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!

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