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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