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.

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