The Theory of Money, Part 23

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This end-of-the-year holiday time is a busy one for most people, including me, so let’s see if I can make this a quick one!

Last week, 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 money in this fictitious society of ours.

First, I want to make sure I was clear about what monetary expansions and contractions do. They have a few effects, and this may not be 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). Second, they increase uncertainty in prices, making long-term contracts more challenging and leading to more investments failing (loss of Labor 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, 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 Labor 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! They saw 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 a huge efficiency cost to this change in prices. And this inefficiency cost is incurred each time the rate of inflation or deflation changes, and this inefficiency cost is probably incurred (albeit to a lesser degree) even when inflation or deflation is happening but 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 policy. Let’s just hope 2023 brings less of that than how much we’ve had since the pandemic started! Part 24 here.

The Theory of Money, Part 22

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Last week, we talked about how expansions and contractions of the money supply indirectly lead to a loss of labor units due to the skewed purchasing behaviour and lost investments that they 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 gold coin:LU 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 Story 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. 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.

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. 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.

The Theory of Money, Part 21

Image credit: Lynne Sladky

Two weeks ago, we saw how the bankers came together to form a reserve-sharing central bank, which succeeded at avoiding that near-collapse when the bank run started. Last week, 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 Indie Bank’s experience, they set the reserve-sharing interest rate very high to discourage banks from having to use this safety net. They also started being a little bit more parsimonious with loans they were giving out so that their fractional reserve banking system doesn’t topple. (Don’t kill the goose that is laying their golden eggs!) As a result of all this, their average reserve ratios rose.

You know what the implication of higher reserve ratios is, don’t you? Let’s find out.

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. This is a huge drop!

And this drop is going to cause some serious issues. Let’s finish up this week’s post by looking at those issues.

Actually, let me first clarify what isn’t going to be a serious issue. If the total number of Labor 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 Goldnote:LU ratio, which changed from 0.1 to 0.2. So, to be clear, no LUs were directly lost from the circulating Goldnotes decreasing.

But I said “directly” in that last sentence for a reason. A lot of LUs 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 circulating Goldnotes. People setting prices would simply price their goods and services in terms of LUs and then use the moment’s exchange rate to determine the price in Goldnotes. That way, the price paid is always the true price, as expressed in LUs. They could even do this for loans, quantifying the size of the loan (and also the interest rate) in LUs rather than Goldnotes.

Unfortunately, we don’t have a way of knowing the money:LU 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 know that the value of money has changed. Or, sneakily, we keep the price the same and give less 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 money:LU 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 before.

How about an example?

Let’s say, in our ficitious society, 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 Goldnote:LU ratio, so prices had not 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 LUs 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. So many of those LUs that were invested end up being lost.

I hope this example helps illustrate how LUs 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 next week.

The Theory of Money, Part 20

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Wow, 20 parts already! I wish I’d gotten all the way to discussing crypto already, since that seems to be a hot topic right now. But things have to go in order so they make sense. I will at least discuss a little crypto stuff at the end of this post though.

Last week, in Part 19, I said we’d discuss societal leverage and societal diversification, so let’s do that now.

Societal Leverage

Remember the three kinds of societal leverage from Part 15? Bank leverage, government leverage, and individual leverage. How did these contribute to the near-societal default?

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 don’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 wealth to keep them going, then it’s not such a huge issue when some of that money is lost. People can stand to lose it, as undesirable as it is. 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 both high individual leverage and high bank leverage were needed to trigger this near-catastrophe. I haven’t gotten government involved in this fictitious society yet, but the impact of the government defaulting on loans would have had a compounding effect on all of this because even more people would have been suddenly not getting paid for their work.

Those are my thoughts on how societal leverage contributed to this near-societal default. Get rid of the bank leverage and there won’t be a huge amount of surplus cash suddenly, which means the big trend of making all sorts of risky investments (and taking out loans to do so, triggering the high individual leverage) would not have happened, and society would have continued to generate wealth at a sustainable pace.

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 maybe there would have been a lower default rate and the banks wouldn’t have been on the verge of collapse.

Diversification is important for a society just as it is for an individual to help weather unforeseeable challenges.

These two factors–societal leverage and societal diversification–can help anyone evaluate the risk of a society to default. If they’re highly diversified and not highly leveraged in any of the three ways, it will be a solid society to invest in.


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 it 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.

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 instituted fractional reserve banking. These days, there’s enough wealth around that they can happen even without a sudden influx of cash. But I hope you, my readers, know by now after 20 parts of this series that wealth is not created from nothing and, therefore, sudden influxes in cash are probably a dilution of wealth rather than an actual increase in wealth anyway.

Many crypto “investments” are speculation these days, and I’ll explain more later why an intrinsically worthless currency 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.

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