Month: December 2022

In Part 22, we saw the banks start using non-cash assets as reserves, which opened up a lot more potential for expanding the number of circulating Goldnotes. Let’s just clean up a few topics related to that this week to make sure everything is settled before we move on to what happens next in the evolution of Avaria’s money.

First, I want to make sure I was clear about what monetary expansions and contractions do. They have a many effects, so this should not be considered a complete list. First, they skew purchase decisions by giving the illusion of wealth or poverty (depending on which way the money supply is moving) until prices adjust to the new value of money. Second, they increase uncertainty in prices, making long-term contracts more challenging and leading to more investments failing (loss of Wealth Units). Third, they cause a transfer of wealth from some people to other people; for example, when there is new money created, the first few people this money passes through get to spend it at pre-inflation prices, and thus they are getting additional wealth transferred to them at the expense of others further down the chain.

Now, related to that second point about price uncertainty, let’s talk more about prices to show how destructive monetary expansion and contractions are.

Prices are super important as an indicator of the value of something in the market! Each thing’s price is derived from millions of individual decisions made by all the other participants in the economy. For example, some people decide one thing is too expensive, so they substitute something else for it. Others cannot substitute, so they are willing to pay that fairly high price. Others decide something is cheap, so they’re going to buy more of it or use it for additional purposes, which leads to changes in how much of other things they buy. And so on and so on.

The aggregation of all these millions of individual self-optimizing decisions is what forms the market price of a thing, which is what every other participant in the economy uses to figure out how to further optimize their own situation and needs. This is how things are put to their most effective uses. This is how an economy runs efficiently to generate as many Wealth Units as possible and distribute them appropriately according to the value provided by someone.

We’ve seen government systems in the past try to have “experts” set prices for all or most things in an economy, and suddenly the value and efficiency derived from accurate prices became very apparent! Trials of administrative pricing (central planning of an economy) showed how inefficient an economy becomes when you lose the information that market prices provide with all those millions of points of data they contain. Administrative price setting was tried especially in communism experiments, although communism is merely the most widespread and famous effort at that. There are tons of other price setting attempts going on today, including in the United States, and the reasons for administratively setting prices seem compelling when policy makers don’t have a clear understanding of the cost of losing the information that market-generated prices provide.

So, putting all of this together, when we have monetary expansions and contractions, it is ruining the accuracy of the price of EVERY SINGLE THING in the market, which induces a communism-like effect on the efficiency of a market! Sure, this is a temporary situation that lasts only until prices adjust, and, sure, people can at least guess at what the true price of a thing is if all prices are rising generally a similar amount, but there will still be huge inefficiencies due to this change in prices. And this inefficiency cost is incurred each time the rate of inflation or deflation changes, and it is probably even incurred (albeit to a lesser degree) when inflation or deflation is happening at a relatively stable rate.

These are the reasons I don’t like inflation and deflation, and in this series we will soon get to how governments induce monetary expansions and contractions (inflation and deflation) in modern monetary systems. Part 24 here.

In Part 21, we talked about how expansions and contractions of the money supply don’t directly lead to a loss of Wealth Units, but they do indirectly lead to a loss of WUs due to the skewed purchasing behaviour and lost investments that those fluctuations cause.

I also said that people were starting to throw some blame at the bankers for these economic challenges–after all, they had no problems like this until the banks came around. So what do the bankers do?

They see that their shift toward higher reserve ratios has caused a lot of deflation. The people are unhappy because, as prices are still adjusting down to reflect the new WU:Goldnote ratio, everything seems so expensive. And the bankers are unhappy too because they want to get back to lending out as much money as they were before so they can start making a ton of profit like they were before.

The proprietor of Storybook Bank, being a storyteller with a big imagination, is pondering this problem one night when he comes up with an ingenious idea. He thinks, “The people want more money flowing again, and us bankers want to make that happen because it means we’re lending out lots of money again. But we can’t risk going down on our reserves like we did before. Hmmmm. So far, we’ve only been using cash assets as reserves for lending. What if we tried using non-cash assets? Only about 10% of society’s wealth is stored in the form of cash, and the rest is in all the other assets, then this would open up a huge new source of reserves for us!”

Let’s work through what might happen if he does this.

Maybe, during the near-collapse, when there were so many people defaulting on their loans, some of those loans were secured with collateral, and Story Bank ended up with a couple automobiles from debtors who couldn’t pay and had their collateral (their automobile) seized. He’s been wondering what to do with those automobiles. He’s been trying to sell them, but he hasn’t been able to yet what with the money scarcity and everyone being tightwads lately. So they’ve just been parked in a warehouse somewhere collecting dust and depreciating. But he has the titles to both of them in his vault. Each automobile is worth 500 gold coins, which means the title is essentially receipt money worth 500 gold coins.

He could use the current money multiplier of 5 (based on the recently enacted policy of maintaining a 20% reserve ratio) and print 1,000 x 5 = 5,000 new Goldnotes for lending based on those two titles. More money in the economy! Just what the people want. And more money for him to lend! Just what he wants.

But if he only has 4,000 gold coins in his vault (and, therefore, 4,000 x 5 = 20,000 Goldnotes circulating), now he is going to have 25,000 Goldnotes circulating. And he knows that people have been requesting up to 15% of Goldnotes to be exchanged for specie on any given day lately (because they want to reassure themselves that they can still get it!), that means 25,000 x 0.15 = 3,750 gold coins could be requested on any given day. That’s dangerously close to 4,000.

But, worst case scenario, if he hasn’t sold the cars yet and his gold coin reserves drop dangerously low, he has a few options. He probably couldn’t give someone a car instead of 500 gold coins–that would look suspiciously like he is running out of gold coins, which could spark a bank run all over again. But he could at least quickly sell one or both of the cars for a bargain price. Or he might be able to trade the car titles for 1,000 gold coins (or a little less) from another bank. Or he could just borrow some specie from the other banks (at the fairly high interest rate that was set) through their new reserve-sharing central bank.

Ultimately, he decides that the risks are low enough based on the worst-case scenario options he has thought through, and he goes ahead and uses the car titles as reserves. He also recognizes that if anyone sees the small size of gold coins in his vault, they will flip out and maybe trigger another bank run, so he restricts access to the vault to only those who are trusted to keep it quiet how few gold coins are in there. And he explains to those trusted individuals that the number of gold coins is smaller because he has the rest of the reserves (like those two cars) stored elsewhere in the form of non-cash assets.

The other banks catch on soon and start doing the same thing, which stops the burgeoning deflation (with all its perceived relative poverty) in its tracks. The people are happy that money is flowing again, and the banks make sure to take credit for saving the day! If it weren’t for those banks, where would they be?

I guess I’m starting to portray banks as the bad guys, but I should be clear about this: They are not the bad guys per se. They are rational people seeking ways to leverage a situation to earn money, which is the basis for capitalism and the majority of welfare-improving innovations in society! What is bad is the incentives in the system. Good people can have honorable or even altruistic motivations, but if they’re stuck having to work within a system with bad incentives, their impacts on society may still be bad.

Anyway, to wrap up, I just want to state explicitly what happened in this post: Banks started using non-cash assets as reserves. If 90% of society’s wealth is contained in non-cash assets, that means 90% more intrinsically valuable things have just become potential reserves, which can be the basis for many new Goldnotes. Obviously, in this society where people are still expecting specie on a regular basis, the bankers are limited in how much of their reserves can be based on things that are not gold coins, but it’s one step closer to how our modern banks work. Part 23 here.

In Part 19, we saw how the bankers came together to form a specie pool, which succeeded at avoiding that near-collapse when the bank run started. In Part 20, we analyzed the situation further to show how a lot of societal leverage plus a lack of societal diversification is what led to the near-collapse of the banking system (one of the hallmarks of a societal default) in our fictitious society. So let’s see what happens next!

Because the banks all learned that hard lesson from Independent Bank’s experience, they set the reserve requirement to 20% and set the reserve-lending interest rate very high to discourage banks from going below that number. They also started being a little bit more parsimonious with who they would loan money to so that their fractional reserve banking system doesn’t topple (through a high default rata) at the slightest provocation. Remember, they don’t want to kill the goose that is laying their golden eggs! So they’ll make sure that goose lays a safe number of eggs.

So now the average reserve ratio increased from around 10% to around 20%. You know what the implication of higher reserve ratios is, don’t you? Let’s see what happens.

If, in all of society, there were 10,000 total gold coins, and nearly all of them (for simplicity) were stored in banks, and the pre-bank run average reserve ratio was only 10%, using our handy formula to figure out what the money multiplier was (Money Multiplier = 1 / Reserve Ratio), we get a money multiplier of 10, which means there were 100,000 Goldnotes circulating.

After the almost-collapse, if the reserve ratio increased to 20%, the money multiplier changed to 5, which means the total number of circulating Goldnotes dropped down to 50,000. 50% of what it was before. This is a huge drop! And it is going to cause some serious issues.

First, let me first clarify what isn’t going to be a serious issue. If the total number of Wealth Units stored in the form of cash in society was 10,000, that number doesn’t change when the number of circulating Goldnotes changes. All that changed was the WU:Goldnote ratio, which changed from 0.1 to 0.2. So, to be clear, no WUs were directly lost from the circulating Goldnotes decreasing.

But I said “directly” in that last sentence for a reason. A lot of WUs get lost as an indirect result of this wild swing in the value of money. I mentioned this before when discussing the costs of implementing fractional reserve banking, but at that time I referred to it as unstable prices being inefficient for an economy. I never gave a full explanation of it, so let me provide a little more detail on that now.

If there were a magical way of people being able to know exactly what the total number of Goldnotes circulating at any given moment is, there would be no problem with changes in the number of circulating Goldnotes. People setting prices would simply price their goods and services in terms of WUs and then use the moment’s exchange rate to determine the price in Goldnotes. That way, the price paid is always the wealth price, as expressed in WUs. They could even do this for loans, quantifying the size of the loan in WUs rather than Goldnotes.

Unfortunately, we don’t have a way of accurately knowing the up-to-the-minute WU:money ratio. So we set a price according to all the information we have at the time, and if the value of money changes, we adjust our prices once we come to know that the value of money has changed. Or, sneakily, we keep the price the same and give less (shrinkflation) hoping our customers won’t notice and will therefore think they’re getting a great deal!

During the lag time between the value of money changing and the prices being adjusted to reflect that new WU:money ratio, some prices are adjusting faster than others, and a lot of inefficiencies arise. I will summarize them all by saying this: When prices are no longer accurately reflective of the the value of things, people no longer have the information needed to put limited resources to the best uses. Hayek wrote most persuasively about this, as I have discussed here and here.

How about an example?

Let’s say, in Avaria, a posh driving muffler (scarf) company arose during the height of the money boom right before the bank run. Lots of people were buying those newfangled automobiles, and they wanted to look good (and keep warm) driving around showing off. This company, let’s call it Posh Muffler, was selling out each week. They borrowed a lot of money to build a big nice store and decorate it to be as posh as the mufflers they were selling.

This huge demand for automobiles and posh mufflers was a result of society suddenly having an abundance of cash (not knowing each Goldnote they owned was actually worth less). Posh Muffler, as well as the other sellers, didn’t have the magical way of knowing the WU:Goldnote ratio, so prices had not yet risen to account for the lower value of money, which meant that everything seemed so cheap. And when everything seems cheap, you start buying more luxury goods, like mufflers from Posh Muffler.

The company was selling so many high-end mufflers that it started sourcing more woven cotton from England, which was where the highest quality of woven cotton was being produced. Back then, it would take at least a week to send an order across the ocean. And then the factory would fill the order, which maybe took a couple weeks, and then they would send it across the ocean, which would take another week. So, there was at least a month lag time from placing an order to receiving a shipment. Realistically, it probably took a lot more time than that.

If Posh Muffler sent in a big order right at the peak of the boom, and then everything changed suddenly with the bank run, by the time they received their new bigger-than-ever order, the financial state of the company could be completely different. If they paid up front for all those mufflers, now they have no cash left because they’re not selling many mufflers anymore but they still have employees to pay and a big loan on their new store to pay as well. Soon, they have no cash left, and they have to declare bankruptcy.

Sad story, right? Think about all the WUs that went into that company. The planning phases, the new building, all those top-quality cotton mufflers that cost a pretty penny to acquire but are now worth very little (because of lack of demand). So many of those WUs that were invested into Posh Muffler end up being lost.

That example helps illustrate how WUs are lost indirectly as a result of the number of circulating Goldnotes changing. And it happens both because purchasing behaviour was skewed when inflation was first hitting and because investments go bad when deflation is first hitting.

Now we have seen the initial backlash of the bank run. It was pretty bad. A lot of people found that they had bought things they couldn’t afford. A lot of companies went under. Many jobs were lost. And many jobs were at risk of being lost, so people were investing less and saving more, which caused economic progress to grind ever closer to a halt. The bankers came out okay because they averted a banking collapse, but people are starting to suspect many of these issues were caused by them. Blame starts getting thrown at them. But those ever-resourceful bankers, they always have a surprising response. We’ll see what they do in Part 22.

In Part 19, I described the devastating impact of a societal default, and then I explained how the bankers averted it by creating a specie pool arrangement.

In this post, I’ll explain how societal leverage and societal diversification affect the risk of a societal default.

Societal Leverage

Remember the three kinds of societal leverage from Part 14? They are bank leverage, government leverage, and individual leverage. Let’s look at how each of these contributed to the near-societal default.

We haven’t added an Avarian government into the mix quite yet, so there was no government leverage at play here.

Next, take a look at individual leverage. If there hadn’t been so many individuals dependent on their expected income from that year to make good on their loans, the banks wouldn’t have dealt with such a high default percentage. But this is what happens when a society is suddenly flush with cash. People start making risky investments assuming money will continue flowing. There’s a generalized excitement that arises, neighbours seeing neighbours get rich quick and not wanting to be left behind, so they want to get in on the action to avoid being the ones who didn’t ride the wealth bubble up with everyone else.

Now, if people are making all sorts of investments with cash that they can stand to lose because they truly do have plenty of stored cash wealth to keep them going, then it’s not such a huge issue when some of that money is lost. But, as a rule, when society is suddenly flush with cash due to a dilution of the currency (through fractional reserve banking, in this case) and prices haven’t yet adjusted, this is not money people can stand to lose in most cases.

And, as for the banks, if they hadn’t been so highly leveraged, the high percentage of loans in default wouldn’t have triggered a bank run.

So high individual leverage and high bank leverage were the triggers of this near-catastrophe.

Those are my thoughts on how societal leverage contributed to this near-societal default, and, with that as context, it should be clear what the solution is. If you can avoid the sudden increase in bank leverage in the first place (optimally, by preventing the institution of fractional reserve banking), there wouldn’t have been the illusion of prosperity with a huge amount of surplus cash flooding the market, which means fewer high-risk loans and high-risk investments would have been made, individual leverage would not have ratcheted up so high, and society would have continued to generate wealth at a sustainable pace.

I think this is a good place to point out that booms and busts are not a “natural” part of an economic cycle. Sure, there are times when a natural disaster or a low crop yield can cause a loss of a lot of expected wealth from society, which will cause an economic downturn; and there are also times when a particularly high crop yield or something else can cause an unexpected influx of wealth to a society. But, as we just saw when I described Avaria’s societal default, these normal ups and downs are completely different from the economic torture incited by the booms and busts that come about from the wealth unit:money exchange rate rapidly changing as a result of human institutions (mostly banks and governments) tampering with the money supply. That tampering is what caused the initial boom through the illusion of wealth, and the aftermath of it is what caused the subsequent bust.

It’s like a spring that was pulled too far, and when the conditions that allowed it to be pulled so far like that went away, the spring contracted back suddenly. Normal economic growth and wealth generation build the spring to be longer, adding coils one by one. Sudden monetary expansion doesn’t add more coils; instead, it just stretches the spring. And the more strongly the spring is stretched, the more likely it is to suddenly recompress at the slightest provocation, the consequence of which is to rapidly destroy many of the coils that were slowly added one by one over many years of real economic growth.

Let me reiterate that point more concisely: Economic booms and busts are incredibly destructive of society’s wealth, and they are caused by human institutions tampering with the money supply.

Ok, now on to societal diversification . . .

Societal Diversification

If the society wouldn’t have been so dependent on a good crop every year to continue to make payments on their loans and keep up the house of cards, they could have weathered this much better. What if half of the new wealth coming into this society was from the farmer, but the other half was from exporting a product to other societies? Then a lower percentage of individuals in society would have lost all or part of their annual income when the crop was ruined, and that would have translated into a lower default rate, so the banks probably wouldn’t have been on the verge of collapse.

Income diversification is important for a society to help it weather unforeseeable drops in income streams.

These two factors–societal leverage and societal diversification–can help anyone evaluate the risk of a society to default. If a society is highly diversified and not highly leveraged in any of the three ways, it will be an economically solid society, and investments in that society would have a particularly favorable risk-return profile.

Honestly, I wish someone would start calculating these things for the different countries in the world. It would establish an incentive for countries to be prudent with their leverage and become well diversified because doing so would bring more international investment money in. Of course, other factors would also need to be evaluated, such as corruption and the degree of economic decentralization/freedom allowed.

Speculation

One last thing for this week. I want to give my definition of the word “speculation.”

I believe a risky investment crosses over into speculation when the investment returns are predicated primarily upon the price continuing to go up.

If the investment is not actually generating any wealth through providing goods and/or services, or it’s only generating a little bit of wealth relative to its price (and without any solid prospects of it increasing that wealth generation significantly), then the only way to earn a good return on that investment is for its price to continue going up, which requires people to be willing to buy it for more than you did.

At some point, the hype over this continually rising price will die down as people realize that there’s no way this investment can actually bring in earnings commensurate with its price (ahem, tulips, beany babies, Tickle Me Elmo, . . .), and that’s when the buyers disappear and the last ones holding the investment take the huge loss.

The end result of speculation is not an increase in total wealth. The end result is just a transfer of wealth from the people who got stuck holding the investment at the end to the people who sold before the price started dropping. This is just like gambling. You’re making money off of others’ losses rather than from actual wealth generation, plus the deadweight loss of all the time and energy dedicated to the speculating.

Historically, the trigger for any speculative bubble is often a sudden influx of cash/perceived wealth just looking for a way to be invested, like what happened when the banks in Avaria instituted fractional reserve banking and rapidly lowered their reserve ratios. These days, there’s enough excess wealth around that speculative bubbles can happen even without a sudden influx of cash to an economy. All they need is a sufficient amount of hype to get the bubble started.

Let’s briefly apply this discussion to a modern topic: cryptocurrencies. Most cryptocurrency “investments” these days are nothing more than speculation, and I’ll explain more in future parts of this series why an intrinsically worthless currency (even one that cost a lot of electricity to mine, *ahem, sunk costs*) that doesn’t have a government requiring people to use it through legal tender laws is always going to be speculative in nature. Part 21 here.