Month: October 2022

In Part 13, I explained how the introduction of Goldnotes had anonymized the specie stored in Peppercorn Bank, which shifted it from a Gringotts style to a McDuck style and, without an auditing system to go along with that change, opened up the way to instituting fractional reserve banking.

In this post, I’ll introduce the idea of societal leverage, which will be necessary to help us more completely evaluate fractional reserve banking’s effects.

We hear about personal leverage and business leverage fairly regularly in financial discussions, but nobody ever talks about the idea of societal leverage.

When people think of leverage, they probably know it generally has to do with borrowing money, which increases risk but also increases the potential for greater gains. Thinking about leverage like this is a good starting point, and 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.

The risk of taking on leverage is that you will not be able to make your loan payments. This is called “defaulting” on your loan. And the risk of defaulting goes higher as the amount of leverage goes higher. For example, if a person earning $10,000/month takes on a loan requiring a monthly payment of $300, it’s a fairly small payment relative to his monthly income. But if he takes on a much larger loan that requires a monthly payment of $3,000, it’s a huge chunk of his monthly income. All it would take for him to default on that huge loan payment is a loss of income for even a short time or a large unexpected expense such as his furnace dying in the middle of winter.

On a societal level, we could say that the amount of “societal leverage” is a measure of how much of society’s wealth is borrowed. And its risk for defaulting (i.e., having a large percentage of the loans that constitute that societal leverage not be receiving payments) goes up as the amount of leverage goes up.

The reason talking about societal defaults is important is because a societal default is financially catastrophic for a society–it will destroy a large chunk of the society’s wealth and make society very unstable overall as well–just as an individual default is financially catastrophic and makes life very unstable for an individual. I’ll illustrate exactly how this plays out in future posts, but for now I want to look at the factors that predispose to a societal default.

Should societal leverage be calculated based on society’s total wealth (cash and non-cash assets), or should it only take 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, we want to know how at risk a society is of defaulting (i.e., the risk of a “societal default”). And since making a loan payment is difficult to do with most non-cash assets (even if the lender would be willing to accept a vehicle as a loan payment, the borrower still needs to get to and from work!), looking only at cash assets probably makes more sense.

So what could cause a societal default? There are three factors.

Factor 1: Bank leverage

Remember how Avaria originally only had 10,000 Goldnotes circulating, but then the banker eventually printed an extra 23,000 of them? After that, 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 referring to the amount of leverage the bank has on the 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 with the passage of the Federal Reserve Act the reserve requirement was lowered to 15%, plus or minus a little bit depending on the bank type. 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! And we’ve all seen what happens when speculation-fueled bubbles pop.

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 can legally be 100% leveraged (but have other inducements to maintain some amount of reserves–specifically, they get paid risk-free interest on all of their reserves). Wow. That’s just a taste of how banks have been able to shape U.S. monetary policy in ways that benefit them like crazy. Instead of only earning money on their exploitative loans, they’re earning money on those and on their reserves as well. And if that interest rate on their reserves is too low, reserves will drop as banks shift to making more loans instead of keeping money as reserves, and they could become 100% leveraged. This is just asking for bankruptcies or bailouts (we’ll get to those too).

Factor 2: Government leverage

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 for a government. 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 Government Leverage = Total Monthly Debt Obligations / Total Monthly Income. This seems like a good measure to use when considering a government’s risk of default.

Currently (in 2022), the U.S. federal government spends about 10% of its revenue on loan interest payments (update in October 2024–that number has risen rapidly and is up to 18%) (update in July 2024–that number has risen even more rapidly and is now up to 27% according to Grok). This number does not include any payments on the loan principal, but, still, it’s historically not the worst position for a government to be in from a debt standpoint. [When I originally wrote that sentence in 2022, it was true, but now in 2025 it’s no longer true.] 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 by fellow Canadian Alasdair Roberts. Of course, those payments in the 1800s were not just interest-only payments–they included payments on the principal as well.

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 or if a war starts. [Translation in 2025: We’re in a really dangerous financial position from the standpoint of government leverage.]

Factor 3: Individual leverage

Maybe a more accurate name for this factor would be “average individual leverage” or “aggregate individual leverage,” but just calling it “individual leverage” is simpler.

The calculation of this one would be the same as government leverage: Individual Leverage = Total Monthly Debt Obligations / Total Monthly Income, only applied to an individual’s income and debt payments. If we really wanted to get into the nitty gritty of this one, we would also have to consider individuals’ assets (especially their cash assets and fungible assets) since some individuals have a low income but a wealth of assets that they could use to make loan payments, but I’ll leave that alone because that level of detail isn’t necessary to get my point across.

Individual 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 and then the economy suffers a hit (from a bank default, a government default, a natural disaster, a war, etc.) in a way that decreases a lot of individuals’ income enough to cause them to default on their loans.

Ok, so that covers the three kinds of leverage–bank leverage, government leverage, and individual leverage–that could cause a societal default.

I’m sure there’s a really erudite way to precisely define what officially constitutes a “societal default” and then use a whole bunch of historical data and come up with a really cool calculation of overall societal leverage that integrates all three of those categories of leverage into a single number that closely correlates with the risk of a societal default (which would be really helpful for assessing the riskiness of making investments in a country), but that kind of sounds like a PhD dissertation, so I’ll leave that to someone else.

I don’t know what the “safe” amount of societal leverage is, but the intuition should be clear that the higher the leverage goes of any one of those three types, it represents a higher risk of a societal default. And if two or three of them of those types of leverage are high at the same time, it increases the risk of a societal default even more and increases the likely severity of that societal default.

Take a look at the great depression as a good example of how a societal default can set a society back years or even decades in its progression of increasing wealth for the populace.

Well, there’s an introduction to societal leverage. It touched on many principles that I haven’t yet explained in this series, but introducing it early like this will prove useful in the next post, in which I will wrap up the pros and cons of fractional reserve banking.

In Part 12, 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. I will continue that discussion in this post 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–picture Scrooge McDuck’s room full of money.

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

Let’s imagine that Peppercorn Bank originally stored each individual depositor’s gold coins on their own separate shelf in the vault (Gringotts style). That specific stack of gold coins would have a receipt number next to it, and if the depositor brought in that receipt (issued specifically to them with their name on it, remember), the banker could go straight to that specific stack of coins and know that the number of coins in that stack was equal to the number stated on the receipt.

In a Gringotts-style system like this, each gold coin was allocated to a specific receipt and, thus, to a specific depositor.

But then Goldnotes came along and changed all of this. When the banker switched out all of those receipts for Goldnotes, all the coins allocated to each receipt were taken off their shelves and thrown into the giant pile of gold coins assigned to Goldnotes in general. I guess the banker could have found a way to stamp a number on each gold coin and then issue a Goldnote with the same number on it, thereby assigning each Goldnote to a specific gold coin, but that would have been a lot of work, and, from the banker’s point of view, there would have been no benefit to doing it.

That’s why, when Goldnotes were first issued, Peppercorn Bank’s banking style shifted from the Gringotts style to the McDuck style. Specific gold coins were no longer assigned to specific depositors–the gold coins had become anonymized.

The upshot of this is that there is no longer any direct accountability to ensure each Goldnote has a gold coin backing it. No person can walk into the bank and demand to be shown their stack of gold coins anymore. All they can do is bring in a stack of Goldnotes and request to see that there are at least that many gold coins in the vault. And they would never know if there were enough gold coins in the vault to redeem everyone’s Goldnotes.

Therefore, the introduction of receipt money in Avaria–which I’ve said was an upgrade to their money–also opened up the way to having less than 100% backing of that receipt money. And when the banker has the option of storing fewer gold coins than there are Goldnotes circulating, he has no barriers left to instituting fractional reserve banking.

Assuming the Avarians were savvy enough to anticipate this situation, is there a way they could have transitioned to receipt money without opening up the way for the banker to transition to fractional reserve banking with all its associated inflation and usurped wealth?

There are two options. The first is what I described above–each Goldnote would be assigned to a specific gold coin. When Goldnotes are all being used locally, that’s a reasonable option.

But if Goldnotes started to be used all over the country, then it’s possible that the vault that contains a specific Goldnote’s coin could be hundreds of miles away from the person who has the Goldnote, and that gets to be inconvenient if someone ever wants to redeem their receipt money for specie. So, in the case of anything other than a pretty localized receipt money circulation area, receipt money issuers need an auditing system.

This auditing system could be rather simple. The banker would be required to keep track of how many Goldnotes he has circulating, and then the auditor would compare that number to the total number of gold coins they count in all of the vaults. The two numbers should match.

An auditing system like this would have allowed Avaria to transition to receipt money (with its associated anonymization of Peppercorn Bank’s specie) without allowing Peppercorn Bank to institute fractional reserve banking.

By the end of this series, you’ll see that 100% backed receipt money is probably the best monetary system imaginable, and anything beyond it is a downgrade, which means that the simple auditing system I just described is the most important roadblock a society could create to stop its monetary system from going past that point on the evolutionary road of money.

In Part 14, I’ll get back into looking at the effects of fractional reserve banking. There’s still more to process with that one!

In Part 11, I wrote about the benefits of inventions and innovations to the wealth of a society, and I also mentioned that new ideas need capital to bring them to fruition, which is why the loans the banker made after instituting fractional reserve banking were potentially very beneficial to Avaria’s future overall wealth.

This week, let’s talk more about the societal costs of instituting fractional reserve banking.

Let’s first remember where Avaria’s monetary system is. It 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%. Avaria went from having 10,000 Goldnotes in circulation to 33,000 Goldnotes in circulation, the extra 23,000 of them being created out of nothing when the banker printed them to lend out.

Now on to the costs of doing this . . .

Let’s say each Goldnote (or, really, each gold coin that the Goldnote entitled the bearer to) originally represented 5 WUs before the transition to fractional reserve money.

(As a reminder, that means you would need to work for 5 hours performing average unskilled labor to earn one gold coin.)

5 WUs x 10,000 Goldnotes = 50,000 WUs stored in the form of cash assets in society.

And then the banker printed an extra 23,000 Goldnotes, so what happened to the WU:Goldnote 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 (and sun)!), so the number of total WUs saved in the form of cash by society hasn’t changed. Thus, our new WU:Goldnote ratio is 50,000:33,000, which means each Goldnote is now worth only about 1.5 WUs, 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 wealth was 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 money prices when Goldnotes are suddenly only worth 30% of what they were worth before? Yes, eventually money prices will adjust to be approximately triple what they were before. But, until then, Avaria is flooded with money, and people don’t know their wealth hasn’t actually increased as much as the amount of money suggests, so this will cause other problems we’ll discuss in future posts.

So, the loans were a potential 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. And also remember what I told you to remember in Part 6–when the value of money is unstable, it makes investments riskier, so investment (at least, investment by people who are investing their own money) will decrease.

There are some other costs to fractional reserve money that I haven’t discussed yet: One is booms and busts (and the bank failures that go along with them). And another is that fractional reserve banking acts as a gateway to the road that leads to fiat money with all of its attendant exploitations. 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 theoretically possible, and it depends on how much benefit to society those loans precipitate. 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 start his gas-powered vehicle company. I’m going to ask my biggest 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 or usurpation of wealth happened!

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 linked post explains why prices are so important in an economy, but this series will also directly address the specifics of this situation in upcoming posts), the booms and busts and bank failures that monetary expansions and contractions cause, and the significant risk that the society’s money will continue all the way down the evolutionary path to fiat money with all its issues.

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.

But before I end this post, I’d like to introduce two new terms: exploitative loans and assentive loans.

An exploitative loan happens when someone is lending wealth that isn’t theirs and that they don’t have approval to lend out. For example, the banker, who is storing other people’s wealth, is exploiting those owners of the wealth by lending out their wealth (without their consent) and earning interest on it.

An assentive loan happens when someone is lending wealth with the assent of the owner of the money (usually because the owner of the wealth is directly making the loan). Like the counterfactual I described above.

Assentive loans don’t induce any inflation, and the owner of the wealth gets the benefits of the loan.

Exploitative loans induce inflation (because the banker carries them out by printing extra Goldnotes), and the banker is the one who gets all of the benefits of the loan.

As a final sidenote, have you noticed that I introduce a lot of new terms in this series? It’s because people need clearly defined and precise terms to encapsulate ideas. Once an idea has been well understood and encapsulated into a term, that term acts as a base upon which new ideas can be built. In this way, you can construct a huge edifice of clear and thorough understanding about a topic that was previously incomprehensible. So that’s what we’re systematically doing here. And, if I achieve that purpose well, the impact that this knowledge will have on your opinions about modern governments’ fiscal policy are hard to overstate.

Part 13 here.

I introduced so many new things in Part 10 that it will take several posts to process them before progressing Avaria’s monetary system further.

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

Remember how I said way back in Part 1 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 Wealth Units (WUs)? Well, what happens to those WUs after they’ve been gleaned is they get distributed throughout society as people provide goods/services for each other and get compensated.

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

We discussed this already when we talked about the blacksmith painting 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 materials used to make the paint cost 4 WUs, those 4 WUs 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 WUs from society.

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

Maintaining a human society costs WUs every day. All things are depreciating, so they are all dissolving away WUs each day. And if there are lifestyle changes (for example, that people decide they want to live in larger houses that now depreciate more WUs 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 that can decrease the cost of travel and farm work. 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 wealth from the land (say, he expands the number of acres he farms the next season), this innovation has now increased the overall wealth entering society. By the way, I’m assuming here that the depreciation of the tractor is lower than the additional WUs it enabled the farmer to glean.

So, like I explained in Part 4, the inventions that make a society wealthier do so by lowering the cost of maintaining their standard of living. And any invention that does that for the wealth-gleaners and frees up more of their time so they can glean more wealth per year is especially helpful for increasing society’s wealth.

I haven’t added in the extra layer of complexity of considering trade with other societies, but it shouldn’t be too difficult to see that if Avaria starts actively trading with other societies, this will increase its wealth even more as Avarians start to specialize in things that they are particularly good at making and then achieve even greater efficiency gains through economies of scale while also receiving goods from other societies doing the same (assuming travel costs don’t outweigh the lower wealth prices they’re getting from imports).

An important point about how trade increases wealth is this: When two people or two societies make a willing trade, it’s not like one is getting wealth and the other is getting goods. Both are trading things that they see as approximately equivalent value, which means that there is not automatically a net flow of wealth in one direction or the other. The exception to that is the profit that the business owner is receiving. For example, if the blacksmith starts exporting his excellent cook pots to another society, and he’s charging 10 gold coins per pot, with 1 of those being his profit, then when he gives up a pot that cost 9 gold coins to make (including the materials and his time) and gets 10 gold coins in return, there has been a net transfer of 1 gold coin to Avaria. And if the WU:gold coin exchange rate is 5:1, that means Avaria has netted positive 5 Wealth Units as a result of the trade. Of course, businesses based in the other societies are also receiving profits, so it all may be a wash. It really just depends on where the business owners live, because that’s where the profits from the business are getting sent to.

Ultimately, this is how we progressed from hunter-gatherer and agrarian societies to our modern-day societies filled with more wealth (and spending more WUs 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.

So that was the first thing I wanted to spell out a little more clearly.

And the second thing, related to all of that, is this: Inventions often require capital to develop and disseminate them. 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. Each of his loans have a chance of paying off bigtime to society.

And my final point of this post is to point out the difference between money and wealth in a new context by asking, What pays for things–money or wealth? I hope it’s obvious by now that money doesn’t pay for things; wealth pays for things. Money is just the medium we use to store that wealth. I hope this makes it clear why I emphasized that so much early on–that money has two purposes, and the second one that many people forget is that it is a store of wealth.

So, when you pay for something by giving money, you’re doing that because the money is storing wealth. And people need to be compensated for their work (and the goods and services they’re providing) with wealth because wealth is the only thing that can be traded for other forms of wealth, such as food and clothing and shelter.

For example, if you live in Avaria and are hungry, you can go to the general store and exchange some wealth (stored in the form of a gold coin) for another form of wealth–food. Contrast that with if you brought in some Monopoly money to the general store and tried to buy food with it. Why would the store owner refuse? It’s not because it’s the wrong kind of money; it’s because that money is storing no wealth. (Clearly Avaria is not in Canada because Monopoly money is basically is what we use there.)

I’m explaining this last point specifically and thoroughly because it’s another insight that modern monetary theorists don’t understand–they think that money is what buys things, so they think printing more of it will be able to buy everything everyone in society needs. I hope I’ve thoroughly debunked that misunderstanding by now.

That’s all for this post. In Part 12, we’ll talk about the downsides of the banker giving all of those loans.