The Theory of Money, Part 17

Image credit: AFP/Getty Images

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.”)

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