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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