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

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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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