some safeguards to lower the risk of him losing this new revenue stream and his entire government savings in one fell swoop. These consisted of establishing a reserve-sharing central bank, establishing a minimum reserve ratio, and also giving himself the authority to suspend banking transactions temporarily in the event of a bank run or other financial emergency.

I’m going to now throw caution to the wind and move things quickly through the last several changes to this monetary evolution. But I don’t want it to seem rushed. I want each change to be shown as a logical and reasonable next step for the decision makers to make, given their circumstances. And once we get this money to the end of my planned state of evolution, then we can take some time to process the impacts of those changes after that.

We haven’t seen much bad banking behaviour in our fictitious society so far, but historically there probably would have been a number of exciting events by now, including some bank runs that led to bankruptcies, some banks that were on the verge of bankruptcy and stayed afloat by temporarily ceasing giving specie in exchange for their Goldnotes, and others that were forced to cease business or get bought out due to unscrupulous practices.

All these events commonly happen if a society is given enough time with fractional reserve banking. And an important result of it is that the bank notes from some banks end up being traded at a discount relative to their stated worth because of uncertainty about whether the bank will continue to be in business or continue to exchange its bank notes for specie.

For this reason, things have gotten confusing. There are a bunch of different banks issuing Goldnotes, and all of them have different values.

First Bank’s Goldnotes, on the other hand, are seen as more reliable. People believe that if the government is backing a bank, it’s more likely to come out all right in the event of a panic, so it’s quickly becoming the de facto currency for commerce.

President sees all this and decides it’s time for a change. He wants more uniformity in his country’s monetary system, which will decrease the frictions people are experiencing when they are transacting with different forms of receipt money. President hopes this change will “grease the wheels of commerce.” And, with a government-run bank at his disposal, he has all the tools necessary to finally do this.

So he declares that First Bank now has a monopoly on issuing bank notes, and he passes a legal tender law (explained in Part 24) backing that up. To symbolically demonstrate this change, all First Bank Goldnotes will be newly printed with a new pithy name: First Bank Note.

*Moment of silence for Goldnotes*

And on these new First Bank Notes will be the legal tender inscription: “This note is legal tender for all debts, public and private.” Each First Bank Note will be worth one gold coin, which means any bank will be required provide one gold coin when they are presented with one First Bank Note. This will establish a stable value (relative to gold coins) for the country’s new official receipt money.

The logistics of the Goldnote phase out would be relatively straightforward. Each bank’s Goldnotes will be assigned a value based on the current accepted value in the market. Then the issuing bank will be provided with the correct number of newly printed First Bank Notes to allow them to buy back all their circulating Goldnotes. People will be required to trade in all the Goldnotes in their possession within, say, 1 month, after which time no more buybacks will be allowed.

So if Indie Bank Goldnotes are trading at 0.9 their stated worth (a residual effect from the scare I described in Part 17), and they have 1,000 Goldnotes circulating, they would be given 900 First Bank Notes with which to buy back the Goldnotes with the Indie Bank stamp on them. I’ve ignored fractions of gold coins until now, and I’ll continue to do so; surely this society can have half coins, quarter coins, etc., and it can have receipt money that reflects those fractional coins as well. I just think talking about that doesn’t help explain anything and risks confusion.

Anyway, we have finally achieved a uniform currency! If my planning is correct, there are three other big monetary changes that need to take place, which I will describe starting next week.

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