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 / 0.3 = 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 all the way down to 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.