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.

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