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!

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