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.

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