The Theory of Money, Part 27

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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.

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.

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.

The Theory of Money, Part 26

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Last week, we saw President get his government into the banking business by shifting all 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.

I’m going to now throw caution to the wind and move things quickly through the last several changes to this monetary evolution. But I don’t want it to seem rushed. I want each change to be shown as a logical and reasonable next step for the decision makers to make, given their circumstances. And once we get this money to the end of my planned state of evolution, then we can take some time to process the impacts of those changes after that.

We haven’t seen much bad banking behaviour in our fictitious society so far, but historically there probably would have been a number of exciting events by now, including some bank runs that led to bankruptcies, some banks that were on the verge of bankruptcy and stayed afloat by temporarily ceasing giving specie in exchange for their Goldnotes, and others that were forced to cease business or get bought out due to unscrupulous practices.

All these events commonly happen if a society is given enough time with fractional reserve banking. And an important result of it is that the bank notes from some banks end up being traded at a discount relative to their stated worth because of uncertainty about whether the bank will continue to be in business or continue to exchange its bank notes for specie.

For this reason, things have gotten confusing. There are a bunch of different banks issuing Goldnotes, and all of them have different values.

First Bank’s Goldnotes, on the other hand, are seen as more reliable. People believe that if the government is backing a bank, it’s more likely to come out all right in the event of a panic, so it’s quickly becoming the de facto currency for commerce.

President sees all this and decides it’s time for a change. He wants more uniformity in his country’s monetary system, which will decrease the frictions people are experiencing when they are transacting with different forms of receipt money. President hopes this change will “grease the wheels of commerce.” And, with a government-run bank at his disposal, he has all the tools necessary to finally do this.

So he declares that First Bank now has a monopoly on issuing bank notes, and he passes a legal tender law (explained in Part 24) backing that up. To symbolically demonstrate this change, all First Bank Goldnotes will be newly 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 be worth one gold coin, which means any bank will be required provide one gold coin when they are presented with one First Bank Note. This will establish a stable value (relative to gold coins) for the country’s new official receipt money.

The logistics of the Goldnote phase out would be relatively straightforward. Each bank’s Goldnotes will be assigned a value based on the current accepted value in the market. Then the issuing bank will be provided with the correct number of newly printed First Bank Notes to allow them to buy back all their circulating Goldnotes. People will be required to trade in all the Goldnotes in their possession within, say, 1 month, after which time no more buybacks will be allowed.

So if Indie Bank Goldnotes are trading at 0.9 their stated worth (a residual effect from the scare I described in Part 17), and they have 1,000 Goldnotes circulating, they would be given 900 First Bank Notes with which to buy back the Goldnotes with the Indie Bank stamp on them. I’ve ignored fractions of gold coins until now, and I’ll continue to do so; surely this society can have half coins, quarter coins, etc., and it can have receipt money that reflects 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! If my planning is correct, there are three other big monetary changes that need to take place, which I will describe starting next week.

The Theory of Money, Part 25

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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!

The Theory of Money, Part 24

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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.

Taxing is unpopular. Borrowing money is 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 apply 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 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.

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