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.

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