The Theory of Money, Part 10

We talked last week about the characteristics of optimal money and found that Goldnotes actually do a little better than gold coins.

This week, let’s move forward and see what further changes this shift to receipt money leads to.

First, let me add a new term. The general term for intrinsically valuable stuff being used as money (whether the society is using gold or corn or cigarettes or anything else intrinsically valuable) is specie. Not to be confused with species.

Ok, now let’s get back to our fictitious society to see what happens next.

Pepper Bank has become a very successful business. After the banker introduced Goldnotes, everyone in society started storing their excess gold coins in Pepper Bank because Goldnotes came to be preferable to having to carry around gold coins.

The banker, however, wasn’t finished with finding ways to make money. Now that Goldnotes were being used primarily instead of gold coins, he always had the majority of everyone’s cash wealth sitting in his vault, and he was charging them a small fee every month to do so. But he would look in his vault every day and think that all those piles of gold were just sitting there doing nothing. What a waste.

He, being a banker, was tracking pretty closely the day-to-day changes in how many gold coins he actually had sitting in his vault. He found that he was usually up around 10,000 gold coins, but it could go as low as 8,000 depending on the time of year and other factors. And he knows it has never gone below 7,000 ever since society shifted to primarily using Goldnotes. So he gets an idea. He says to himself, “Self, what if I lend out those extra 7,000 coins that are just sitting there doing nothing?”

They’re not his gold coins to lend out–they’re his depositors’ accumulated savings. But since nobody is going to need them, he figures it won’t hurt if they’re not in his vault for a while until the loan gets paid back. And he will still be holding in reserve in his vault enough gold coins to satisfy all the demands for specie. If his average is 10,000 gold coins and it has never dropped down below 7,000, he figures he only needs to keep about 3,000 gold coins in his vault at any given time and he’ll be perfectly able to meet any demand for specie.

Carefully, he starts testing this out. An entrepreneur recently moved to town and has been talking about a big idea to start building gas-powered cars, but he needs a ton of capital to first build the factory. The banker and the entrepreneur talk and, after working out the details, they agree to the terms for a loan and the banker lends those extra 7,000 gold coins to the entrepreneur. But they realize the entrepreneur is just asking for a highway robbery if he takes a big cartload of jingling coins, so instead the banker prints 7,000 extra Goldnotes and puts them in a bag for the entrepreneur to take home with him.

This is a great service to society. This new business venture, if it succeeds, is a big step toward enhancing the wealth of this society, and I’ll need to spend more time in future posts discussing why. But for now let’s stick to looking at the banking aspects.

When the banker prints those 7,000 Goldnotes and gives them to the entrepreneur, it is the first time that there are more Goldnotes out in circulation than there are gold coins in the bank. This is a big change. But nobody knows it; they assume the banker is rich enough from all the fees he’s been charging and from being a gold prospector before to lend out 7,000 of his own gold coins.

Fortunately, he was conservative in how much he was willing to lend out, so he always has enough gold coins in the vault to give people in exchange for Goldnotes any time they want, so they’re none the wiser.

In fact, something surprising happens over the next few months after he gave the entrepreneur those 7,000 Goldnotes. He now has 17,000 Goldnotes in circulation, and he finds that he still never has specie requests that total more than 30% of that (just like before), which means the maximum he ever has to redeem is 5,100 gold coins. But he still has 10,000 gold coins in the vault, remember? So he still has 4,900 excess gold coins in the vault just sitting there doing nothing!

So he goes out and again finds someone who wants to borrow some money. This time, he is willing to lend out 4,900 gold coins. So he does, and again he gives the borrower 4,900 Goldnotes instead of giving him a cart-full of gold coins.

He then again watches how his gold coin reserves look for several more months, and he finds that, again, demands for specie never exceed 30% of the total Goldnotes in circulation.

How many Goldnotes are now circulating? With his original 10,000 Goldnotes, plus the two loans, that makes 21,900 in circulation. And demands for specie never exceed 30% of that, which means he only ever needs a maximum of 6,570 gold coins in the vault. But he still has 10,000 gold coins in the vault, which means he still has 3,430 gold coins in excess just sitting there in the vault not doing anything.

This is the point where he realizes he could go through this cycle over and over, and each time the number of excess coins would be smaller. Ultimately, he gets mathematical and derives a formula, 1 / fractional reserve = the money multiplier. The fractional reserve is the percent of specie he needs to keep in the vault (he settled on 0.3, or 30%, as a safe number). The money multiplier says how many Goldnotes he can print for every gold coin in his vault. 1 / 3 = 3.3 (rounded), so 10,000 gold coins x 3.3 = 33,000. He can have in circulation up to 33,000 Goldnotes based on his 10,000 gold coins!

He only has 21,900 Goldnotes in circulation so far, so he decides to print another 11,100 of them and loan them out. Finally! His reserves get pretty low sometimes, but true to his historical trends, they never go below 0.

The banker is very happy. He ends up having about 33,000 Goldnotes out in circulation, and 23,000 of those are ones that he lent out, so he is earning interest on 23,000 Goldnotes every month! And he doesn’t have any more gold coins just sitting in his vault doing nothing.

This is called fractional reserve banking.

Is this wrong? Are new Labor Units being created? Certainly the society feels like it’s booming because it’s suddenly flooded with capital. There is a lot to process with this change, which we’ll do in the coming weeks, but my final point this week is that we just transitioned to yet another type of money!

We started with commodity money, which then shifted to receipt money when the banker created Goldnotes, and we decided this was an upgrade because even though the paper itself was almost worthless, it entitled the bearer to a gold coin, so it was still 100% backed by a commodity of intrinsic value. And now we have shifted to “fractional reserve money,” which still entitles the bearer to 100% of the stated value, but there’s only about 30% of specie actually in the bank compared to the total number of Goldnotes in circulation. So in an aggregate perspective, our money supply is only 30% backed at this point. If the reserve ratio had been set at 20%, the money supply would be 20% backed. The lower it goes, the riskier things become, which we’ll discuss in coming weeks.

The Theory of Money, Part 9

Last week, our gold prospector became a banker. And then he precipitated a change in the society to shift from commodity money to receipt money. (I originally named his receipts goldpaper, but I think Goldnotes is a better name, so I changed it.)

As is often the case, in the intervening week since writing the last post, I’ve been thinking about some things that I want to clarify.

First, I’ve never given my official list of all the characteristics of optimal money, and I think that will be useful moving forward. So, here’s my list so far:

  1. Intrinsically valuable: This requires two things. Whatever is used as money needs to have some use independent of its use as money. But that alone isn’t enough. If something is freely available without exerting any labor to procure it, it won’t necessarily cost anything even if it does have an important use. Oxygen at sea level, for instance. So the second requirement is that labor needs to be exerted to procure it, which now puts a price on getting it. The importance of this becomes clear when I get to the second characteristic . . .
  2. Value is stable over time: This requires supply and demand to be stable over time. Or, if one rises, the other will rise with it so that the value remains approximately the same after the adjustment. Of course, demand will change for all things over time as new uses–and also new substitutes–for it are found. Economic shifts also affect the demand for things (notably, luxury items will be less desirable when there’s a recession). But as long as labor needs to be exerted to procure the thing being used as money, the supply of it will be linked to demand through market effects: If the demand goes up (and price rises along with it), suppliers will work harder to procure more; if demand goes down (and price decreases along with it), suppliers will not procure as much because it may no longer be profitable to continue using the marginal capacity that they added.
  3. Nonperishable
  4. Easy to determine the quality/value of it: If metal is being used, this is easier to determine the purity and weight (and, therefore, the value) than, say, a cow, or a share in a new business.
  5. Can be precisely measured: This is similar to the last one, and these days there isn’t as much of a challenge in measuring things, although back in the day this would have been an important consideration, especially if the type of money being used had a very high value-to-weight ratio, because that would require especially precise measurement instruments.
  6. Easily divisible into the right amount for payment, and dividing it doesn’t alter its value: A live milk cow cannot be easily split into smaller values. Something like corn, on the other hand, meets this criterion perfectly. Or metal that can be melted and divided into different sizes, although that’s not as easy to divide as corn.
  7. Not too heavy: People would rather not be burdened by having to carry really heavy money.
  8. Value-to-size ratio is in the sweet spot: If buying something takes a whole wagonload of money, that’s inconvenient, even if it isn’t very heavy. On the other end of the spectrum, if you’re using diamonds for money, even losing a tiny diamond is a significant loss.
  9. Impossible to counterfeit

There might be other things I’ve missed, but that’s what I have for now. Obviously nothing will meet all those criteria perfectly, but it gives us a standard against which we can evaluate any money. So why don’t we do that right now and see how well gold coins and Goldnotes do?

I won’t go through every criterion listed above for each, but we can at least cover the highlights pretty easily.

Gold coins: Looking through the list, gold coins do a great job overall. They’re a little heavy maybe, but at least they’re fairly small (without being too small), and different-sized coins can be minted quite easily to suit different values. I said our blacksmith figured out how to counterfeit gold coins, but that was admittedly not super believable, and in modern times it would be very difficult to counterfeit gold coins and get away with it for long.

Goldnotes: Your first impression may be to think that it doesn’t meet the first criterion, but remember what I said last week–Goldnotes are directly backed by something that is equal to their stated value, so as long as you can reliably exchange a Goldnote for a gold coin then it’s not a problem. This is an important caveat, as will become clear over the next few blog posts. In some ways, Goldnotes actually do a lot better than gold coins. They’re lighter and easier to stack and carry. And their value is actually more reliable. Historically, when societies shift from metal coinage to receipt money, the banks automatically do an appraisal of each coin they receive to ensure its stated weight and quality is accurate. People couldn’t get away with clipping off the edges of a gold coin and passing it off as a full coin to the bank! Our blacksmith never would have gotten away with his counterfeiting had there been a bank around performing this service when it accepts deposits. Therefore, historically, because the receipt money’s value was more reliably known than the coins themselves, receipt money actually traded at a little bit of a premium compared to coins. So, because Goldnotes are lighter and more reliable in their value, I’m going to declare this shift from gold coins to Goldnotes an upgrade to a better currency! Thanks to the banker.

The other thing I’d like to clarify is standardization of gold coins. I’ve just been talking about them all along as if 1 gold coin was a set weight and quality. This doesn’t happen automatically of course. You could forego standardization and go around using little nuggets instead, but everyone receiving gold as payment would have to have the means of weighing them and assessing their purity. So standardization makes using metal coins much easier to use for exchange.

Historically, this is where governments would help. For example, the solidus (AKA bezant) was a gold coin minted by the Roman and Byzantine empires for several centuries. It weighed about 4.5 grams and was 24 karats. So presumably someone who found a gold nugget could take it to a mint, where its purity would be verified and, for a fee, it would be stamped into a standardized hard-to-counterfeit shape.

I won’t get into how governments figured out that they could mint them with a little less gold for the sake of keeping some for themselves, but that happened too and generally led to the failure of the coins as reliable currency.

Clarifying these details took enough space today that I’ll save the introduction of “fractional reserve banking” for next week. That’s where things really start to get crazy.

The Theory of Money, Part 8

We’ve talked about a lot of stuff by now, and the reasons for all of it will start to become clear as we progress our imaginary society toward a more modern money society.

So, let’s say a gold prospector visits the region and finds a new gold deposit in the mountain right next to the town. He establishes a mining operation there and moves to the town himself. He wants to safely store all this gold he’s mining so it doesn’t get stolen before he can sell it, so he builds into his house a huge safe.

Meanwhile, tragedy strikes. The farmer, who was storing his extra gold coins under the floorboard in his room, had a break-in when he was out working in his fields. The burglar found his emergency stash of gold coins and took them. That was several weeks’ worth of labor that he lost!

Suddenly everyone in town is a little more hesitant about storing their hard-earned Labor Units in their house. And they have all been doing that because they’ve been so industrious and have all accumulated some wealth that they’re storing primarily in the form of gold coins. That’s when they remember that the prospector has a large and secure safe in his house, so they make a proposal: “How about you store our gold savings in your safe for us? There’s excess capacity anyway in there. In return, we’ll pay you a small fee each month to do so.”

It’s a no-brainer for the prospector, and voila! Our town has a bank, and he has become a banker. And since he loves spices, he names it Pepper Bank.

Each time a person brings some gold coins to store, he carefully counts them out and makes two copies of a piece of paper. He gives one to the depositor and keeps one in the safe. The papers say how many gold coins that person has stored in Pepper Bank. And each time they visit him to put more money in the bank (or take some out), he updates the papers.

What a relief. The townspeople have a solution to their worries about break-ins. Because even if the burglar strikes again and steals someone’s deposit paper, it’s worthless. The burglar can’t show up to Pepper Bank and expect the banker to give him the person’s gold coins!

Then one day, the banker has an idea. It would be much faster for him to simply work with the town printer and make a bunch of little pieces of paper that each state, “The bearer of this paper is entitled to 1 gold coin at Pepper Bank.” And it would also be convenient for the townspeople because then they wouldn’t have to carry around bags of gold every time they wanted to buy something. They could instead use these pieces of paper for their transactions. The downside of switching over to this system is that those pieces of paper are steal-able, but at least a little stack of papers would be easier to hide in a house than a chest of coins, and the added convenience probably outweighs that downside.

The banker also thinks that if people start using the paper for transactions, more people will end up storing their gold coins in Pepper Bank, so he will earn even more money off storage fees!

What should he call these pieces of paper? Initially, he decides to call them gold coin receipts, but that’s too long and awkward to say, so it eventually gets shortened to Goldnotes.

So the banker visits every depositor and shares with them his new Goldnotes idea, and they love it, so he gives them each the appropriate number of Goldnotes to represent the number of gold coins they have already saved in his bank. And from that point on, he always gives Goldnotes in exchange for gold coins stored in his bank. He cautions everyone not to lose any Goldnotes because there will be no way to prove that they didn’t give the papers to someone else. But he does say that if a Goldnote is getting old and torn, they can bring it to him and he’ll exchange it for a nice fresh one.

Pretty soon, the townspeople are making exchanges both with gold coins and Goldnotes, because they have found that any time they present to the banker a Goldnote, he will trade it for a gold coin.

Well there you have it. We have finally made the transition to a new kind of money! We started with commodity money, landing on precious metals as the most convenient kind of commodity money, and now we have receipt money.

Is it ok that these Goldnotes are, themselves, nearly worthless? Yes, because they are 100% backed by a commodity equal to their stated value.

This is just like the title to a house. The title itself is nearly worthless (a piece of paper and some ink), but it is 100% backed by an asset, so whoever owns that title has claim to the asset that backs it.

Next week, we’ll talk about what the banker decides to do when he sees all that gold just “sitting there doing nothing” in his vault.

The Theory of Money, Part 7

Photo by Keenan Constance on Pexels.com

Last week, I talked about how storing Labor Units (LUs) in the form of an asset is risky because any asset is susceptible to shifts in value, so you could lose some of your LUs simply by the asset losing value. This is the risk of storing LUs, but it’s a risk worth taking in order to have some wealth saved away in case of an emergency (or for retirement).

Today I’m going to cover two more foundational ideas before I start building more on the foundation I’ve laid: (1) the cost of a lifestyle and (2) how to be immune to inflation.

The Cost of a Lifestyle

Let’s think about how many hours someone has to work to sustain their lifestyle.

Way back in the hunter-gatherer societies, people’s needs were pretty basic. Food, water, clothing, and shelter comprised the majority of their financially costly needs. There was no innovation to significantly augment the number of LUs per hour someone could generate, so when they went to work hunting and gathering and finding places to shelter, they were probably earning about 1 LU’s worth per hour. But because their needs were so simple, their total weekly cost to sustain their lifestyle was probably only around 50 LUs. So, they worked for about 50 hours, and the rest of their time was free to sleep and attend to social duties and recreate. They wouldn’t ever really work much extra like we do these days because they had no easy way to store additional wealth that they might have generated with that extra work. Storing too much extra food was pointless because saving it for too long would just make it go bad. They didn’t accumulate belongings because those were too difficult to carry around with their nomadic lifestyle. So they worked each week for what they needed and that was it.

Compare that to today. Our modern lifestyles cost way more than 50 LUs per week. Fortunately, innovation has enabled us to generate way more LUs/hour as well, so even those living below the poverty line can afford a lifestyle that is way more lavish than anyone who lived even a couple hundred years ago. But still, how much of it is necessary? Do we need to eat so much and spend to much on entertainment and travel and things? It’s this rat race of working so hard to just barely be able to afford a modern lifestyle. We also have the ability, as opposed to our ancient counterparts, to work extra to store some wealth in case of a time of need, but so many of us spend so much and work so much that there’s no leftover wealth to save or invest and no leftover time to work and generate more wealth either.

I work at the hospital an average of 4 12-hour shifts week, and I sometimes wonder how many of those 48 hours are generating LUs that simply go to sustaining my lifestyle that week. Maybe I could become more frugal and only need to work 3 12-hour shifts per week, and it would be enough to sustain my lifestyle and also invest for retirement. Then I could spend more time doing things that are more important to me. How many shifts/week would facilitate the greatest happiness and fulfillment?

How to Be Immune to Inflation

All right, so those were my thoughts on the number of LUs it takes to sustain a lifestyle and how it has changed over time. Now let’s talk about becoming “inflation proof.”

Remember last week when I talked about the blacksmith starting to counterfeit gold coins? The effect of that was that the number of LUs stored in the form of gold coins stayed the same, but the total number of gold coins had increased, so each gold coin represented fewer LUs. I’ve said this same thing in a few different ways now. Another way I’ve said it is that the LUs got “diluted” over a larger total number of gold coins. I’ve also given a ratio to express this same idea, which I inarticulately called the aggregate-number-of-gold-coins:aggregate-number-of-LUs-attempting-to-be-saved-as-cash ratio.

Understanding this principle is prerequisite knowledge to understanding inflation. We perceive inflation by seeing diffusely higher prices, but what is really happening is that the number of LUs represented by a unit of money is decreasing. So, when $1 only represents 0.049 LUs instead of 0.05 LUs, the money is worth less, which means you need to give more dollars to pay for something worth 1 LU.

There are lots of different factors that cause inflation, and I haven’t talked about most of them yet. But most of them alter the money:LU ratio by altering that inarticulate ratio above. Printing more money is one way to do it.

As a sidenote, I think this is a good place to mention that when a society uses money that has intrinsic worth (i.e., commodity money like gold or corn), it prevents a government from causing inflation (i.e., taking some of your wealth without your consent) by printing more money.

In this series, I’ve been distinguishing stored wealth as cash-wealth and non-cash-wealth for a reason. Cash wealth–if it’s the kind of cash that does not have intrinsic value–is susceptible to the government making more of it and thereby taking some of your LUs through inflation. On the other hand, non-cash wealth, such as a house or ownership in a business, doesn’t lose any value when inflation happens. Let me explain.

Let’s say the farmer has 100 LUs worth of grain that he’s stored to sell next year because he’s going to grow a different crop next year. Then, the blacksmith counterfeits a bunch of gold coins and causes 10% inflation in the intervening months. Has the farmer lost any LUs worth of grain? Nope. He still has the same amount of grain. And he’ll figure out the gold coin:LU ratio and price the grain accordingly. Maybe he would have sold it for 10 gold coins last season, but this season he sells it for 11 gold coins instead. Either way, he is getting paid 100 LUs worth of money.

In summary, cash assets are susceptible to inflation and non-cash assets are not because their prices simply change to reflect the new money:LU ratio.

So, you want to be “inflation proof”? Store your wealth in non-cash assets and you’ll be fine.

I believe this is the last of the foundation I needed to build to finally move on to more modern money things, starting with the invention of banks in our fictitious society, which is where everything changes.

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