Month: January 2023

In Part 27, Avaria finally transitioned to a centralized currency. To be clear, its money is still 20% backed by gold (based on a reserve ratio of 0.2), but its receipt money is now uniformly First Bank Notes. And now the only way someone can get an actual gold coin is by going to a First Bank branch and trading a First Bank Note for one, which I mentioned people are doing less and less as the years pass and they get used to exclusively transacting using First Bank Notes.

For clarity in my terminology, I will now only use the term Goldnote to refer to the pre-centralized currency. And I will only use the term First Bank Note to refer to the post-centralized currency.

One other terminology clarification: To refer to the non-government-run banks, I’ve been calling them “private banks.” But, realistically, if they are owned publicly (with bank stock freely available to purchase on the stock market), then the term private bank is probably no longer appropriate. So, I will call them “commercial banks” instead.

All right, with those terminology clarifications aside, let’s see what happens next.

Since the transition to a centralized currency, transacting has become easier because now everyone is using the same notes instead of a bunch of different banks’ Goldnotes each with its slight difference in valuation (according to the reputation/riskiness of the issuing bank).

Importantly, gold (and some other non-cash assets maybe) is still the only form of reserves. That will eventually change, but for now reserves are still only intrinsically valuable assets.

So, now that the commercial banks are no longer able to issue their own currency, what do they do?

As we discussed with Astro Bank in Part 27, not much has changed. It still has its reserves (which are now “reserve credits” at First Bank rather than piles of gold coins in its own vault), and its sole revenue stream continues to be lending out money in accordance with how many reserve credits it has. But commercial banks no longer deal in gold coins. If a depositor comes to Astro Bank hoping to deposit a gold coin, Astro Bank refers it over to First Bank, where the customer will receive 1 First Bank Note in exchange for each gold coin they deposit. And then the customer could turn around and bring those First Bank Notes to Astro Bank to deposit them for safe keeping.

Annoyingly for the commercial banks, even if they do a great job enticing many new customers to deposit their First Bank Notes in their vaults, none of that will increase their reserve credits. So their income from a lending perspective is capped at what it was when the transition to a centralized currency took place.

They can still find other ways to earn money, such as by helping customers invest the money stored in their vaults and charging advisor fees, or by utilizing all that newly emptied space in their vaults to store other forms of valuables for customers. So there is some amount of competition between the banks to win customers so they can provide those extra services to them. As part of that competition, the banks want to make transacting with their bank more convenient, so they eventually invent checking accounts, which allow depositors to basically just write an IOU when spending money at any merchant, and the merchant will take that IOU to the customer’s bank and have the money deducted from the customer’s account and given to the merchant.

But, overall, the private banks are unsatisfied because their primary source of income–loaning money–is capped, all while they are accumulating huge piles of First Bank Notes in their vaults that are “just sitting there doing nothing” (this is a reference to what our original banker said in Part 10, and which should give you a hint about where this is going . . .).

I’ll get to that in Part 29.

And, to finish out this part, let me clarify a couple more changes that occurred as a result of centralizing the currency.

I first want to describe how the specie pool changed. Remember how banks would lend reserves to each other through the “specie pool” if, at the end of a day, a bank’s reserve ratio was below the agreed-upon minimum and another bank had excess reserves?

Well, the same thing still happens, but the process is slightly different.

At the end of each day, each commercial bank reports to First Bank the total value of its outstanding loans. If that number is more than 5 times its reserve credits, it is short on reserves and needs to borrow some reserves from another bank. First Bank will facilitate an overnight transfer (purely an accounting process) of reserve credits to the bank that is short from any bank that has excess that night, and the borrowing bank will pay some interest to the lending bank. Commercial banks negotiate over the interest that will be paid, and that interest rate is called the interbank lending rate.

However, if no bank has enough excess reserves, then the commercial bank that was short on reserves will have to borrow some reserve credits directly from First Bank (the “lender of last resort”), which has the authority to (1) create out of thin air new reserve credits for lending and (2) unilaterally set the interest rate on borrowing those newly created reserve credits. First Bank will set that interest rate fairly high so that it will discourage too many banks from being overly aggressive in how much they are lending relative to their reserves. Plus, as a nice perk, this is yet another way for the government (through First Bank) to get some of the profits that this banking industry is making!

For reasons that aren’t relevant to this discussion, the historical term for the place where a commercial bank employee could go to the currency-issuing bank to borrow overnight reserves like this was called the “discount window,” and the interest the commercial bank would pay for those reserve credits was (and still is) called the “discount rate.”

Let’s discuss one more change that will happen as a result of all the gold being consolidated in First Bank’s vaults.

Imagine having a bunch of vaults that everyone knows are packed with all of the country’s specie in gold. Kind of a scary thought, right? First Bank vaults have become a major target for anyone in the world looking to get rich quick by stealing tons of gold that they can make untraceable by melting it down and re-casting it.

Sooner or later, First Bank is going to need to find a way to store this gold more securely. It eventually determines that storing the gold in just a few super secure locations will be safer and more efficient. So, we can eventually (say, within the 20-30 years after centralizing the currency) expect at least one giant vault to be built, and a large percentage of the total gold will gradually be moved there.

Fort Knox, anyone? The U.S. formalized its centralized currency via the Federal Reserve Act of 1913, which induced the transfer of all the gold in commercial banks’ vaults to the Federal Reserve bank vaults. And, 23 years later, in December 1936, Fort Knox was completed, and by the end of 1937 a huge percentage of the gold reserves had been moved there.

Is the gold still there in Fort Knox? I suspect it isn’t, for reasons that will become clear later on.

One last thing for this post: Another benefit that First Bank now has is the fact that, with a monopoly over printing First Bank Notes, invariably some percentage of them will get lost or ruined each year, so First Bank can print new ones to introduce into circulation and prevent deflation from a gradually diminishing money supply. Who should it give these new First Bank Notes to? There’s no way to know who actually owned the First Bank Notes that got lost or destroyed, so it will simply give them to the government to spend. President really likes this new source of free money!

Phew. That was a lot of information to process from that change to a centralized currency.

As an aside, what a fun journey to be on, right? Figuring out money and banking, and also figuring out how to explain it in a comprehensible format, is much more interesting than I ever expected. Maybe because I’ve come to appreciate just how important these things are to understanding why our modern economies are getting messed up in serious ways. If you haven’t ever read anything on money and banking, you should try it. For example, try reading these speeches (PDF) made by some Ph.D. economists during a United States congressional hearing on fractional reserve banking in 2012. If you already understand what they’re talking about, their statements make sense. But if you don’t, man is it all befuddling (which I suspect is partly on purpose to help preserve the whole banking industry’s wealth-stealing scheme by hiding it behind Byzantine institutions and terminology). I’m sure I fail sometimes at demystifying it, but I hope my deliberate stepwise approach to this information (plus some simplifications that don’t alter the underlying mechanics) helps.

All right, in Part 29 I’ll add some technology into the mix and then jump right to transitioning to the next phase in the evolution of money.

In Part 26, I teased that President was about to make some changes to the laws to bring about a uniform currency. Let’s see what he does!

As a preface to this part, you should know that this was the most difficult transition in the entire evolution of money for me to figure out. The information on this specific aspect of the history of money is much less readily available. But I’ll do my best to explain how this has happened in the real world many times before, and I’ll attempt to do it in a logical order without skipping any steps.

With the goal of making First Bank Goldnotes the standard common medium of exchange countrywide, President creates two new laws:

First, there will be a tax on the lending of non-First Bank Goldnotes. So, from that point on, any time another bank loans out their own Goldnotes and earns interest on them, they have to pay, say, 5% of the total loan value to the government in the form of taxes. That’s pretty high, especially considering that most loans are probably earning less than that.

Second, banks are allowed to switch out their own Goldnotes for First Bank Goldnotes by sending all of their gold coins (and other acceptable assets) to First Bank. Non-cash assets that are being used as reserves for lending, such as the cars that Storybook Bank found itself owning back in Part 22, may or may not be accepted by First Bank, and the bank that owns those non-cash assets may just have to retire those assets from their role as reserves once the loans made based upon those assets have been repaid.

The first law makes it no longer profitable to lend out their own Goldnotes. It became much cheaper instead for banks to transact using First Bank Goldnotes, which gives them a big incentive to take advantage of the opportunity offered in the second law by switching over to First Bank Goldnotes.

Let’s see how this switch would occur with Astro Bank:

First, Astro Bank has to pack up its entire store of specie (gold) and cart it to First Bank. And when it delivers all of its specie to First Bank, in return it will be credited in its First Bank account with an equal amount of “reserve credits.” This dictates how many First Bank Goldnotes Astro Bank is allowed to lend out. For example, if the reserve ratio is 0.2 (money multiplier of 5) and Astro Bank just deposited 4,000 gold coins into First Bank, it will receive 4,000 reserve credits, and each reserve credit allows Astro Bank to lend out 5 First Bank Goldnotes. The details of this will be discussed further in Part 28.

Second, First Bank announces that all Astro Bank Goldnotes are now retired, and there will be an exchange period to allow any holders of Astro Bank Goldnotes to present them to First Bank and, in exchange, they will receive First Bank Goldnotes. For simplicity, let’s assume they just trade them 1:1 straight across. Any existing contracts denominated in Astro Bank Goldnotes will automatically be updated to be denominated in First Bank Goldnotes instead. Then, after that exchange period ends, any Astro Bank Goldnotes that haven’t been traded in will be officially worthless.

So if Astro Bank owned loans that were worth 20,000 Astro Bank Goldnotes, they now own loans that are worth 20,000 First Bank Goldnotes. And just like way earlier in this series (Part 18), whenever Astro Bank receives a loan payment, the interest portion of that payment will go into their Revenue stack of First Bank Goldnotes in their vault and the principal portion will go into their Money to Lend section. Once there are enough First Bank Goldnotes in the Money to Lend section, they can give a new loan. Thus is the ever-rotating cycle of the majority of Goldnotes.

This process turns out to be an offer the banks can’t refuse, and they all agree to it. From then on, they get to avoid the tax on lending non-First Bank Goldnotes, and they don’t even have to worry about finding the storage space for big piles of gold coins in their vaults anymore!

Pay attention to what just happened here. The government (through its bank) essentially seized all of the gold from all of the banks. But it did it through shaping bank incentives just right, no force required. And everyone, including the banks, are pleased with the outcome because Avaria now has a conveniently uniform monetary system.

And that is how Avaria shifted from a decentralized fractional reserve currency to a centralized fractional reserve currency. There are other ways this has been done, including simply by making the printing of receipt money illegal for non-government-approved banks, or by requiring a government license to print receipt money and then not granting any new licenses and letting the old ones lapse over time.

From now on, any time someone wants to exchange a Goldnote for a gold coin, they have to go to a First Bank branch to do so. And just like Peppercorn Bank discovered way back when it invented fractional reserve banking, a low enough percentage of people actually do that that there are always enough gold coins in the vault.

Incidentally, which bank’s “account” would the gold coins come from when someone comes to First Bank with a First Bank Goldnote requesting to trade it for a gold coin?

None. Those gold coins have been anonymized in First Bank’s vaults, so as long as there aren’t too many First Bank Goldnotes in circulation, they will always have enough gold.

But having enough gold in the vaults is becoming less and less relevant of a concern anyway because people are trading out First Bank Goldnotes for gold coins less and less often as they, with time, get used to transacting exclusively in First Bank Goldnotes and come to trust that they are a reliable form of money.

What does President do once all of the other banks’ Goldnotes are completely phased out? He creates a couple more laws to protect the ground he has won.

First, to forever prevent regression back to a multi-currency society, he declares that First Bank now has a permanent monopoly on issuing bank notes.

Second, to reinforce First Bank Goldnotes as the only form of acceptable money in the country (in the unlikely event of a banking fiasco that harms their reputation and tempts citizens to start using something else–such as another country’s currency–as their common medium of exchange), he passes a legal tender law (explained in Part 24) that requires acceptance of First Bank Goldnotes for all debts, public and private.

And to commemorate this change, all of First Bank’s subsequent Goldnotes will be printed with a new pithy name: First Bank Note.

*Moment of silence for the end of Goldnotes*

And on these new First Bank Notes will be the legal tender inscription: “This note is legal tender for all debts, public and private.” Each First Bank Note will still be exchangeable for one gold coin, which can be redeemed at any First Bank branch, so the country’s new official receipt money will still have an anchor to gold to keep its value from drifting arbitrarily.

Oh, one more thing. For simplicity, up to this point I’ve ignored fractions of gold coins, and I’ll continue to do so; but surely this society can have half coins, quarter coins, etc., and it can use any form of receipt money (either with paper or with “token coins,” which are cheap metal coins with their official monetary value stamped on them) to represent those smaller denominations. I just think talking about those smaller denominations doesn’t help the overall explanation and risks adding confusion.

Anyway, in summary, we have finally achieved a centralized (uniform) currency! It’s starting to seem like modern money, isn’t it? Believe it or not, First Bank Notes are still different than modern money in huge ways.

As a little hint about where this series is headed, check out a comparison of two American bills (which, interestingly, are now known as Federal Reserve Notes, which you will see printed on any bill today).

The United States transitioned to a centralized currency in 1913 after the passage of the Federal Reserve Act. Check out this 1922 ten-dollar bill with the following text printed on it: “This certifies that there have been deposited in the treasury of the United States of America ten dollars in gold coin, payable to the bearer on demand.” (Remember that the term “dollar” originally just specified a certain weight in gold.) It also has the legal tender inscription on it.

Now compare that to a more modern dollar bill. This one also has the legal tender inscription (rewritten to be more concise), but notice the change in text: “Federal Reserve Note, The United States of America, one dollar.”

There’s no mention of gold, nor any mention of it being exchangeable for anything else. Interesting, right? . . .

In Part 28, we will process more of the implications of this change before we finish with the last few major money transitions.

In Part 25, we saw President get his government into the banking business by shifting all of his government money into a newly created government-run bank that we are calling First Bank. President also implemented some safeguards to lower the risk of him losing this new revenue stream and his entire government savings in one fell swoop. These consisted of establishing a specie pool, establishing a minimum reserve ratio, and also giving himself the authority to suspend banking transactions temporarily in the event of a bank run or other financial emergency.

What happens next?

Something I have purposefully not yet acknowledged in this series is that, historically speaking, by this time there would have been a number of other exciting banking events in Avaria, such as bank runs that actually did culminate in a local or regional financial collapse, fraudulent banking practices, banks ceasing giving specie for various lengths of time, and myriad other unscrupulous business dealings.

Thus, realistically, the business practices and reputation of a bank is a big deal at this stage in the evolution of money. Consequently, Goldnotes from the different banks always end up being traded at different values according to the public’s image of the bank.

This would make for a very confusing monetary system! Can you imagine having a whole bunch of different currencies, all of which have different values, all being used at the same time?

I hope you can see where this is leading. It would make a lot of sense to simplify the monetary system by standardizing around a single bank’s bank notes. Importantly, this would make pricing and trade much more efficient. President knows this. And, for the first time ever, he has all the tools at his disposal to make it happen.

So how does he go about enacting it?

The obvious first choice is to standardize around First Bank’s Goldnotes. Not only would this be beneficial for First Bank (and, therefore, financially beneficial for the government) by strengthening First Bank’s presence in the financial community, but also First Bank’s Goldnotes are already, on account of them being backed by the full faith and credit of the government, seen as the most reliable Goldnote option. That is why First Bank’s Goldnotes have already started to become the preferred common medium of exchange.

Let’s wait until next week to discuss the specific laws that President enacts to make this transition.

In Part 24, we introduced a new character, who we named President. He is the representation of the government over our fictitious society. And we introduced his quandary as well: He (his government, really) is limited on how much he can tax people, and he is limited on how much more he can borrow as well because he still owes money from his last war. He’s worried about another war arising, which he would have no way to pay for, so he’s vulnerable. Therefore, he has been looking for a solution to this concern. That’s when his economic advisor tipped him off to this part of his country where there are five banks that have implemented fractional reserve banking (now using non-cash assets as reserves too) and a specie pool, all of which seems to be bringing a lot of wealth to the area while the bankers are making a killing lending out other people’s money. So what does President do about all this?

His first thought is that he needs to get into the banking business. Currently, when the government gets paid taxes, he is storing it in several different local banks (he knows about diversification), and he realizes now that these banks may actually all be lending out his government money and earning interest on it!

So he passes a law chartering a brand new bank: The First Bank of Avaria. We’ll call it First Bank for short.

President then gradually takes all the government’s money (in specie) out of those other banks and deposits it all into First Bank. First Bank now has 50,000 gold coins in it, which can all be used as reserves to establish fractional reserve banking and earn the government some money! If he chooses a reserve ratio of 20%, that means the money multiplier is 5, so 50,000 gold coins can act as the reserve for 250,000 Goldnotes.

If he is lending out all that money at market rates, let’s say he is earning 5% on it, which means he now has a new income stream of 12,500 gold coins every year. He just increased his income substantially! This alone could pay off his war bonds if he puts all of it into them over the next 10 years. What a relief. This will probably persuade banks to lend him more money next time (and persuade more citizens to buy war bonds) if another war happens and he has a larger revenue stream plus a history of reliably repaying his government bonds.

Unfortunately, he has no idea the costs he is inducing on society as a result of this seemingly flawless financial trick. But all this banking stuff is so new that there really aren’t many people who have figured out all its effects yet, so we can’t blame him. And, realistically, he may not be inducing any new costs on society yet anyway because, chances are, all the banks that used to be storing the government money were already lending it out through the magic of fractional reserve banking. So really there are no new costs to society as a result of First Bank being created, it’s just that the government is now taking some of the profits of the banking industry.

But, now that he has stored all his government money in a single bank, he has to worry about bank runs. Remember, he understands diversification, so he knows that if his bank ever has to declare bankruptcy, he will lose all his government money, which is even scarier of a prospect than the threat of an enemy attacking him at this point.

So he implements some safeguards.

First, he gets all the banking leaders together in his region and establishes a region-wide specie pool.

Next, he uses his legislative power to require the daily interest rate for all specie pools to be fairly high to discourage the need to use them (but not so high that it will cause the borrowing bank to bleed money so fast that it ends up having to declare bankruptcy anyway, which would also reflect poorly on/decrease trust in the banking industry).

Next, he establishes a country-wide minimum reserve ratio, which will also minimize the risk of bank runs. You see, he’s not stupid–he knows that a bank run is the one thing that could take away his new revenue stream AND all his government money in one fell swoop.

Next, he gives himself the authority to suspend all banking in the case of a financial emergency. That way, he can stop a bank run in its tracks by sending all the lining-up people home and try to ease the public panic before re-opening all the banks, which he could potentially even do the next day.

In this way, he feels confident that he has adequately protected his bank, and all banks, from the risk of collapse.

I think we’ll stop there for this part. We have now established banking regulations.

One thing to bear in mind with this change is that, say a bank does end up still having to declare bankruptcy, whose fault will it be? If the bank was abiding by the government regulations, they will easily be able to pass the blame on to the government! So the government, by taking over the regulatory aspect of this, has now made itself susceptible to getting blamed for any banking fiascos, which will certainly affect how it responds to a banking fiasco (i.e., it will affect how likely the government is to bail out a bank).

In Part 26, we’ll see what President does next now that he has dipped his toes into this exciting new source of income. He is starting to feel like if he is creative enough, he may be able to squeeze a lot more money out of this system for his government!

We’ve spent a lot of time processing the impact of fractional reserve banking on our fictitious society. In Part 22, we saw the bankers get creative and start using non-cash assets as reserves, which brought the illusion of prosperity back to society (through inflation) and the people are happy again for the moment (until prices catch up). In Part 23, we wrapped up a few more details about the impact of fractional reserve banking by looking at the negative effects of inflation and deflation.

This week, let’s finally introduce government into the narrative.

So far, I’ve assumed that this fictitious society has been mostly free to develop its monetary system on its own. The only involvement of government has been to offer a service to mint standard-weight, standard-quality gold coins. And I don’t want to undervalue that contribution: If minted reliably the same size and quality and in a shape that minimizes the risk of counterfeiting and coin clipping, then that is a huge contribution to efficient commerce and, thus, increasing wealth!

But now the government gets wind of what’s happening with all these banks, so its further involvement starts.

Let’s just simplify this government down to a single individual and call him President.

Sidenote: I have used all male characters to this point, and it’s because I am imagining this all to be taking place during the (illogical) time period when women were not often the tradespeople or banking leaders or government leaders. If my lack of anachronistic gender balancing offends you, I suggest you share this blog and all its injustices with everyone you know.

Anyway, back to this president who we are calling President. He is struggling to figure out how to make government ends meet because his means of acquiring money are limited. Currently, he only has two: He can either tax the people or he can borrow money.

But taxing is unpopular.

And, as for borrowing money, it’s limited by the number of people willing to lend money to the government. Borrowing money also means he has to pay it back, plus interest, which he doesn’t like because ultimately he’s going to have to tax more (or cut spending) to do it. He has enough foresight to recognize that government borrowing is just deferred taxation.

By the way, how do governments borrow money anyway? They have two options. They can do what everyone else does and ask a bank for a loan. Or they can simply sell government bonds.

So far, President has been able to limit borrowing money to emergency situations only, but he nearly lost his most recent war because he couldn’t get enough people to buy government bonds to finance the last part of the war, and no bank would give him a loan. His saving grace was actually a stroke of genius on his part–he resorted to paying his soldiers and suppliers in short-term government IOUs near the end of the war, promising to redeem them for gold coins within 12 months, and at the same time he passed a law that required merchants to accept them the same as if they were gold coins. (President’s economic advisor is still trying to figure out why prices suddenly shot up at the same time . . .) But he’s hesitant to try this again because the people didn’t like it.

Let’s pause at this point to talk about this law just for a paragraph. A law that requires something to be accepted as money is called a legal tender law, and the piece of paper that is being required to be accepted as money will have a statement printed on it declaring that it is legal tender. Legal tender laws can can either be narrow–applying only to public debts (meaning only the government is required to accept the piece of paper as money, such as when people use it to pay taxes)–or legal tender laws can be broad, meaning they apply to everyone. When they apply to everyone, it means all merchants have to accept the pieces of paper as money, so it’s legal tender for public and private debts as well. If the legal tender law applies to everyone, then the statement on the piece of paper would go something to the effect of, “This note is legal tender for all debts, public and private.”

So, ever since that war, President has been struggling under the weight of paying those short-term IOUs back. He even had to increase taxes and cut some spending programs to do it! And he hasn’t even gotten to the point of paying back those bonds yet. The taxes and spending cuts have all made him less popular, but more than that he’s worried about another war. He has become incredibly peaceable in an attempt to avoid any further expensive conflicts (he’s a pragmatic guy), but if a potential enemy sees his limited-access-to-funds weakness and decides to take advantage of it by invading his country and taking his country’s wealth for themselves, his country might not be able to defend itself. Borrowing opportunities are limited, and raising taxes would cause revolts and possibly an internal political conflict. For the good of the country, he needs some kind of surefire way to raise money in case of an emergency.

That’s when he hears about this whole fractional reserve banking system that has even developed a specie pool to make it more sustainable. And he gets to thinking. We’ll see what he comes up with in Part 25.