Month: January 2023

***This post is under construction as I clarify what I originally wrote***

Ok, for those following along, last week I pointed out some issues that didn’t make sense with some of these recent changes I said President made. It’s time to clarify them. I may go back and just do that in the original posts later on for the sake of avoiding confusion for future readers, but we’ll see.

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! If you haven’t ever read anything on money and banking, you should. Try, for example, reading these speeches (PDF) made by some Ph.D. economists during a 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 befuddling. I’m sure I fail sometimes at making it completely comprehensible as well, but I hope a deliberate stepwise approach to this information (plus some simplifications that don’t alter the underlying mechanics) helps.

Anyway, here’s a quick summary of the issue needing to be clarified: The confusion was about exactly how we transition from our current system with a bunch of different banks offering their own version of Goldnotes to this new system of exclusively using First Bank Notes.

I originally said that we could phase out all the other banks’ banknotes by having First Bank give each bank enough First Bank Notes to directly buy back all their circulating Goldnotes, and that you could take a First Bank Note to any bank and exchange it for specie. But I identified some problems with that method last week–the biggest problem was that, since anyone could get specie in exchange for a First Bank Note from any bank, it basically converted all banks into a single huge bank with a single shared reserve. And that means any bank could get away with lending out a lot more (draining the collective reserve) and earning more money than the rest, which would soon lead to all the others following suit, and then the reserves would be depleted and a banking collapse would occur.

My challenges with getting our fictitious society to make this transition arise from the difficulty I’ve had in finding more details on the specifics of how a government-run bank’s monopoly on the issue of banknotes actually gets enacted. So let’s do this in a different way that makes a little more sense to me.

We’ll start by clarifying that First Bank Notes are good for one gold coin, but you can only make that exchange at First Bank itself. It’s First Bank guaranteeing this receipt money can be converted back into commodity money at any time, so it makes sense for that to be the only place someone can make that exchange.

And if First Bank notes are the only ones that are going to be used in all of society, and anyone can go to First Bank to request a note be exchanged for a gold coin, then all the gold reserves also have to be in First Bank.

So, these are the steps I think President could take to make this transition:

First, he will have each bank send all their gold coins to First Bank, and those gold coins will be deposited into each bank’s account. Yes, this means every bank now has a bank account at First Bank.

In return, he will give them First Bank Notes. Since the established reserve ratio is 0.2 right now, that means the money multiplier is 5, so he will give them 5 times the number of First Bank Notes than they gave in gold coins, which they will then have to use to trade in all their circulating Goldnotes.

All contracts will also need to be converted into First Bank notes or gold coins. So, if a contract is currently denominated in Story Bank Goldnotes, which are trading at 0.9 of their stated value, the conversion would be simple. If a contract is worth 1,000 Story Bank Goldnotes, then it will immediately get switched to be worth 900 First Bank Notes to retain its current market value.

I think that’s it. Ultimately, the exact process of how this works is less important than the fact that people are only using First Bank Notes now. And when banks are lending out money, it’s First Bank Notes that they are giving out, which they are getting from First Bank in return for the specie that they’re storing in their account at First Bank.

From what I can tell, historically the phase-out of other bank notes was done by charging a higher and higher tax on any non-government bank notes, which made them worth so much less that they became no longer viable as a low-cost means of using as a common medium of exchange. But information on the exact details of how that went down is not readily available based on my searching and reading.

All right, next week we’ll resume our more rapid progress through the last few changes our fictitious society’s money needs to make.

In Part 26, our fictitious society finally transitioned to a uniform currency. To be clear, their money is still backed by gold, but their receipt money is now uniformly First Bank Notes.

***This post is under construction as I clarify what I originally wrote***

Since that transition, transacting has become easier because now everyone is using the same notes, and they are each worth the same as a gold coin, which is much simpler than what they had to do before when they were trying to account for discounted Goldnotes from many different banks.

Let’s bring up and address some of the other implications of that change.

First, now that banks can’t print their own money, does that mess up their day-to-day operations?

No. Their accounting has probably become simpler actually because all they have to worry about is how many total First Bank Notes they have lent out and make sure that 20% of that amount is in their vault. And as they earn more money, they will be earning that money in the form of First Bank Notes, so 80% of it can be used to lend out and 20% of it has to be stored in their vault.

Thinking big picture about this system now, the core of the monetary system is the specie–piles of gold coins, all of which are now sitting in First Bank’s vault. And with a reserve ratio of 20%, if there are 1 million gold coins in that vault, that means there are 5 million First Bank Notes circulating. If any are lost or destroyed and calculations show that there are less than 5 million First Bank Notes circulating, First Bank will just print more and give them to the government, which can then spend them, thereby introducing them into circulation.

But a question arises about this system.

What happens if a bank has a ton of people come and request specie in exchange for First Bank Notes? Aren’t we risking banks running out of specie since there are many times more First Bank Notes than there are gold coins in any one bank?

The answer is that if a bank has to give up a ton of its specie, it is getting First Bank Notes in return, which it can then take and get specie from any other bank.

But this brings up another question.

What’s the point of a reserve-sharing central bank if any bank can get reserves from another bank simply by giving a bunch of First Bank Notes that it has on hand? It seems like all bank reserves have become shared since the receipt money now in use entitles a person to a gold coin at any bank.

This is true, and it means I haven’t perfectly thought through the exact steps that a banking system takes to get from there to here. Sure, these steps are just transitional steps, but I think it’s important to understand each one thoroughly nonetheless.

So this is what I’m going to do. I’ll stop here this week and do some more reading and thinking by next week. This is a great reminder of an important point: my knowledge is imperfect. I hope that’s not a surprise to anyone. I’ve written before about academic integrity, and I just re-read that post and still completely agree with everything I wrote. I recommend taking a look at it. It applies to my knowledge of money and banking just as much as any other topic. If any of that makes you uncomfortable, then I suspect you have been living in ignorance of the imperfect state of the knowledge of the other “experts” you listen to. The stronger one’s reputation, the more tempting it is to pretend you know something you don’t. And that’s not something I’m interested in starting to do.

Last week, 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 reserve-sharing central bank, 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 our fictitious society such as bank runs that actually did culminate in a collapse, fraudulent banking practices, banks ceasing giving specie for various lengths of time, and myriad 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. To expand their use, President decides to create a few 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 Goldnotes, they have to pay, say, 3% of the total loan value to the government in the form of taxes.

Second, banks are allowed to use First Bank Goldnotes as their reserves instead of specie.

Third, any bank that wants to trade out their Goldnotes for First Bank Goldnotes can do so.

This is how that third law would work. The bank has to pack up their entire store of specie and bring it to First Bank. When they give their specie to First Bank, in return they will receive that many First Bank Goldnotes PLUS enough Goldnotes to buy back all of their circulating Goldnotes (subject to a cap–if the bank is under their required minimum reserve of 0.2 at that point, they will only get as many as would allow them to buy back 5 times the number of gold coins they provided).

So First Bank would be giving the bank two lump sums of First Bank Goldnotes: (1) a lump sum of Goldnotes to replace their reserves–one First Bank Goldnote in exchange for one gold coin–and (2) a lump sum of Goldnotes to allow them to buy back their circulating Goldnotes.

The calculation of the second lump sum would be as follows: If the bank’s Goldnotes are trading at 80% of the value of a First Bank Goldnote, and they have 10,000 of them circulating, then 80% x 10,000 = 8,000 First Bank Notes.

The exchange rate used in that calculation will be locked in from that time forward, so all contracts that specify money in terms of that bank’s Goldnotes will be amended to specify 0.8 times the number of First Bank Goldnotes instead. And there will be a buyback period, where anyone who possesses that bank’s Goldnotes can bring them in to the bank to be traded out for 0.8 times the number of First Bank Goldnotes. After the buyback period, that bank’s Goldnotes will immediately and forever have no monetary value.

This is an offer the banks can’t refuse. Trading out their reserves of specie for First Bank Goldnotes does not hurt them in the least if they will no longer be required to redeem Goldnotes with gold coins, and receiving enough First Bank Goldnotes to buy back all their circulating Goldnotes also does not take any wealth away from them. But making this exchange does allow them to avoid the 3% tax.

Any bank that takes that deal will then forever after have First Bank Goldnotes as their reserve. Instead of giant piles of gold coins in their vault, they will have giant piles of government-stamped pieces of paper.

Other than the change in the physical form of banks’ reserves, the society’s fractional reserve banking system will continue to operate exactly the same, and probably nobody will notice anything except for the convenience of finally everyone getting to use the same money that was the preferred form of money already. But we will see soon enough that this change has major implications on the future of their monetary system.

And, voila. Over the next several months after passing those three new laws, Goldnotes from all the various banks start to disappear as they get traded in. And all the specie in the entire country has now been transferred, without forcing anyone to do so, to First Bank.

Once all of the other Goldnotes are completely gone, President 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 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).

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 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 worth 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, I’ve ignored fractions of gold coins until now, and I’ll continue to do so; but surely this society can have half coins, quarter coins, etc., and it can have receipt money (whether it’s paper money or token coins) that reflects the value of those fractional coins as well. I just think talking about that doesn’t help explain anything and risks confusion.

Anyway, we have finally achieved a uniform currency! It’s starting to seem like modern money, isn’t it? Take a look at this . . .

Next week, we will process more of the implications of this change before we finish with the last few major money transitions.

Last week, 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 and a reserve-sharing central bank, 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. I guess since we haven’t ever actually named our society, I will say that the new government-owned bank is called The First Bank of Our Fictitious Society. We’ll call it First Bank for short.

President then 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 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 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 sharing in 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 reserve-sharing central bank.

Next, he uses his legislative power to require the daily interest rate for all reserve-sharing central banks to be fairly high to discourage the need to use it (but not so high that it will cause the borrowing bank to bleed money so fast that it ends up declaring bankruptcy anyway).

Next, he establishes a 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 week. 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.

Next week, 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. Two weeks ago, we saw the bankers get creative and start using non-cash assets as reserves, which brought the illusion of prosperity back to society and the people are happy again. Last week, 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 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 prevents counterfeiting and coin clipping, then that may be the most important thing a government can do to contribute to efficient commerce and 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 male 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 borrowing is pretty much 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 reserve-sharing central bank to make it more sustainable. And he gets to thinking. We’ll see what he comes up with next week.