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.
Clear Thinking on Healthcare 