The Theory of Money, Part 20

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Wow, 20 parts already! I wish I’d gotten all the way to discussing crypto already, since that seems to be a hot topic right now. But things have to go in order so they make sense. I will at least discuss a little crypto stuff at the end of this post though.

Last week, in Part 19, I said we’d discuss societal leverage and societal diversification, so let’s do that now.

Societal Leverage

Remember the three kinds of societal leverage from Part 15? Bank leverage, government leverage, and individual leverage. How did these contribute to the near-societal default?

If there hadn’t been so many individuals dependent on their expected income from that year to make good on their loans, the banks wouldn’t have dealt with such a high default percentage. But this is what happens when a society is suddenly flush with cash. People start making risky investments assuming money will continue flowing. There’s a generalized excitement that arises, neighbours seeing neighbours get rich quick and not wanting to be left behind, so they want to get in on the action to avoid being the ones who don’t ride the wealth bubble up with everyone else.

Now, if people are making all sorts of investments with cash that they can stand to lose because they truly do have plenty of stored wealth to keep them going, then it’s not such a huge issue when some of that money is lost. People can stand to lose it, as undesirable as it is. But, as a rule, when society is suddenly flush with cash due to a dilution of the currency (through fractional reserve banking, in this case) and prices haven’t yet adjusted, this is not money people can stand to lose in most cases.

And, as for the banks, if they hadn’t been so highly leveraged, the high percentage of loans in default wouldn’t have triggered a bank run.

So both high individual leverage and high bank leverage were needed to trigger this near-catastrophe. I haven’t gotten government involved in this fictitious society yet, but the impact of the government defaulting on loans would have had a compounding effect on all of this because even more people would have been suddenly not getting paid for their work.

Those are my thoughts on how societal leverage contributed to this near-societal default. Get rid of the bank leverage and there won’t be a huge amount of surplus cash suddenly, which means the big trend of making all sorts of risky investments (and taking out loans to do so, triggering the high individual leverage) would not have happened, and society would have continued to generate wealth at a sustainable pace.

Societal Diversification

If the society wouldn’t have been so dependent on a good crop every year to continue to make payments on their loans and keep up the house of cards, they could have weathered this much better. What if half of the new wealth coming into this society was from the farmer, but the other half was from exporting a product to other societies? Then maybe there would have been a lower default rate and the banks wouldn’t have been on the verge of collapse.

Diversification is important for a society just as it is for an individual to help weather unforeseeable challenges.

These two factors–societal leverage and societal diversification–can help anyone evaluate the risk of a society to default. If they’re highly diversified and not highly leveraged in any of the three ways, it will be a solid society to invest in.


One last thing for this week. I want to give my definition of the word “speculation.”

I believe a risky investment crosses over into speculation when the investment returns are predicated primarily upon the price continuing to go up.

If the investment is not actually generating any wealth through providing goods and/or services, or it’s only generating a little bit of wealth relative to its price (and without any solid prospects of it increasing that wealth generation significantly), then the only way to earn a good return on that investment is for its price to continue going up, which requires people to be willing to buy it for more than you did.

At some point, the hype over this continually rising price will die down as people realize that there’s no way this investment can actually bring in earnings commensurate with its price (ahem, tulips, beany babies, Tickle Me Elmo), and that’s when the buyers disappear and the last ones holding the investment take the huge loss.

The end result of speculation is not an increase in total wealth. The end result is just a transfer of wealth from the people who got stuck holding it to the people who sold before the price started dropping. This is just like gambling. You’re making money off of others’ losses rather than from actual wealth generation.

Historically, the trigger for any speculative bubble is often a sudden influx of cash/perceived wealth just looking for a way to be invested, like what happened when the banks instituted fractional reserve banking. These days, there’s enough wealth around that they can happen even without a sudden influx of cash. But I hope you, my readers, know by now after 20 parts of this series that wealth is not created from nothing and, therefore, sudden influxes in cash are probably a dilution of wealth rather than an actual increase in wealth anyway.

Many crypto “investments” are speculation these days, and I’ll explain more later why an intrinsically worthless currency that doesn’t have a government requiring people to use it through legal tender laws is always going to be speculative in nature.

The Theory of Money, Part 19

Image credit: Roberto Machado Noa

Last week in Part 18, we looked at the financial details of Indie Bank to understand more thoroughly how a bank run was triggered by the farmer’s bad crop. It was originally a pretty discombobulated post, so I just went back and edited it for clarity and flow. Check out the new version if you want, or just read this quick recap of what I was trying to convey:

  • Our fictitious society’s 5 banks are simplified banks with only one source of revenue: the interest they earn from lending out the money they created through fractional reserve banking
  • These banks have fixed costs (building maintenance, wages, etc.), which need to be paid for with the interest income they are getting
  • If a bunch of borrowers default at the same time, their revenue may drop below their costs, which would mean they are stuck trying to pay their costs either with even more newly created money or by paying directly with specie they have in the vault, both of which result in the same problem–even lower reserve ratios/even more severely depleted stores of specie
  • Depleted reserves trigger bank runs when word gets out and people get scared

All right, it’s finally time to see what the banking leaders do when they see the long line of people trying to exchange their Indie Bank Goldnotes for specie. Remember, they know perfectly well that Indie Bank will run out of specie before the day is through and that it will have to declare bankruptcy if they don’t do anything to stop it.

First, they organize an emergency meeting. The leaders of all 5 banks are there, although the leader of Indie Bank is in the corner playing a melancholy song on a lute.

They other four leaders initially talk about allowing Indie Bank to declare bankruptcy and then spinning this to the public to convince them that Indie Bank was the only imprudent bank and that all the rest of them are very safe. Their hope is that a strong and widespread PR campaign will prevent generalized distrust in the banking system after Indie Bank goes bankrupt. They would then have to prove how safe they are by being a little more conservative (at least for a while) with their reserve ratios and loan risk.

But after discussing this idea for a while, they are not convinced it would work. Even with a great PR campaign, there is still a reasonable risk that the panic will spread to the other banks, and they know none of them would be able to weather that storm. And they can’t let that happen–think of how disruptive to society it would be if everyone loses (the rest of) their savings! For the sake of the people, they tell each other, it is their duty to find a better option.

So, they hatch an ingenious solution. The society’s original goldminer-turned-banker, the proprietor of Pepper Bank, has a thoughtful look on his face for a while and then says, “What if . . . hmmm. Hear me out on this one because I just had an idea that sounds a little crazy but might work. You see, us other four banks still have gold coins in our vaults, right? What if we lend Indie Bank some of those gold coins–just for the short term–to help them avoid bankruptcy. We could make a big show of delivering cartloads of gold to Indie Bank. The people in line will see all that gold, and they’ll see the people at the front of the line walk away one by one with all the gold coins they requested, and eventually they’ll start to second guess their decision to wait in line when it seems that there are enough gold coins for everyone. Eventually, their panic will subside enough that the line will dissolve. We can then think of a clever marketing campaign to explain how what happened was pure unfounded public hysteria and reassure everyone that the banking system as a whole is rock solid.”

Eyebrows were raised, and then two concerns were also raised.

The first concern was that this could make one or more of the other four banks run out of specie. This concern was overcome easily by clarifying how much each bank could afford to lend and by realizing that the loan to Indie Bank would probably only need to be for a very short term, maybe even just for a day or two.

The second concern raised was more difficult to overcome. Someone pointed out that if they bail Indie Bank out like this, it will create bad incentives for all banks. It would essentially be taking away the consequence for too-risky lending and too-low reserve ratios, so all the banks would then have an incentive to engage in risky behaviour just like Indie Bank had been doing, knowing that they can get away with high risk and high rewards and, if anything goes wrong, they’ll simply be bailed out. But there may not be enough reserves in other banks to bail them out if everyone is behaving in such a risky way like this.

So they decided that there should be a price associated with needing to be bailed out. They would charge a high daily interest rate on any specie lent from another bank. This solution would actually turn out to be a win win because it alleviates the bad incentives while generously compensating the lending banks at the same time.

In the end, they collectively agreed to this solution and put it into writing. They then immediately sent word to the other four banks to start carting gold coins to Indie Bank. Within hours, their scheme had worked and the panic had dissolved. Crisis averted. Phew, that was really close to a societal default!

This solution was pretty tricky, right? The bankers just invented something new. If you’ve heard the term central bank before, you should be aware that I don’t like that term because it refers to multiple things; it’s not specific enough. So I will call this solution they came up with a reserve-sharing central bank. We will encounter the other kinds of central banks soon.

Where is our fictitious society now? It still has fractional reserve banking, and now it also has a reserve-sharing central bank to help the banking system continue to milk the cash cow that is fractional reserve banking.

Next week, we’ll look at how societal leverage contributed to this situation, and we’ll also talk about societal diversification as a means of reducing the risk of a societal default.

The Theory of Money, Part 18

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Well I guess it wasn’t the “same bat time” this week because this post is a little late. If you recall, I left you with some suspense at the end of Part 17 when Indie Bank was on the verge of collapse due to a bank run getting triggered. But I’m sorry to say that that suspense is not going to be resolved in this post because, in reading through last week’s post, I realized I need to spend more time clarifying some of the details surrounding the whole Indie Bank financial situation.

So let’s look at a bunch of different details of the finances of these banks, which hopefully will come together by the end of this post to make my point.

Bank revenue. These banks in our fictitious society are simplified, so they only have one revenue stream, which is the interest they earn on the money they create through fractional reserve banking. If you’ll recall, Pepper Bank originally charged fees, but (something I never mentioned at the time) those fees mostly went away when it shifted to fractional reserve banking.

How can banks earn more from their one revenue stream? There are two ways: (1) they can push their reserve ratios even lower to lend out even more money, and (2) they can find a way to charge higher interest rates. The way to charge higher interest rates is by making riskier loans.

Bank costs. These banks also have costs. They have building maintenance costs, printing fees, other supplies, wages for security guards, wages for tellers, etc.

Bank profitability. Hopefully the income they earn (interest on their loans) is more than their costs. If so, then they have a profit, which either gets reinvested into growing the business or distributed to the owners of the bank.

Money the bank receives. Regardless of whether the debtors are paying their monthly loan payments in specie or receipt money, it’s all the same to Indie Bank. If someone gives them a Goldnote from Pepper Bank, they can simply go down the road to Pepper Bank and exchange it for a gold coin. Or maybe Pepper Bank has received some of Indie Bank’s Goldnotes as payments, so they could trade Goldnotes for Goldnotes. At this point in our fictitious society, it’s all the same. Every bank’s Goldnotes are equal in value to one gold coin.

Breakdown of the payments banks receive. Each time a debtor makes a monthly loan payment, some portion of the payment goes to paying interest, and the rest goes to paying down the principal. Let’s pretend each bank actually takes each payment and stores the interest portion in the Revenue section of their vault, and the principal portion will be put in the Money to Lend section of their vault.

What is this money in the Money to Lend section? It’s the extra Goldnotes they printed for the sake of lending and have now gotten back. Picture it as a big pile of Goldnotes. They could keep them in their vault (out of circulation) or even burn them, and it would be like they’d never printed them in the first place–their reserve ratio would go back up to where it was before, prices would drift back to what they were before, etc. The only lingering evidence that they had existed at all would be (1) the nice pile of money in the Revenue section of their vault, (2) whatever benefits accrued to society as a result of someone being able to borrow that money and do something with it, and (3) the aftermath of all the costs to society that that money induced (discussed thoroughly in Part 15).

Did I just suggest the banker could burn that money he got back? Let’s not be crazy. No self-respecting banker would burn perfectly good money when it could be used again to lend out and start earning interest for him and his investors again! This is why this section of the vault is called the Money to Lend section. The banker is just waiting for enough Goldnotes to accrue in there so he can lend it to a new debtor.

All right, I think those are all the details about bank finances that are needed to better understand the predicament Indie Bank got itself into, so let’s jump into Indie Bank’s situation directly.

Let’s say Indie Bank, in an effort to be particularly profitable, was pushing its reserve ratio extra low so it could lend out as much money as possible. And let’s say that it was also making fairly risky loans so that the interest it was charging on that loaned-out money was fairly high.

Then the bad crop happened, and a lot of people lost some or all of their annual income. Suddenly a lot of people were defaulting on their loans. And since Indie Bank was making the riskiest loans, it found itself with a higher default rate than its competitors.

This meant that its Money to Lend pile wasn’t growing as fast, which was not immediately a big problem (they just have to wait a little longer before making another loan), but it also meant that its Revenue section was also not accumulating money as fast as it normally does. But its costs are mostly fixed costs, so the bank was still having to spend a lot of money from its Revenue section. This was a big problem!

Soon enough, Indie Bank’s Revenue section ran dry, and its leaders had three choices. They could (1) default on their payments to suppliers and employees, (2) print more Goldnotes and pay them with those, or (3) pay them directly with specie from the vault. Options 2 and 3 are basically the same–either way, the reserve ratio goes down and the vault gets further depleted of specie.

The leaders of Indie Bank eventually chose to print more Goldnotes (less conspicuous that way), which predictably led to some of those Goldnotes being exchanged for specie, and the vault’s piles of gold coins became progressively smaller. This is what led the employee to conclude that they were about to run out of specie altogether, which is why he ran home to tell his family to exchange all their Indie Bank Goldnotes for specie before they become worthless.

Ok, I hope this clarifies how a bad crop (or any other financial shock) can lead to a bank’s reserves getting low and eventually trigger a bank run. Next week we’ll talk about how the bankers respond.

The Theory of Money, Part 17

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Last week, we went from one bank to five banks in a pretty short time. We also saw that the bankers and their investors started getting greedy, pushing their reserve ratios down lower and lower. I described it as a house of cards.

So what will we do this week to try to topple this house of cards?

Let’s say the farmer has a bad crop. Maybe there was an early frost. These things happen. And it means that one of the primary sources of new wealth for the society didn’t produce as much this year. Unfortunately, a lot of people were planning on that additional wealth coming into society, so let’s trace the ripple effects of this bad crop!

First, the farmer, ever since buying the tractor and expanding his farm, has been hiring a lot of farm hands lately. Suddenly he doesn’t need them for several months.

And then there are all of the people who are normally employed to help transport and process and re-sell all the food the farmer harvests. They all lose a large portion of their income as well.

When you start adding up all the people who just lost some or all of their annual income, it comprises a large minority of society. And what do people do when they are suddenly impoverished? They especially cut back on luxury items.

With business previously booming in society, there were a lot of companies selling luxury items and growing quickly, and they were borrowing a lot of money to rapidly increase production capacity. Suddenly their sales have dropped precipitously, and they can’t afford to make their loan payments. Some factories that were half-built have to be scrapped entirely. What a loss of Labor Units! This, remember, is in addition to the loss of Labor Units (relative to expectations) that the farmer would normally provide.

So now we have a lot of businesses defaulting on their loans, and surely a lot of families as well. Therefore, commercial loan and private mortgage defaults start rising quickly. And who do you think gets hit the hardest by all these loan defaults? Yes, of course, it’s the people who own all the loans–the bankers. They, after all, are the ones lending out the majority of money in society.

Let’s say the problems start with Indie Bank. As the newest bank, it was being extra aggressive to try to play catch up with the other banks and earn its fair share of the market, so it was pushing its reserve ratios the lowest. Then, many of its loans go bad. It has been counting on getting paid back those Goldnotes it lent out so it can continue to pay its employees and other expenses. But now it doesn’t have enough of those, so it resorts to paying in gold coins directly from the vault. This, in addition to the usual exchange requests, drops the number of gold coins to only a few small piles.

One of the employees walks into the vault and sees that the bank is running out of gold. He runs home and tells his family members that they better exchange their Indie Bank Goldnotes quickly because the bank is going to run out of gold coins soon. So they all run to the bank and line up, asking for specie in exchange for all their Indie Bank Goldnotes. Other passersby see the line and ask what’s going on, and the people in line tell them the bank is running out of gold and that they better redeem their Indie Bank Goldnotes quickly.

The news spreads, and the line grows longer. Within another few hours, Indie Bank is going to be completely out of gold, which would mean telling its depositors that they can’t get specie anymore and then having to liquidate its assets to try to repay them.

This is our fictitious society’s first bank run! How exciting, right?

Does this mean we have a societal default on our hands? There are a lot of people defaulting on loans, but I would say it hasn’t necessarily led to a full-blown societal default yet.

But never fear–the owners of all the banks see what’s happening. They see that this could go downhill for all banks real quick if people start worrying about the reserves in them as well. That means their entire system of massive wealth generation for themselves (i.e., fractional reserve banking, the house of cards) could completely topple! They need a solution, and fast. We’ll see what they decide to do next week. (It feels like this is where I should add, “Same bat time, same bat channel.”)

The Theory of Money, Part 16

As I promised last week at the end of Part 15, I went back and read through Parts 10-15 again to see if I’ve missed anything important that came about as a result of the institution of fractional reserve banking.

I only had two small thoughts to add to all of that.

The first is that bankers really love fractional reserve banking. Think about it: All wealth (Labor Units) in society is stored either in the form of cash assets or non-cash assets, and the banker is earning interest on a large percentage of the entire cash assets in the society. In the case of Pepper Bank, he was earning interest on 23,000 of the total 33,000 Goldnotes in circulation, which is 70% of the entire cash assets of the society! Wow.

Here’s a new formula I’ll introduce to help you quickly calculate that:

Portion of Society’s Total Cash Wealth that Bankers Took from Others and Are Earning Interest On = 1 – Reserve Ratio

That formula does assume everyone has deposited all their gold coins into Pepper Bank, so maybe the number ends up being a little less. But still, that’s why bankers can get very rich off of fractional reserve banking.

The second thought I wanted to mention is that I haven’t clarified exactly why unstable prices are so inefficient for an economy. I have, however, written before about the importance of prices being accurate, and there may be an opportunity to further illustrate that principle before this series ends. We will see.

All right, it’s finally time to get back to the story of our fictitious society and see what monetary changes arise next! (It only took 5 posts to unpack all the changes that came about as a result of instituting fractional reserve banking, which I’d say isn’t too bad.)

Maybe you can guess what happens after the banker starts earning all that money from interest on the 23,000 Goldnotes he printed and lent out. People start seeing that he’s earning a lot of money. They eventually figure out what he’s done, and the clever ones figure out a great secret: They can start a bank and do the same thing!

The town storyteller decides he has lots of rich friends who pay him to tell them stories, and he’s not earning enough just telling stories, so he uses his persuasive speaking skills to get them to invest in a new bank. He names it Story Bank. He spends the investment money on a beautiful new bank building with a nice big modern and extra-safe vault in it, and he designs a more beautiful banknote that, for simplicity, he also decides to call a Goldnote (but there’s the seal of Story Bank on this one instead of the Pepper Bank seal).

Through all these efforts, plus on the recommendation from all the rich influential people who just invested in the bank, many people start choosing to store their gold coins in Story Bank instead of Pepper Bank.

Others do the same. There’s the town preacher who founds Verity Bank with the investment of his parishioners, and the Astrid Bank founded by the industrious Scandinavian immigrant community, and the Indie Bank founded by the musician who has some wealthy fans. All told, there are 5 banks at this point. Kind of overwhelming, really!

They all find their niches and start earning money for their investors by instituting fractional reserve banking. And they all closely track the variability in the amount of specie in their vault and lend out the maximum number of Goldnotes they can get away with, sometimes even pushing their reserve ratios down to below 15%. After all, their investors want as high of a return on their investment as possible, and the founders of all these banks made big promises to them.

I just want to pause briefly here and remind you what a 15% reserve ratio means. If all banks have a 15% reserve ratio, that means 85% of the money circulating is NOT backed by specie. The society’s money started out at 100% backing, then it dropped to 30% when Pepper Bank instituted fractional reserve banking, and now it’s at 15%.

Additionally, a 15% reserve ratio means banks are highly leveraged. 85% to be exact. This is obviously pretty high.

Meanwhile, business is booming in society. There’s so much capital available that new businesses are cropping up all over the place, everybody is hiring, and there’s excitement in the air. Sure, prices are rising like crazy (from the total number of circulating Goldnotes continuing to increase as reserve ratios drop), but that’s a small concern because money seems so plentiful everywhere. People don’t ask why there’s so much apparent wealth everywhere. Why question such a wonderful thing? They know that they’ve worked hard for so long as a society, their reward was bound to come sooner or later.

You can see where this is going. This house of cards is set to topple at the slightest provocation. We’ll give it a little push next week and see what happens!

The Theory of Money, Part 15

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I’ve been thinking more about how to clarify last week‘s topic of leverage and the risk for societal default, and I actually went back and edited last week’s post a little bit. And now I’ll clarify some terminology for easier referencing in the future.

The two main possible causes of a societal default are “bank leverage” and “government leverage.” Bank leverage is the percent of total cash that the bank created through fractional reserve banking. As a reminder, it’s calculated like this: 1 – Reserve Ratio = Bank Leverage. Government leverage is the percent of government income that has to go to servicing debts. As a reminder, it’s calculated like this: Government Monthly Debt Payments / Government Monthly Income = Government Leverage.

And then there was sort of a third contributor to the risk of societal default, which is the average amount of leverage of individuals in the society. I guess we could call it “individual leverage” (“average individual leverage” seemed too long of a name). It would be the same calculation as government leverage, only applied to an individual’s income and debt payments. This third kind of leverage can come into play and contribute to a societal default if a large percentage of people in the society owe a lot of money (i.e., the average individual leverage is high) because a hit to the economy may lead to a lot of people not being able to pay their loans, which will probably spark one or both of the other two forms of leverage that would cause the default to become more generalized, in which case it becomes a full-blown societal default.

Ok, nice and tidy. Bank leverage, government leverage, and individual leverage.

I also realized I had made an error in Part 13 when I talked about the auditing system, so I went back and clarified that part of that post. Basically, I forgot that Pepper Bank doesn’t have to keep track of any individual account balances anymore because the only way for someone to get a gold coin is to present a Goldnote. Modern-day banks do keep track of account balances though, so I explained how the auditing system would differ in that case.

All right, with those clarifications out of the way, and with the new terminology I defined above, I want to write just a little more about the two options for making use of all those piles of gold coins that were in Pepper Bank’s vault.

The first option, which is the one the banker chose, was to institute what we call fractional reserve banking. This created bank leverage that allowed for greater individual leverage (because now more cash was available for borrowing). Individual leverage is all well and good–people need to borrow money sometimes, especially for big expenditures like business ventures–but it’s the bank leverage that caused so many problems because it artificially expanded the total cash in society, which meant that each gold coin or Goldnote was worth much less, so people lost a lot of their LUs they’d been storing in cash and also prices became very unstable, which is very inefficient for a market.

The second option, which I described as a counterfactual in Part 12, was for the banker to get individuals to combine together to lend some of their savings to be able to fund some of those loan requests. Basically, I’m realizing now, it was a primitive version of Kickstarter. It’s crowdfunding. So, from this point on, this counterfactual will be referred to as the crowdfunding option. And it involves NO BANK LEVERAGE. But it of course still involves individual leverage because individual people are still borrowing money. The big downside is that there won’t be as much money made available for lending, but the money that is made available for lending is being proffered by people who are ok to give up some of their savings for a while, so an investment failure with complete loss of their money probably also won’t be so financially catastrophic in most cases.

Compare that to the impact of all people losing a large percentage of their stored LUs when the banker implements fractional reserve banking. Many of those people probably couldn’t stand to lose any of their LUs, and maybe a few richer members of society could have stood to give up more! But, unfortunately, regardless of which group a person is in, they don’t get any of the interest from their LUs being taken and lent out. Only the banker gets the benefits of lending out the depositors’ money. The best the people can hope for is that fractional reserve banking goes away after the loans are paid off so they at least can get their original LUs back when the gold coin:LU ratio goes back to how it was.

Switching back to the crowdfunding option, let’s look at this idea from the standpoint of my save, spend, or invest explanation from Part 4. The super brief refresher of that concept from Part 4 is this: When someone has money that they don’t need to use immediately, their 3 options are to save it, spend it, or invest it. So, thinking about the crowdfunding option, it’s giving people an opportunity to shift more of their stored wealth from the save category (where it’s doing nothing for them) to the invest category (where it’s earning more money for them). This is great!

You can probably see that I’ve come to believe that the crowdfunding option is a better solution than than the fractional reserve banking option. But I’m not blind to the big downside of the crowdfunding option, which is that less money will be made available for borrowing. But let’s think about that for a moment to see how big of a downside it really is.

If there is less money available for borrowing, it means not as many investment opportunities will get funded. The big question is whether the people who are making the decision about which investment opportunities to fund are correctly predicting the ones that will be the most successful. If they are doing a good job of that, then the investment opportunities that don’t get funded are the lower-yield ones that will have less of a benefit to society anyway. So how much are we losing if we only miss out on investing in the lower-quality investments? Maybe not so much.

Of course, there are always those investments that seem off the wall but get funded due to an excess of capital around and then end up paying off bigtime, so I can’t say for sure that avoiding bank leverage (which would make available a whole bunch more capital for lending) is the guaranteed best outcome for society.

So that’s the short-term analysis. Longer term, think about what is likely going to happen sooner or later with enough bank leverage: a societal default. No, we still haven’t talked about how this might happen! Trust me, we’re getting there. But anyway, when a societal default happens, it causes the wealth of a society to regress so much that you may end up further behind and have less wealth to invest overall than if you’d just stuck with the slower steadier crowdfunding option.

And there are other reasons to avoid a societal default. Not only will it cause the wealth of a society to regress, but also it creates massive amounts of suffering for those individuals and families who, maybe of no fault of their own, ended up getting hit the hardest and lost a lot of their wealth that was critical to their continued wellbeing.

Before I end this post, I want to address one more question that has arisen in my mind about all this. If a prudent amount of government leverage and individual leverage can be used beneficially, what about a prudent amount of bank leverage? Maybe just keep the reserve ratio nice and high so a bank failure is nearly impossible?

This could work, but don’t forget about the guaranteed costs of any amount of bank leverage: the change in the gold coin:LU ratio, which causes people to lose a percentage of their LUs that were stored in cash and that causes prices to become unstable. Government leverage and individual leverage don’t have these same guaranteed downsides. So I would say that bank leverage is a form of leverage that you cannot “use prudently” like the other two types. The guaranteed, significant, generalized downsides of bank leverage make it not worth whatever benefits you hope to get out of it.

All right, that’s it for this week. Eventually we’ll get back to seeing what happens next in our fictitious society, but there have been so many things to process with this major shift from receipt money to fractional reserve money that occurred way back in Part 10! Before I write next week’s post, I’ll go back through all those parts to see if there’s anything I’ve missed before I start progressing our fictitious society again.

The Theory of Money, Part 14

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Yes, I’m still going through my theory of money. (Here’s Part 13 from last week.) As a reminder, this is still primarily a health policy blog. But I share other interests here as well. And economics is a significant interest of mine! It’s the core of health policy, and it’s also the core of monetary policy. I have several weeks’ worth of thoughts on money still, so feel free to come back in a few months if this isn’t of interest to you. Once I’m done writing about money, I’ll clean up a few other topics in health policy and then start on a new longterm project going through all the foundational papers in the health policy and economics field and see what happens when I build my ideas about the healthcare system from scratch again. Or, you know, build them as much from scratch as a biased human with imperfect insight who is susceptible to the effects of cognitive dissonance can hope to achieve.

All right, a couple clarification topics up front, and then we’ll talk about societal leverage after those.

First clarification point: The impact of goods versus services on a society’s aggregate Labor Units (LUs) is different, and I haven’t specifically talked about this yet. I said before that goods depreciate or are consumed, which means the cost of those things in LUs is being lost from society. But I didn’t mention what happens with services. Think, for example, of a massage. Are any LUs lost from society? Nope. The payment the masseur receives is simply a redistribution of LUs. There is an opportunity cost, however, because that labor is not going directly to gleaning more wealth from the land or finding a way to decrease the daily Labor Unit cost of living for society. But it certainly improves quality of life! We could list out a bunch of different types of services and find that some of them do directly or indirectly increase society’s wealth (the labor of a farm hand, for example) and the rest do not increase society’s wealth but don’t cause it to lose any LUs either (other than the opportunity cost).

Second clarification point: I want to look back at the paint maker for a second to illustrate how this way of thinking about the cost of things in terms of Labor Units explains the profit of a business. If black paint suddenly becomes popular and the paint maker is able to increase his prices from 10 LUs/can to 15 LUs/can, he’s earning an extra 5 LUs/can. If his actual costs, not including his labor, of making a can of paint are 5 LUs, and it takes him an average of 2 hours to make a can of paint, he used to be earning 2.5 LUs/hour. But now with the price increase, assuming his costs are about the same, he is making 5 LUs/hour. Any price increase or decrease serves to increase or decrease the number of LUs someone is earning per hour of labor. If an entrepreneur builds a successful business and sells it for a large sum of money, that means each hour of work he put into that business ultimately yielded a very large number of LUs. I guess one could say that the profit they earned is how many more LUs they received relative to what they originally valued their time at, but it’s semantics at that point.

Ok, now on to a discussion of leverage. We hear about personal leverage and business leverage, but I want to introduce the idea of societal leverage, especially as it relates to fractional reserve banking.

When people think of leverage, I think they usually know it generally has to do with borrowing money, which increases risk but also increases the potential for greater gains. This is a good starting point. I’ll avoid getting too much more specific than that because it can get unnecessarily complicated.

But I will introduce one way to calculate leverage. It’s pretty easy, especially when viewed from an individual-level example. If a person has a house worth $400,000 and he still owes $200,000 on it, his debt is $200,000 and his asset is worth $400,000, so 50% of his asset is borrowed. In other words, he is 50% leveraged.

On a societal level, we could similarly say that leverage is a measure of how much of the society’s wealth is borrowed. But should this refer to the percent of society’s total wealth (cash and non-cash), or should it just be taking into account society’s cash wealth?

There’s no right or wrong answer here; there are just more-useful and less-useful choices for our calculation. And the usefulness depends on the question we’re trying to answer.

In our case, I want to know how at risk a society is of defaulting (i.e., having something happen that really ruins the society’s overall wealth and impairs its ability to make good on debt payments). We could call it a “societal default.” What constitutes a societal default? Well, thinking about the biggest things that ruin a society’s overall wealth, two come to mind. The first is a major bank declaring bankruptcy. We haven’t yet talked about how that could happen, but we’re getting there. The second is the government defaulting on its debts. I’m including that one because government financial trouble really does impact the wealth of the entire society in a significant way. I guess a potential third thing that could constitute a societal default would be if a large percentage of people in society all default on their debts at the same time, but I’m not sure how that would come about without at least one of the other two things happening, so I’ll leave that one alone.

I’m sure there’s a really erudite way to precisely define “societal default” and then use a whole bunch of historical data and come up with a really cool calculation that integrates all those factors into a single overall number that closely correlates with the risk of a societal default, but that kind of sounds like a PhD dissertation. So we’ll table that for now and just discuss some general things about the two main causes of societal defaults.

Bank Bankruptcy: In our fictitious society, remember that originally we only had 10,000 Goldnotes, but then the banker eventually printed an extra 23,000 of them? By then, the bank had issued 33,000 total Goldnotes, 23,000 of which were basically money borrowed from depositors (see the explanation of this in Part 10), which leads to this calculation just like I illustrated above with the house example: 23,000 / 33,000 = 0.7. So Pepper Bank is 70% leveraged. Note that 1 – Reserve Ratio = Bank Leverage (specifically on the bank’s receipt money it has issued). So a bank with a 30% reserve ratio is 70% leveraged. Even if a bank has a lot of other assets, if those assets are not easily sold to get more cash to keep up with withdrawals, low reserve ratios can be a pretty risky proposition.

I did some searching about historical reserve ratio requirements, and this article written by some people at the Federal Reserve said they were originally instituted in 1863 with the passage of the National Bank Act. The initial requirement was 25% (75% leveraged, that is), but in 1913 the reserve requirement was lowered to 15%, plus or minus a little bit depending on the bank type, with the passage of the Federal Reserve Act. Then the reserve requirement was lowered again a few years later to 10%. I won’t chronicle all the changes and how they may or may not be a causative factor in various booms and busts in America’s turbulent financial history, but think of the monetary expansion that would have caused! Speculation city when you’ve got that much cash suddenly available for borrowing!

In the 1980s, the requirement was 12%, then it was lowered to 10% in the early 1990s, and then finally in 2020 the Federal Reserve lowered the ratio again, this time to 0%. Yes. That means banks are currently 100% leveraged. Wow. That’s risky and is just asking for bankruptcies or bailouts (we’ll get to those too).

Government Default: This one should be calculated a little differently because the denominator (i.e., the total asset value) of the leverage calculation we’ve been using is difficult to ascertain. So instead let’s use the same number that banks use when they’re deciding whether to give an individual a loan. They look at the individual’s monthly income and then add up all the debt payments they have to pay each month. They generally won’t give a loan so large that, when you add in the new loan’s monthly payments, the person has to pay more than about 1/3 of their total income each month to all their debts. So, the calculation would be Total Monthly Debt Obligations / Total Monthly Income = Leverage. This seems like a good measure to use when considering a government’s risk of default as well.

Currently, the U.S. federal government spends about 10% of its revenue on loan interest payments. This number does not include any payments on the loan principal. That’s not super terrible, as government debts go. For comparison, state governments in the 1830s and 1840s racked up huge debts for infrastructure investments and were having to put a much higher percentage of revenues into their loan payments. The specific numbers are not readily available online, but they were sometimes greater than 50% of revenues, as documented in the book America’s First Great Depression, which is a book I mentioned before. Of course, these were payments on the interest and principal.

Depending on how much of a government’s annual expenditures are discretionary as opposed to mandatory, even 15% of a government’s revenue going to servicing the debt could be a big problem if revenues go down too much.

I don’t know what the “safe” amount of societal leverage is for either one of those two explained above. But the intuition should be clear that higher bank leverage and higher government leverage both mean higher risk of societal default. And a societal default is something we really want to avoid because the costs can be so huge. The great depression is a good example of the repercussions of a societal default.

Well, there’s an introduction to societal leverage. This is a difficult topic to write about because my ideas aren’t completely consolidated yet and because it is related to so many things that I haven’t yet written about. But I hope these ideas prove useful as we move forward deciding whether the risks of fractional reserve banking justify the benefits. Part 15 here.

The Theory of Money, Part 13

Image credit: Jon Torres
Image credit: Disney

Last week, we talked about the counterfactual to fractional reserve banking, which led into a new discussion of comparing and contrasting those two options to see which is better for society. So let’s continue that today by first discussing the two different ways banks can store specie. It seems like a random thing to talk about, but you will see that it has implications on how money evolves in the society.

First, for anyone who has read Harry Potter, you know about Gringotts Wizarding Bank. They store each depositor’s gold coins and other valuables in individual vaults.

The other way to store specie is by making one giant pile of coins in a single big vault a la Scrooge McDuck.

So the two options for specie storage are the Gringotts style and the McDuck style.

If Pepper Bank had stored each individual depositor’s gold coins on their own shelf in the vault (Gringotts style), that would have worked fine until Goldnotes came along. But when people started transacting with Goldnotes, someone could spend their entire savings and all that gold would still be sitting on their shelf. The coins on individual shelves/in individual vaults has become meaningless. All that matters is if you possess Goldnotes. Therefore, the coins have been anonymized–that is, no coin in the vault, regardless of whose shelf it’s on, can be attributed to any one specific owner. So, shelves or no shelves, the specie storage style of Pepper Bank automatically shifted to the McDuck style once receipt money was implemented.

This is what opened the way to fractional reserve banking, because now nobody can know whether their coins are still in the vault. Anybody could request to see the piles of gold coins in there, and they would be satisfied that there are way more coins in there than Goldnotes they possess. But it wouldn’t tell them whether are enough coins in the vault to redeem everyone’s Goldnotes.

So if we transition to receipt money, which I’ve said is a good idea, how do we prevent bankers from printing excess receipt money and lending it out? In other words, how do we prevent bankers from instituting fractional reserve banking, with all its associated inflation and lost savings and extra profits for bankers?

We need an auditing system. It would be rather simple. The banker would be required to keep track of how many Goldnotes are in circulation, and then the auditor would do a surprise visit to the bank several times per year and look at how many Goldnotes are circulating and then count up the total number of gold coins in the vault. The number should match.

Remember that when Pepper Bank switched over to using Goldnotes instead of deposit certificates, it meant that there were no more account balances to keep track of. The only thing a person needed was a Goldnote to be entitled to a gold coin.

In modern times, it would be a little different because banks do keep track of how much they owe each depositor. That’s what your “account balance” is. In this case, if the reserve ratio is 30%, then you just need an auditor to compare the total of all the depositors’ account balances to the amount of money in the vault. If the amount of money in the vault is at least 30% of the total of the account balances, then they’re good.

Anyway, an auditing system like the one described for Pepper Bank would allow our fictitious society to have the benefits of receipt money without the banker being able to take advantage of the receipt money-induced gold coin anonymity and institute fractional reserve banking.

Next week, we’ll get back into looking at the effects of fractional reserve banking. There’s still more to process with that one!

The Theory of Money, Part 12

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Re-reading last week’s post, one small thing that I should have said specifically about inventions is that, ofttimes, they increase the number of LUs a person can generate per hour of work. For example, the tractor that decreased the harvest time from 800 hours to 200 hours enabled the farmer to earn a lot more LUs per hour harvesting. So innovations can lower the number of LUs it costs to sustain a society, and they can also increase the number of LUs gleaned from the earth that will circulate through society. These are the two ways that the wealth of a society increases a lot faster!

All right, so where are we now? Our society’s money has evolved all the way to fractional reserve money (see Part 10), which means the receipt money (Goldnotes) that used to be 100% backed by specie is now, according to the banker’s self-imposed limit, only backed 30%. The society went from having 10,000 Goldnotes in circulation to 33,000 in circulation, the extra 23,000 of them being created out of nothing when the banker printed them to lend out.

Those loans, as we discussed last week, can be a boon to a society by enabling innovations to come forth that help progress the society toward greater aggregate wealth. But I also said those loans come at a cost. What cost?

Let’s say each Goldnote (or, really, each gold coin that the Goldnote entitled the bearer to) originally represented 5 LUs before the transition to fractional reserve money. 5 LUs x 10,000 Goldnotes = 50,000 LUs stored in the form of cash assets in society. And then the banker printed an extra 23,000 Goldnotes, so what happened to the Goldnote:LU ratio? No new Labor Units were generated when he printed those extra Goldnotes (wealth doesn’t come out of nothing–it comes out of the earth!), so the number of total LUs saved by society hasn’t changed. Thus, our new Goldnote:LU ratio is 33,000:50,000, which means each Goldnote is now worth only about 1.5 LUs, which is about 30% of what they were worth before. This means that when the banker printed all those extras, he took 70% of everyone’s cash wealth from them! They didn’t know it at the time, but their hard-earned Labor Units were being taken from them to furnish all those loans. And the only one who will profit from all of this is the banker, who will be earning interest on all the loans he owns.

And what do you think will happen to prices when Goldnotes are suddenly only worth 30% of what they were worth before? Yes, eventually prices will adjust to be approximately triple what they were before.

So, the loans were a boon to society, but they came at the cost of everyone losing 70% of their cash wealth, plus they imposed another major cost to society–that of some serious economic inefficiencies that arose from prices dramatically shifting.

There are some other costs to fractional reserve money that I haven’t discussed yet: booms and busts (and the bank failures that go along with them), and the evolution that always seems to happen from fractional reserve money to fiat money with all of its weaknesses. I’ll be explaining these in due time!

Overall, will the benefits of the innovations fueled by those loans outweigh all those costs to society?

In the long term, it’s possible. But let’s consider a counterfactual.

What if the banker, instead of switching the society to fractional reserve money, instead said, “All this gold is just sitting around doing nothing. And there’s that entrepreneur who’s looking for a 5-year loan to build his gas car factory. I’m going to ask my depositors if they’re willing to allow me to lend any of their cash savings to the entrepreneur for those 5 years and, in return, I’ll pay them a portion of the interest I charge him.” So the banker asks around and it turns out that, in aggregate, his depositors are willing to lend out 7,000 gold coins.

How exactly would this lending work? Let’s say the farmer originally deposited 400 gold coins in the bank and still has all 400 of those Goldnotes in his possession. He agrees to lend out 300 of his Goldnotes, so the banker takes the 300 Goldnotes from the farmer and, in exchange, gives him a certificate that says, “This entitles the farmer to 300 Goldnotes in 5 years and 1 Goldnote monthly in interest until then.” Yep, it’s a bond, which has always just been a fancy name for the piece of paper that someone gets when they lend money to someone.

The entrepreneur got to borrow 7,000 Goldnotes to build his factory, and no inflation was caused!

Having only 7,000 Goldnotes to lend (instead of 23,000) means much less investment in potential wealth-generating innovations. Those other entrepreneurs who would have borrowed money will just have to wait until society has more to lend. Or, they could find outside funding from another society, which would work just as well.

Which version of reality is better?

On the one hand, with fractional reserve banking, you’ve got a lot more investment earlier on, but it comes with several major costs, including people losing 70% of their cash wealth without having any way to stop it (while the banker gains a bunch of wealth by taking all the interest from loaning all that money!), dramatic price shifts and the economic inefficiencies they induce, the significant risk that the society’s money will continue all the way down the path to fiat money with all its issues, and the booms and busts and bank failures that monetary expansions and contractions can cause.

And on the other hand, you’ve got less investment earlier on, but there are no major costs to it.

Over the next few weeks, I’ll delve more into the downsides of fractional reserve banking, which will help us better quantify them so we can weigh them against the upsides.

The Theory of Money, Part 11

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I introduced so many new things last week that I might need to take a few weeks to process them before progressing further in our society.

First, I said that this new gas cars business venture will be very beneficial to society if it works. Why?

Remember how I said many weeks ago that all of society’s wealth originally is gleaned from the land (mixed with labor)? And remember how we are quantifying wealth in units that I’ve been calling Labor Units (LUs)? Well, what happens to those LUs after they’ve been gleaned is they get distributed throughout society as people provide goods/services for each other and get compensated.

So the LUs are spreading around from person to person, but do those LUs ever get consumed/lost from society? Or do they just keep circulating around and around forever?

Think of the blacksmith that painted his house black. That paint is slowly going to wear off over the next several years, and then he’s going to have to paint his house again. So if the paint cost 10 LUs to make, those 10 LUs are now lost from society. But that’s better than not painting his house and the whole thing rotting, which might lead to a loss of 10,000 LUs from society.

Or think of the farmer feeding his family with part of his harvest. Every bit of food that is eaten is LUs that are lost from society.

Maintaining a human society costs LUs every day. All things are depreciating, so they are all dissolving away LUs each day. And if there are lifestyle changes (for example, that people decide they want to live in larger houses that now depreciate more LUs per year than their previous smaller houses), the daily cost of maintaining that society increases. And as long as the society can afford it, this is not a problem.

But it’s wonderful when there are innovations that decrease the daily cost of maintaining a society . . . innovations like gas-powered cars and tractors. If the farmer and his farmhands used to spend an accumulated 800 hours of labor per year harvesting grain, but then the farmer buys a tractor that cuts the harvesting time down to 200 total hours, he has just saved 600 hours of labor. And assuming at least some of that extra time is put into working to glean more LUs from the land (say, he expands the number of acres he uses the next season), this innovation has now increased the overall wealth of society. I’m assuming here that the depreciation cost of the tractor is lower than the additional LUs it enabled the farmer to glean.

Ultimately, this is how we progressed from hunter-gatherer and agrarian societies to our modern-day societies filled with more wealth (and spending more LUs per day) than humans even a couple hundred years ago would ever have imagined. It happened one invention at a time–the loom, the printing press, electricity, the lightbulb, the internet, etc.

And inventions often require capital to develop and disseminate. Without enough investment into these ideas, nothing happens with them, and the wealth of a society doesn’t progress.

So that’s why I said the banker’s loan to the entrepreneur provided a great service to society. All of his loans have a chance of paying off bigtime to society.

But these loans come at a cost as well. We’ll talk more about that next week.

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