Month: November 2022

In Part 18, I explained the financial details of Independent Bank to show more thoroughly how the financial shock led to a drain on the bank’s reserves and triggered the bank run. Here’s a quick recap of that to clarify it:

• Avaria’s 5 banks are simplified banks with only one source of revenue: the interest they earn from lending out the money they created through fractional reserve banking
• These banks have fixed costs (building maintenance, wages, etc.), which need to be paid for with the interest income they are getting
• If a bunch of borrowers default at the same time, a bank’s revenue may drop below its costs, which would mean it is stuck trying to pay its costs either with even more newly created money or by paying directly with specie it has in the vault, both of which result in the same problem–even lower reserve ratios, which always translates into even more severely depleted stores of specie
• Depleted reserves trigger bank runs when word gets out and people get scared

Before I describe the ingenious solution the banking leaders come up with to prevent Avaria’s entire monetary system (the house of cards) from collapsing, how about I describe the likely outcome of this situation if the banking leaders did nothing? Yes, it’s time to see how damaging fractional reserve banking can be to a society when it leads to bank failures.

First, the people in line at Independent Bank see people from the front of the line walking away with bags of gold coins that they received in return for their Goldnotes. But then, finally it happens–someone gives the teller a pile of Goldnotes and requests they be exchanged for gold coins, and the teller comes back with only a few gold coins in hand, apologizing that these are the last of the gold coins from the vault, and the bank forces everyone out and closes its doors. The other customers who were in line freak out, realizing that their Independent Bank Goldnotes are now worthless. If only they’d gotten in line earlier, they could have avoided losing all that money!

What do they do? They immediately go home and collect all the Goldnotes that they own from the other four banks and send them with family members to the originating banks so they can get in line early enough to exchange them for gold coins. Soon, word spreads and long lines form at the other four banks. And, of course, since the other four banks don’t have enough gold coins in their vaults to redeem every Goldnote they have in circulation, they all close their doors as well.

Within a few hours, Avaria went from an illusion of prosperity to a financial panic. Some people lost all of their cash wealth because they didn’t get in line early enough, and now they’re worried about starving. Stores stop accepting those worthless Goldnotes and demand gold coins for payment. But prices are still so high from Avaria being flooded with money lately that few have the money to buy much, which furthers the economic upheaval. In the panic, mobs of scared people are entering grocery stores and looting whatever they can carry home.

Why are prices suddenly so “high”? Remember that the money price of a thing is determined by the WU:money ratio. Prior to fractional reserve banking, a gold coin or Goldnote was worth 5 WUs (see Part 12). But then, after the institution of fractional reserve banking, 33,000 Goldnotes were circulating, which diluted the same number of WUs over a much larger number, so each Goldnote came to only be worth 1.5 WUs. And with the recent banking competition pushing banks to decrease their fractional reserves further, it would have dropped lower than that even. For simplicity, let’s say that each Goldnote represented 1 WU when this panic started. So if the true price of all the food needed to feed a small family for a week was 20 WU, its money price listed at the grocery store would have been 20 gold coins (or, equivalently, 20 Goldnotes). But now that all the Goldnotes are deemed worthless and not accepted as a common medium of exchange anymore, the WU:gold coin ratio is back up to around 5:1. So if, on the day of this panic, someone actually paid the full listed money price with gold coins, they would be paying 5x too much! They should only pay 4 gold coins if the money price had adjusted instantaneously to account for the new WU:money ratio, but instead customers are being asked to pay 20 gold coins. And since money prices only gradually change as store owners slowly acquire information suggesting that money has come to be worth more again, those artificially elevated prices will stick around for a while. This is why people are panicking even when they have 40 gold coins–it seems like they only have enough money to feed their family for 2 weeks.

Even though money prices will gradually adjust to the new WU:gold coin ratio, the damage will already have been done. There was a horribly uneven redistribution of cash wealth because some people lost all of their cash assets and other people (who got in line at the banks early enough) found that they ended up with more cash assets than before. And others were stuck overpaying up to 5x for things they desperately needed. There was social upheaval. There was crime. There may have been starvation in spite of an adequate aggregate amount of food. Investment into new ventures screeched to a halt, and other new ventures failed. What I’m describing is the aftermath of a societal default.

In additional to all of that, the trust in banks as a whole was completely lost, which will probably last a generation or two until the societal memory of the event fades and new bankers find a way to brand themselves as wholly different than those “bad” banks of generations past.

Meanwhile, the Avarians still don’t clearly understand how it all happened–the banking system had become so obscure, perplexing, and incomprehensible. (Which is a myth! That’s why I’m writing this series!) So the Avarians will probably find themselves with fractional reserve banking again eventually, not knowing that a simple bank auditing system (as described in Part 13) could prevent all that damage from coming back and progressing to even worse damage as their monetary system once again travels down the natural evolutionary path of money.

Pretty bleak, right? It all seems so unbelievable to our modern sensibilities, doesn’t it? But here’s the thing–these very events (societal defaults, usually driven primarily by bank leverage and also government leverage, as we’ll see later on) have happened to many societies in the past, in the United States and elsewhere, and they happen in modern societies as well.

Unfortunately, societal memory fades so quickly that these things happen over and over again, often within even just a couple of generations. A little understanding of the history of money in the general populace can help prevent us from being “doomed to repeat” that history because people won’t support policies that they know will lead to these sorts of issues. That’s why I’m writing this series!

And now let’s get to what actually happened in Avaria.

The banking leaders decided to act as soon as they saw that long line of people at Independent Bank trying to exchange their Goldnotes for specie. Remember, the bankers know perfectly well that Independent Bank will run out of specie before the day is through, which will likely lead to lines at all of the banks and kill the goose that is laying the golden eggs for them.

First, they organize an emergency meeting. The leaders of all 5 banks are there, although the leader of Independent Bank is in the corner playing a morose song on a lute.

The other four leaders initially talk about allowing Independent Bank to declare bankruptcy and then spinning this to the public to convince them that Independent Bank was the only imprudent bank and that all the rest of them are very safe. Their hope would be that a strong and widespread PR campaign will prevent generalized distrust in the banking system (and the ensuing lines at their doors requesting specie) after Independent Bank goes bankrupt. They would then have to prove how safe they are by being a little more conservative (at least for a while) with their reserve ratios and loan risk.

But after discussing this idea for a while, they are not convinced it would work. Even with a great PR campaign, there is still a reasonable risk that the panic will spread to the other banks, and they know none of them would be able to weather that storm. And, they reason with themselves, they can’t let that happen for the sake of society–think of how disruptive to society it would be if the banks go away! For the sake of the people, they tell each other, it is their duty to find a better option.

So, they hatch an ingenious solution. The society’s original goldminer-turned-banker, the proprietor of Peppercorn Bank, has a thoughtful look on his face for a while and then says, “What if . . . hmmm. Hear me out on this one because I just had an idea that sounds a little crazy but might work. You see, us other four banks still have gold coins in our vaults, right? What if we lend Independent Bank some of those gold coins–just for the short term–to help it avoid bankruptcy? We could make a big show of delivering cartloads of gold to Independent Bank. The people in line will see all that gold, and they’ll see the people at the front of the line walk away one by one with all the gold coins they requested, and eventually they’ll start to second guess their decision to waste all that time waiting in line when it seems that there are enough gold coins for everyone. Eventually, their panic will subside enough that the line will dissolve. We can then think of a clever marketing campaign to explain how what happened was pure unfounded public hysteria and insinuate that it was selfishness on the part of the individuals who were at the front of the line requesting all those gold coins, and in that way we can reassure everyone that the banking system as a whole is rock solid.”

Eyebrows were raised, and then two concerns were also raised.

The first concern was that this could make one or more of the other four banks run out of specie. This concern was overcome easily by clarifying how much each bank could afford to lend and by realizing that the loan to Independent Bank would probably only need to be for a very short term, maybe even just for a day or two.

The second concern raised was more difficult to overcome. Someone pointed out that if they bail Independent Bank out like this, it will create bad incentives for all banks. It would essentially be taking away the consequence for too-risky lending and too-low reserve ratios, so all the banks would then have an incentive to engage in risky behaviour just like Independent Bank had been doing, knowing that they can get away with high risk and high rewards and, if anything goes wrong, they’ll simply be bailed out by the other banks. And, if that happens, there may not be enough reserves in the other banks to bail them out if everyone is behaving in such a risky way like this.

So they decided that there should be a price associated with needing to be bailed out. They would charge a high daily interest rate on any specie lent from another bank. This solution would actually turn out to be a win win because it alleviates the bad incentives while generously compensating the lending banks at the same time.

In the end, they collectively agreed to this solution and put it into writing. They then immediately sent word to the other four banks to start carting gold coins to Independent Bank. Within hours, their scheme had worked and the panic had dissolved. Crisis averted. Phew, that was really close to a societal default!

This solution was pretty tricky, right? The bankers just invented something new. If you’ve heard the term central bank before, you should be aware that I don’t like that term applied to this arrangement because it is misleading and confusing when real central banks are discussed (we’ll get there). So I will refer to this solution they came up with as a mutual specie reserve agreement, or a specie pool for short.

Where is Avaria’s monetary system now? It still has fractional reserve banking, and now it also has a specie pool to help the banking system be a little more stable so the bankers can continue to milk the cash cow that is fractional reserve banking.

In Part 20, we’ll look at how societal leverage contributed to this situation, and we’ll also talk about societal diversification as a means of reducing the risk of a societal default.

In Part 17, I described how Independent Bank’s shortage of gold coins led to Avaria’s first bank run. In this post, I’ll explain more thoroughly how Independent Bank started running low on gold coins in the first place.

So let’s look at a bunch of different details of the finances of these banks, which I hope will come together by the end of this post to make my point clear.

Bank revenue. These banks in our fictitious society are simplified, so they only have one revenue stream, which is the interest they earn on the money they create and then lend through fractional reserve banking. If you’ll recall, Peppercorn Bank originally charged monthly gold coin storage fees, but let’s assume the banks don’t do that anymore because they are competing to get as many depositors as possible, so instead they charge no storage fees in an effort to get as many deposits as possible, which they can use a reserves to lend out even more money.

Before looking at the other financials banks deal with, let’s take a moment to look more closely at the banks’ single revenue stream. How can they earn as much as possible from it? There are three ways: (1) get more deposits, which increases the total amount of money they can loan out, (2) push their reserve ratios even lower to lend out even more money, and (3) find a way to charge higher interest rates on their loans. And the way to charge higher interest rates is by making riskier loans.

Ok, now back to looking at the other financials . . .

Bank costs. These banks also have many different costs, including building maintenance costs, printing fees, other supplies, wages for security guards, wages for tellers, etc.

Bank profitability. Hopefully the income they earn from their single revenue stream (interest on their loans) is more than their costs. If so, then they have a profit, which either gets reinvested into growing the business or distributed to the owners of the bank.

Money the bank receives. Regardless of whether the debtors are paying their monthly loan payments in specie or receipt money, it’s all the same to Independent Bank. And if someone gives them a Goldnote from Peppercorn Bank, they can simply go down the road to Peppercorn Bank and exchange it for a gold coin. Or maybe Peppercorn Bank has received some of Independent Bank’s Goldnotes as payments, so they could trade Goldnotes for Goldnotes. At this point in Avaria, it’s all the same–every bank’s Goldnotes are equal in value to one gold coin.

Breakdown of the payments banks receive. Each time a debtor makes a monthly loan payment, some portion of the payment goes to paying interest, and the rest goes to paying down the principal. Let’s pretend each bank actually takes each payment and stores the interest portion in the Revenue section of their vault, and the principal portion will be put in the Money to Lend section of their vault.

What is this money in the Money to Lend section? It’s the extra Goldnotes they printed for the sake of lending and have now gotten back. Picture it as a big pile of Goldnotes. They could keep them in their vault (out of circulation) or even burn them, and either way it would be like they’d never printed them in the first place–their reserve ratio would go back up to where it was before, money prices would marginally drift back to what they were before, etc. The only lingering evidence that those Goldnotes had existed at all would be (1) the nice pile of money in the Revenue section of their vault, (2) whatever benefits accrued to society as a result of someone being able to borrow that money and do something with it, and (3) the aftermath of all the costs to society that that additional money induced (discussed thoroughly in Part 15).

Did I just suggest the banker could burn that money he got back? Let’s not be crazy. No self-respecting banker would burn perfectly good money when it could be used again to lend out and start earning interest for him and his investors again! This is why this section of the vault is called the Money to Lend section. The banker is just waiting for enough Goldnotes to accrue in there so he can lend it to a new debtor.

All right, I think those are all the details about bank finances that are needed to better understand the predicament Independent Bank got itself into, so let’s jump into its situation directly.

Remember how Independent Bank, in an effort to be particularly profitable, was pushing its reserve ratio extra low so it could lend out as much money as possible? Let’s also say that it was making fairly risky loans so that the interest it was charging on that loaned-out money was fairly high.

Then the bad crop happened, and a lot of people lost some or all of their annual income. Suddenly a lot of people were defaulting on their loans. And since Independent Bank was making the riskiest loans, it found itself with a higher default rate than its competitors.

This meant that its Money to Lend pile wasn’t growing very fast, which was not immediately a big problem–they just have to wait a little longer before making another loan. But the problem was that its Revenue section was also not accumulating money as fast as it normally does. And since most of a bank’s costs are fixed monthly costs, Independent Bank was still having to spend a lot of money from its Revenue section. Do you see the problem?

Soon enough, Independent Bank’s Revenue section ran dry, and its leaders had three choices. They could (1) default on their payments to suppliers and employees, (2) print more Goldnotes and pay them with those, or (3) pay them directly with specie from the vault. Options 2 and 3 are basically the same–either way, the reserve ratio goes down and the vault gets further depleted of specie.

The leaders of Independent Bank eventually chose to print more Goldnotes (less conspicuous that way), which predictably led to the usual percentage of those Goldnotes being exchanged for specie, and the vault’s piles of gold coins became progressively smaller. This is what led the employee to conclude that they were about to run out of specie altogether, which is why he ran home to tell his family to exchange all their Independent Bank Goldnotes for specie before they become worthless.

Ok, I hope this clarifies how a bad crop (or any other financial shock) can lead to a bank’s reserves getting too low and eventually trigger a bank run.

And just to be explicit about one of the lessons to be learned from this situation, I’ll say this: The lower the reserve ratio, the smaller the financial shock needed to drain reserves enough to trigger a bank run.

In Part 19, we’ll talk about how the bankers respond.

In Part 16, Avaria went from having one bank to having five banks in a pretty short time. We also saw that the bankers and their investors started getting greedy, pushing their reserve ratios down lower and lower. I described it as a house of cards.

So what will we do this week to give a little push to this house of cards?

Let’s say the farmer has a bad crop. Maybe there was an early frost. These things happen. And it means that one of the primary sources of new wealth for the society didn’t produce as much this year. Unfortunately, a lot of people were planning on that additional wealth coming into society, so let’s trace the ripple effects of this bad crop.

First, the farmer, ever since buying the tractor and expanding his farm, has been hiring a lot of farm hands lately. Suddenly he doesn’t need them for several months.

And then there are all of the people who are normally employed to help transport and process and re-sell all the food the farmer harvests. They all lose a large portion of their income as well.

When you start adding up all the people who just lost some or all of their annual income, it comprises a large minority of society. And what do people do when they are suddenly impoverished? They especially cut back on luxury items.

With business recently booming in society, primarily because of the influx of cash that gave the Avarians the illusion of greater wealth than they really had, a lot of companies selling luxury items were cropping up and growing quickly, and they were borrowing a lot of money to rapidly increase production capacity. But their sales started dropping as the money price of things adjusted, which caused that illusion of wealth to start to dissipate. And then their sales took a further plunge as a result of the bad crop and resultant shortfall of wealth in a large chunk of society. Those dropping sales led to those businesses defaulting on their loans. Some factories that were half-built had to be scrapped entirely. Many half-made products were never completed. Beautiful new stores were abandoned. What a waste of wealth! And this business-related waste of wealth is in addition to the loss of wealth (relative to expectations) that the bad crop instigated. It’s a powerful example of how damaging uncertainty in an economy can be. And the most potent inducer of uncertainty is when money doesn’t have a stable value because money prices no longer are accurate at indicating the wealth price of things, so nobody can accurately gauge how much wealth they have and how much wealth they are spending.

So now we have a lot of businesses that have defaulted on their loans, and surely a lot of families as well. Therefore, the default rate of commercial loans and private mortgages is rising quickly. And who do you think gets hit the hardest by all these loan defaults? Yes, of course, it’s the people who own all the loans–the bankers. They, after all, are the ones lending out the majority of money in society.

Let’s say the problems start with Independent Bank. As the newest bank, it was being extra aggressive to try to play catch up with the other banks and earn its fair share of the market, so it was pushing its reserve ratios the lowest by making as many loans as possible, including to risky borrowers. And then, when it stopped receiving payments on a large percentage of its loans, for reasons that will be explained in Part 18, its gold coin supply in its vault became critically low.

One of the employees walks into the vault and sees that the bank is almost out of gold coins. He runs home and tells his family members that they better exchange their Independent Bank Goldnotes quickly because the bank is going to run out of gold coins soon. So they all run to the bank and line up, asking for specie in exchange for all their Independent Bank Goldnotes. Other passersby see the line and ask what’s going on, and the people in line tell them the bank is running out of gold and that they better redeem their Independent Bank Goldnotes quickly. The people already in line are happy to share the news with others because it’s exciting and because it won’t hurt them if others get in line behind them.

In this way, the news spreads, and the line grows longer. Within another few hours, Independent Bank is going to be completely out of gold, which would mean telling its depositors that they can’t get specie anymore and then having to liquidate its assets to try to repay them. Independent Bank is on the verge of failure.

This is Avaria’s first bank run! How exciting, right?

Does this mean we have a societal default on our hands? There are a lot of people defaulting on loans, but I would say it hasn’t necessarily led to a full-blown societal default yet.

But never fear–the owners of all the banks see what’s happening. They see that this could go downhill for all banks real quick if people start worrying about the reserves in them as well and then start lining up at their teller windows too. That means their entire system of massive wealth generation for themselves (i.e., aggressive fractional reserve banking, which is the house of cards) could completely topple! They need a solution, and fast. In Part 18, I’ll further clarify Independent Bank’s financials to show how it ran low in gold coins, and then in subsequent posts I’ll move on to explaining the solution the bankers came up with.

As promised at the end of Part 15, in this post I will add a couple more thoughts to everything else I’ve written about fractional reserve banking, and then we’ll see what happens next in Avaria.

The first point I want to make is that bankers really love fractional reserve banking. Think about it: All wealth in society is stored either in the form of cash assets or non-cash assets, and the banker is earning interest on a large percentage of the entire cash assets in the society. In the case of Peppercorn Bank, he was earning interest on 23,000 of the total 33,000 Goldnotes in circulation, which is 70% of the entire cash assets of the society! Wow.

Here’s a new formula I’ll introduce to help you quickly calculate that:

Portion of Society’s Total Cash Wealth that Bankers Took from Others and Are Earning Interest On = 1 – Reserve Ratio

That formula does assume everyone has deposited all their gold coins into Peppercorn Bank, so the number ends up being a little less. But still, that’s why bankers can get very rich off of fractional reserve banking.

The second point I want to make is that I haven’t clarified exactly why unstable prices are so inefficient for an economy. I have, however, written before about the importance of prices being accurate, and there may be an opportunity to further illustrate that principle before this series ends. We will see.

All right, it’s finally time to get back to the story of Avaria and see what monetary changes arise next! (It only took 5 1/2 posts to unpack all the changes that came about as a result of instituting fractional reserve banking way back in Part 10, which I’d say isn’t too bad.)

Maybe you can guess what happens after the banker starts earning all that money from interest on the 23,000 Goldnotes he printed and lent out. People start seeing that he’s earning a lot of money. They eventually figure out what he’s done, and the clever ones figure out a great secret: They can start a bank and do the same thing!

The town storyteller decides he has lots of rich friends who pay him to tell them stories, and he’s not earning enough just telling stories, so he uses his persuasive speaking skills to get them to invest in a new bank. He names it Storybook Bank. He spends the investment money on a beautiful new bank building with a nice big modern and extra-safe vault in it, and he designs a more beautiful banknote that, for simplicity, he also decides to call a Goldnote (but there’s the seal of Storybook Bank on this one instead of the Peppercorn Bank seal).

Through all these efforts, plus on the recommendation from all the rich influential people who just invested in the bank, many people start choosing to store their gold coins in Storybook Bank instead of Peppercorn Bank.

Over time, other entrepreneurs in Avaria found additional banks. There’s the town preacher who founds Veritas Bank with the investment of his parishioners, and the Astro Bank founded by the industrious scientific community, and the Independent Bank founded by the antiestablishment community. All told, there are 5 banks at this point. Kind of overwhelming, really!

They all find their niches and start earning money for their investors by instituting fractional reserve banking. And they all closely track the variability in the amount of specie in their vault and lend out the maximum number of Goldnotes they can get away with, sometimes even pushing their reserve ratios down to below 15%. After all, their investors want as high of a return on their investment as possible, and the founders of all these banks made big promises to them.

I just want to pause briefly here and remind you what a 15% reserve ratio means. If all banks have a 15% reserve ratio, that means 85% of the money circulating is NOT backed by specie. The society’s money started out at 100% backing, then it dropped to 30% when Pepper Bank instituted fractional reserve banking, and now it’s at 15%.

Additionally, a 15% reserve ratio means banks are highly leveraged–85% leveraged to be exact. This is obviously pretty high.

Meanwhile, business is booming in society. There’s so much capital available that new businesses are cropping up all over the place, everybody is hiring, and there’s excitement in the air. Sure, prices are rising like crazy (from the total number of circulating Goldnotes continuing to increase as reserve ratios drop), but that’s a small concern because money seems so plentiful everywhere. People don’t ask why there’s so much apparent wealth everywhere. Why question such a wonderful thing? They know that they’ve worked hard for so long as a society, their reward was bound to come sooner or later.

You can see where this is going. This house of cards is set to topple at the slightest provocation. We’ll give it a little push in the next post and see what happens!

In Part 14, I added the idea of societal leverage to our foundation of knowledge so that I can use it in this post to give a final assessment of the overall impact of fractional reserve banking on a society.

To do that analysis, I will get back to comparing the factual scenario (fractional reserve banking) to the counterfactual scenario (sticking with 100%-backed receipt money).

The factual scenario was to institute fractional reserve banking. This created a ton of bank leverage that also allowed for greater individual leverage (because now more cash was available for borrowing). Individual leverage is all well and good–people need to borrow money sometimes, especially for big expenditures like business ventures–but it’s really the bank leverage that initially caused so many problems because it artificially expanded the total cash in society, which meant that the WU:money exchange rate had a sudden and drastic change, thus initially making people experience the illusion of wealth before money prices adjusted to the new WU:money ratio. And then later those same people realized that they had made a bunch of foolhardy expenditures that they really couldn’t afford because of that illusion of wealth. There are many more detrimental effects on an economy when there’s a sudden shift in the value of money (and, therefore, the money prices of things are all out of whack), and they will be explained in later posts. But suffice it to say for now that this sudden shift caused an upheaval in the Avarian economy, which always results in the loss of a lot of wealth.

The counterfactual scenario was for the banker not to institute fractional reserve banking (maybe instead the Avarians had the foresight to institute an auditing system so that he couldn’t), but he still was able to furnish some loans to individuals by facilitating an effort to get depositors to pool and invest their excess cash wealth. Basically, the banker invented a primitive version of Kickstarter–it’s crowdfunding. And it involves no bank leverage and no exploitative loans. But it does of course still involve individual leverage because individual people are still borrowing money. The big downside of this scenario is that there won’t immediately be as much money made available for lending. But the value of money will remain much more stable, which will encourage investment, and the investments made by loaning someone else money will be through assentive loans, meaning the owners of the wealth that is being lent have agreed to temporarily give up that wealth in return for earning interest. The fact that they have agreed to loan their money probably means that they were able to make an informed decision about the risk of complete loss of their principal, so even if the investment does fail it will not be financially catastrophic in most cases.

Compare that to the impact of all people unconsentingly (it’s a new word) having a large percentage of their stored WUs stolen from them when the banker implements fractional reserve banking. Many of those people probably couldn’t stand to lose any of their WUs. And then the banker uses that stolen wealth to make exploitative loans so he can earn a ton of interest off it. This leads to a substantial shift in wealth from everyone to the banker. He will start to become wealthier and wealthier, and the people will think he has become so well off simply because the gold mining and banking businesses are very profitable these days, not knowing that he’s living off the wealth he has siphoned from them.

Hoping that fractional reserve banking will go away on its own at this point is naive. Why would the banker destroy the extra Goldnotes when they are paid back to him in the form of loan payments? Nope. What he’ll instead do is accumulate them until he has enough of them to fulfill another loan request. The WU:gold coin ratio will never go back to how it was without some external intervention forcing it.

You can probably see that, even in the short term (before we add in all the extra long-term issues that fractional reserve banking leads to), the institution of fractional reserve banking is a terrible idea. What’s crazy is that I learned about it in economics classes in college, and it was presented to me as a normal and interesting and benign fact of life. But when you dig in and really look at how it affects the total amount of and distribution of wealth of a society, it becomes a stark villain.

I’m not blind to the big upside fractional reserve banking has, at least in the short term–it makes more money available for borrowing, which ultimately can push society’s wealth forward much faster by funding new inventions and innovations. But that comes at the cost of forcefully taking away from every owner of Goldnotes a large percentage of their cash wealth to gain that benefit, and they don’t even get any of the interest earned on the loans that are made to those entrepreneurs using their wealth. This potential benefit to society also assumes that the person choosing who deserves the loans will do a good job finding the best place for the money to go.

So that’s the short-term analysis. Longer term, there are two huge and unambiguously negative impacts of instituting fractional reserve banking.

The first is that fractional reserve banking opens up the gate to Avaria’s monetary system continuing down money’s evolutionary road to more and more destructive situations. That will be illustrated thoroughly in the rest of this series, and you will see that the amount of wealth lost (and redistributed through exploitation) due to these monetary system changes is astounding.

The second negative long-term impact of fractional reserve banking is that it introduces bank leverage (plus some more individual leverage as well). Ultimately, bank leverage is probably the most risky form of leverage because, from a historical standpoint, it’s the kind that most commonly leads to societal defaults, which also will be illustrated in subsequent posts.

Based on all of that, here is how I will wrap up my assessment of fractional reserve banking: When you look at the short-term and long-term impacts it has, fractional reserve banking is the worst. No society should ever implement it.

Before I end this post, I want to address one more question that has arisen in my mind about all this. If a prudent amount of government leverage and individual leverage can be used beneficially, what about a prudent amount of bank leverage? Maybe just keep the reserve ratio nice and high so a bank failure is nearly impossible?

This could work, but don’t forget about the guaranteed costs of any amount of bank leverage: the change in the WU:money exchange rate, which causes people to lose a percentage of their WUs that were stored in cash and that causes prices to become unstable. Government leverage and individual leverage don’t have these same guaranteed downsides (assuming the loans they receive are assentive loans). So I would say that bank leverage is a form of leverage that you cannot “use prudently” like the other two types because, by definition, it relies on exploitative loans. Thus, the guaranteed, significant, generalized downsides of bank leverage make it not worth whatever benefits you hope to get out of it.

All right, that’s it for this post. In Part 16, I’ll first add a couple more short thoughts related to the institution of fractional reserve banking in Avaria, and then after that I’ll finally share what happens next.