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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