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.
Clear Thinking on Healthcare 