The Theory of Money, Part 19

Image credit: Roberto Machado Noa

Last week in Part 18, we looked at the financial details of Indie Bank to understand more thoroughly how a bank run was triggered by the farmer’s bad crop. It was originally a pretty discombobulated post, so I just went back and edited it for clarity and flow. Check out the new version if you want, or just read this quick recap of what I was trying to convey:

  • Our fictitious society’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, their revenue may drop below their costs, which would mean they are stuck trying to pay their costs either with even more newly created money or by paying directly with specie they have in the vault, both of which result in the same problem–even lower reserve ratios/even more severely depleted stores of specie
  • Depleted reserves trigger bank runs when word gets out and people get scared

All right, it’s finally time to see what the banking leaders do when they see the long line of people trying to exchange their Indie Bank Goldnotes for specie. Remember, they know perfectly well that Indie Bank will run out of specie before the day is through and that it will have to declare bankruptcy if they don’t do anything to stop it.

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

They other four leaders initially talk about allowing Indie Bank to declare bankruptcy and then spinning this to the public to convince them that Indie Bank was the only imprudent bank and that all the rest of them are very safe. Their hope is that a strong and widespread PR campaign will prevent generalized distrust in the banking system after Indie 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 can’t let that happen–think of how disruptive to society it would be if everyone loses (the rest of) their savings! 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 Pepper 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 Indie Bank some of those gold coins–just for the short term–to help them avoid bankruptcy. We could make a big show of delivering cartloads of gold to Indie 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 wait 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 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 Indie 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 Indie 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 Indie 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. But there may not be enough reserves in 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 Indie 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 because it refers to multiple things; it’s not specific enough. So I will call this solution they came up with a reserve-sharing central bank. We will encounter the other kinds of central banks soon.

Where is our fictitious society now? It still has fractional reserve banking, and now it also has a reserve-sharing central bank to help the banking system continue to milk the cash cow that is fractional reserve banking.

Next week, 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.

The Theory of Money, Part 18

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Well I guess it wasn’t the “same bat time” this week because this post is a little late. If you recall, I left you with some suspense at the end of Part 17 when Indie Bank was on the verge of collapse due to a bank run getting triggered. But I’m sorry to say that that suspense is not going to be resolved in this post because, in reading through last week’s post, I realized I need to spend more time clarifying some of the details surrounding the whole Indie Bank financial situation.

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

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 through fractional reserve banking. If you’ll recall, Pepper Bank originally charged fees, but (something I never mentioned at the time) those fees mostly went away when it shifted to fractional reserve banking.

How can banks earn more from their one revenue stream? There are two ways: (1) they can push their reserve ratios even lower to lend out even more money, and (2) they can find a way to charge higher interest rates. The way to charge higher interest rates is by making riskier loans.

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

Bank profitability. Hopefully the income they earn (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 Indie Bank. If someone gives them a Goldnote from Pepper Bank, they can simply go down the road to Pepper Bank and exchange it for a gold coin. Or maybe Pepper Bank has received some of Indie Bank’s Goldnotes as payments, so they could trade Goldnotes for Goldnotes. At this point in our fictitious society, 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 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, prices would drift back to what they were before, etc. The only lingering evidence that they 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 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 Indie Bank got itself into, so let’s jump into Indie Bank’s situation directly.

Let’s say Indie 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. And let’s say that it was also 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 Indie 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 as fast, which was not immediately a big problem (they just have to wait a little longer before making another loan), but it also meant that its Revenue section was also not accumulating money as fast as it normally does. But its costs are mostly fixed costs, so the bank was still having to spend a lot of money from its Revenue section. This was a big problem!

Soon enough, Indie 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 Indie Bank eventually chose to print more Goldnotes (less conspicuous that way), which predictably led to some 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 Indie 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 low and eventually trigger a bank run. Next week we’ll talk about how the bankers respond.

The Theory of Money, Part 17

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Last week, we went from one bank to 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 try to topple 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 previously booming in society, there were a lot of companies selling luxury items and growing quickly, and they were borrowing a lot of money to rapidly increase production capacity. Suddenly their sales have dropped precipitously, and they can’t afford to make their loan payments. Some factories that were half-built have to be scrapped entirely. What a loss of Labor Units! This, remember, is in addition to the loss of Labor Units (relative to expectations) that the farmer would normally provide.

So now we have a lot of businesses defaulting on their loans, and surely a lot of families as well. Therefore, commercial loan and private mortgage defaults start 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 Indie 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. Then, many of its loans go bad. It has been counting on getting paid back those Goldnotes it lent out so it can continue to pay its employees and other expenses. But now it doesn’t have enough of those, so it resorts to paying in gold coins directly from the vault. This, in addition to the usual exchange requests, drops the number of gold coins to only a few small piles.

One of the employees walks into the vault and sees that the bank is running out of gold. He runs home and tells his family members that they better exchange their Indie 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 Indie 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 Indie Bank Goldnotes quickly.

The news spreads, and the line grows longer. Within another few hours, Indie 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.

This is our fictitious society’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. That means their entire system of massive wealth generation for themselves (i.e., fractional reserve banking, the house of cards) could completely topple! They need a solution, and fast. We’ll see what they decide to do next week. (It feels like this is where I should add, “Same bat time, same bat channel.”)

The Theory of Money, Part 16

As I promised last week at the end of Part 15, I went back and read through Parts 10-15 again to see if I’ve missed anything important that came about as a result of the institution of fractional reserve banking.

I only had two small thoughts to add to all of that.

The first is that bankers really love fractional reserve banking. Think about it: All wealth (Labor Units) 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 Pepper 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 Pepper Bank, so maybe 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 thought I wanted to mention 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 our fictitious society and see what monetary changes arise next! (It only took 5 posts to unpack all the changes that came about as a result of instituting fractional reserve banking, 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 Story 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 Story Bank on this one instead of the Pepper 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 Story Bank instead of Pepper Bank.

Others do the same. There’s the town preacher who founds Verity Bank with the investment of his parishioners, and the Astrid Bank founded by the industrious Scandinavian immigrant community, and the Indie Bank founded by the musician who has some wealthy fans. 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% 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 next week and see what happens!

The Theory of Money, Part 15

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I’ve been thinking more about how to clarify last week‘s topic of leverage and the risk for societal default, and I actually went back and edited last week’s post a little bit. And now I’ll clarify some terminology for easier referencing in the future.

The two main possible causes of a societal default are “bank leverage” and “government leverage.” Bank leverage is the percent of total cash that the bank created through fractional reserve banking. As a reminder, it’s calculated like this: 1 – Reserve Ratio = Bank Leverage. Government leverage is the percent of government income that has to go to servicing debts. As a reminder, it’s calculated like this: Government Monthly Debt Payments / Government Monthly Income = Government Leverage.

And then there was sort of a third contributor to the risk of societal default, which is the average amount of leverage of individuals in the society. I guess we could call it “individual leverage” (“average individual leverage” seemed too long of a name). It would be the same calculation as government leverage, only applied to an individual’s income and debt payments. This third kind of 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 (i.e., the average individual leverage is high) because a hit to the economy may lead to a lot of people not being able to pay their loans, which will probably spark one or both of the other two forms of leverage that would cause the default to become more generalized, in which case it becomes a full-blown societal default.

Ok, nice and tidy. Bank leverage, government leverage, and individual leverage.

I also realized I had made an error in Part 13 when I talked about the auditing system, so I went back and clarified that part of that post. Basically, I forgot that Pepper Bank doesn’t have to keep track of any individual account balances anymore because the only way for someone to get a gold coin is to present a Goldnote. Modern-day banks do keep track of account balances though, so I explained how the auditing system would differ in that case.

All right, with those clarifications out of the way, and with the new terminology I defined above, I want to write just a little more about the two options for making use of all those piles of gold coins that were in Pepper Bank’s vault.

The first option, which is the one the banker chose, was to institute what we call fractional reserve banking. This created bank leverage that 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 the bank leverage that caused so many problems because it artificially expanded the total cash in society, which meant that each gold coin or Goldnote was worth much less, so people lost a lot of their LUs they’d been storing in cash and also prices became very unstable, which is very inefficient for a market.

The second option, which I described as a counterfactual in Part 12, was for the banker to get individuals to combine together to lend some of their savings to be able to fund some of those loan requests. Basically, I’m realizing now, it was a primitive version of Kickstarter. It’s crowdfunding. So, from this point on, this counterfactual will be referred to as the crowdfunding option. And it involves NO BANK LEVERAGE. But it of course still involves individual leverage because individual people are still borrowing money. The big downside is that there won’t be as much money made available for lending, but the money that is made available for lending is being proffered by people who are ok to give up some of their savings for a while, so an investment failure with complete loss of their money probably also won’t be so financially catastrophic in most cases.

Compare that to the impact of all people losing a large percentage of their stored LUs when the banker implements fractional reserve banking. Many of those people probably couldn’t stand to lose any of their LUs, and maybe a few richer members of society could have stood to give up more! But, unfortunately, regardless of which group a person is in, they don’t get any of the interest from their LUs being taken and lent out. Only the banker gets the benefits of lending out the depositors’ money. The best the people can hope for is that fractional reserve banking goes away after the loans are paid off so they at least can get their original LUs back when the gold coin:LU ratio goes back to how it was.

Switching back to the crowdfunding option, let’s look at this idea from the standpoint of my save, spend, or invest explanation from Part 4. The super brief refresher of that concept from Part 4 is this: When someone has money that they don’t need to use immediately, their 3 options are to save it, spend it, or invest it. So, thinking about the crowdfunding option, it’s giving people an opportunity to shift more of their stored wealth from the save category (where it’s doing nothing for them) to the invest category (where it’s earning more money for them). This is great!

You can probably see that I’ve come to believe that the crowdfunding option is a better solution than than the fractional reserve banking option. But I’m not blind to the big downside of the crowdfunding option, which is that less money will be made available for borrowing. But let’s think about that for a moment to see how big of a downside it really is.

If there is less money available for borrowing, it means not as many investment opportunities will get funded. The big question is whether the people who are making the decision about which investment opportunities to fund are correctly predicting the ones that will be the most successful. If they are doing a good job of that, then the investment opportunities that don’t get funded are the lower-yield ones that will have less of a benefit to society anyway. So how much are we losing if we only miss out on investing in the lower-quality investments? Maybe not so much.

Of course, there are always those investments that seem off the wall but get funded due to an excess of capital around and then end up paying off bigtime, so I can’t say for sure that avoiding bank leverage (which would make available a whole bunch more capital for lending) is the guaranteed best outcome for society.

So that’s the short-term analysis. Longer term, think about what is likely going to happen sooner or later with enough bank leverage: a societal default. No, we still haven’t talked about how this might happen! Trust me, we’re getting there. But anyway, when a societal default happens, it causes the wealth of a society to regress so much that you may end up further behind and have less wealth to invest overall than if you’d just stuck with the slower steadier crowdfunding option.

And there are other reasons to avoid a societal default. Not only will it cause the wealth of a society to regress, but also it creates massive amounts of suffering for those individuals and families who, maybe of no fault of their own, ended up getting hit the hardest and lost a lot of their wealth that was critical to their continued wellbeing.

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 gold coin:LU ratio, which causes people to lose a percentage of their LUs that were stored in cash and that causes prices to become unstable. Government leverage and individual leverage don’t have these same guaranteed downsides. So I would say that bank leverage is a form of leverage that you cannot “use prudently” like the other two types. 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 week. Eventually we’ll get back to seeing what happens next in our fictitious society, but there have been so many things to process with this major shift from receipt money to fractional reserve money that occurred way back in Part 10! Before I write next week’s post, I’ll go back through all those parts to see if there’s anything I’ve missed before I start progressing our fictitious society again.

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