The Theory of Money, Part 32

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Last week, I used an example to explain how the true number of Labor Units in the world did not increase when President liberated all the gold coins (i.e., when he turned their money into 0% backed fiat money). I also explained how the people won’t bear the cost of him taking those gold coins from them until (or, if ever) they decide to get back to commodity money/100%-backed receipt money. I will soon show why that may be a worthwhile effort, but first there are some other changes to process now that gold isn’t in the picture anymore.

First, what changes with banks’ reserves now that they’re not using gold for reserves anymore?

If you will recall, when President created First Bank and gave it a monopoly on the issue of bank notes, it required First Bank to store all the banks’ gold coin reserves in its own vault. I explained all this in Part 28. Basically, if First Bank is the only one allowed to print bank notes, then it has to be the only bank where people can go to exchange those notes for gold coins, so all the gold coins needed to be stored there. This is actually how it happened historically, at least in some countries.

Well, now that there are no more gold coin exchanges happening, that means there’s no reason banks have to store their reserves at First Bank anymore.

So, after President passes the no-more-gold-backing law, First Bank sends each bank’s reserves back to them. Sure, the banks originally sent giant piles of gold to First Bank, and now they’re getting back (generations later) giant piles of pieces of paper. But the banks don’t care too much because they can earn the same amount of money off the pieces of paper as they ever could off the gold coins.

Now when the government audits banks, it’s a simple process of counting the number of First Bank Notes in the bank’s vault and then adding up the total value of the bank’s customers’ accounts. If the accounts add up to less than 7x the number of First Bank Notes in their vault, then the bank is good–it has adequate reserves. If the accounts add up to more than 7x their reserves, then the bank will have to borrow some reserves from the collective reserves (from the reserve-sharing central bank agreement, remember) and pay interest on that money.

This can all work automatically if everything is electronic. The bank just needs a method of tracking exactly how much money is in the vault at all times, and then, each day when the bank closes, the total amount in the vault and the total value of all accounts is sent to a centralized system. If a bank is short some reserves, it automatically is allocated some of the shared reserves and pays interest on it until the bank is back to having the minimum required reserves. And if a bank has extra reserves, it automatically will have some of its excess reserves allocated to the banks that are short and it will receive interest from those banks.

The system could be very equitable in how it shares excess reserves. If our fictitious society’s original 5 banks are the ones participating in this reserve-sharing central bank, and one bank (say, Story Bank) is short 10,000 First Bank Notes one day at the close of business, then the 10,000 notes are borrowed equally from the other four banks that have excess reserves. That would mean each of the other four banks would electronically have 2,500 of their excess notes allocated to Story Bank and get paid interest from Story Bank automatically each day. And if one of the banks only has 2,000 excess notes, the other 500 notes Story Bank needs could be borrowed from the remaining three banks equally. Simple and automatic.

But what if there aren’t enough excess reserves to meet the needs of all the banks that are short on reserves? This could be catastrophic if suddenly lots of people in society are all wanting to withdraw lots of money all at the same time and there aren’t enough shared reserves anywhere.

Ah, that’s when First Bank can step in and work some magic. President has anticipated this problem, and his solution is to allow First Bank to allocate as much money as is needed to any bank that is still short on reserves after going through the reserve-sharing process. There’s no limit to how much First Bank can lend, because it’s all electronically allocating made-up money anyway. And if the financial situation gets dire enough that bank vaults are actually truly empty of First Bank Notes, it wouldn’t be difficult for First Bank to actually print the First Bank Notes that are being allocated to those banks and physically deliver them.

Banks love this. Now they’re essentially bank-run-proof! The only remaining risk is that they have such a huge mass withdrawal of money from their bank that they go bankrupt from all the interest they have to pay to the other banks (for borrowing their reserves) and to First Bank (for lending them the rest).

A mass withdrawal like this could happen, but it’s exceedingly unlikely, so bankers feel like they have entered a new era of banking system security.

I know I’ve been describing this all as happening automatically electronically, but I think it’s helpful to drop back and look at how it would have happened before the digital age. So let’s picture the process of how this could all go down at the end of each business day.

Let’s say all the banks are all located on a single street. Each banker locks his doors after the last customer leaves and immediately checks the total number of First Bank Notes in his vault and the total accounts balance. He then determines how above or below his required reserve he is, prints out the number on an official-looking sheet of paper, and walks down the street to the reserve-sharing central bank office. The bankers all arrive at generally the same time submit their pieces of paper.

The office employee quickly tabulates the numbers and figures out how much of each bank’s excess reserves go to each bank that is short. He then prints out a receipt for each bank. For the ones that had excess reserves, the receipt states which banks are borrowing some of their excess reserves that night and how much each of those banks will owe them tomorrow. For the ones that were short on reserves, it says how much they’re getting from each bank that had excess reserves, and how much interest they will owe each one of those banks tomorrow.

If the situation occurs where there aren’t enough excess reserves to meet the needs of the banks that are short, the sheet also states how much more the banker needs to go get from First Bank.

So the banker takes that sheet and walks down the street to First Bank, which has built a window into the side of the building for just this purpose. The banker taps on the window and an employee opens it. The banker gives his sheet to the employee, and, while the employee looks the sheet over, probably says something like, “So what’s the rate tonight?” He’s asking what the interest rate will be on the money he’s borrowing. Sometimes this rate is called the “discount rate,” which is why this window is called the “discount window.”

The employee gives the banker a receipt stating how much money First Bank is allocating to him that night (which the banker already knew anyway) and how much interest he’ll owe on that money tomorrow.

From now on, this process of banks borrowing from First Bank at the discount window will be called discount window lending. And we’ll work through the implications of this process starting next week.

But what we have now, finally, is what people are usually referring to when they say “central bank.” It’s not just a reserve-sharing central bank like we’ve seen in this fictitious society for quite a while; it’s a “money-creating central bank,” the defining feature of which is that it can create extra money to lend out any time it wants!

The Theory of Money, Part 31

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Last week, we finally arrived at a fully unbacked fiat money. Wasn’t that exciting? Let’s process some of the impacts of that major change.

First, let’s talk about how this changes the money supply from an aggregate perspective.

Assuming the reserve ratio when this change happened was all the way down to a little less than 15%, that puts the money multiplier at 7. So, if there were 100,000 total gold coins being stored at First Bank, then there were 700,000 total gold coins worth of currency in the society. 100,000 of those were gold coins stored in First Bank, and 600,000 of those were First Bank Notes.

I think it’s important here to mention that whether those 600,000 First Bank Notes were physically in people’s wallets or whether they were credits in their bank accounts, it’s all the same because, either way, people act generally the same, whether the money is in a bank account balance or in a stack under their mattress, they still perceive that they have that money, and they act accordingly. If the blacksmith buys a new furnace, whether he does it by handing over physical First Bank Notes or by writing a cheque that transfers them from his account to the seller’s account directly, the amount of money he had and is giving to someone is the same. I felt that this is worth mentioning because, in the 1900s, some politicians wanted to limit inflation in their countries, so they tried to keep the reserve ratios higher by making laws limiting the number of physical bank notes that banks could print and lend out. How did banks respond? They kept lending out just as much money as before but simply distributed those loans as account balances (and had their customers write cheques) instead of handing out physical bank notes. The laws were completely ineffectual, and only after watching this play out did the politicians realize their oversight.

Anyway, when President made the change to pure unbacked fiat money, basically all he did was take those 100,000 gold coins out of the First Bank vault and then print 100,000 new First Bank Notes to put in their place. So, there are still 700,000 gold coins worth of currency in society, it’s just that all 700,000 of them are now First Bank Notes.

What does President do with all those gold coins then? Anything he wants! They’re his to spend however he wants, no strings attached. Nobody else has any claim to them anymore. It’s like a magic trick. If a single gold coin represents, say, 4 Labor Units, that means he just created an extra 400,000 Labor Units out of thin air, right? Because nobody lost any of their cash wealth when he made this change, but suddenly he has 400,000 more LUs.

By now, it should be clear that Labor Units (i.e., wealth) don’t come out of thin air; no accounting gimmick or banking trick, no matter how clever or convoluted, can create more wealth. So let’s see if I can clarify what’s going on with this apparent doubling of Labor Units with an example.

Let’s say a society is using exclusively receipt money (bank notes), but it’s 100% backed by gold coins being stored in the society’s single bank. Nobody ever exchanges a bank note for a gold coin, they only use bank notes every time they are transacting. If they have an aggregate of 40,000 bank notes, there are 40,000 gold coins sitting there in that bank’s vault. And, for simplicity, let’s say that 1 gold coin = 1 Labor Unit. So there are 40,000 LUs worth of wealth sitting in his vault. But because nobody ever actually exchanges a bank note for a gold coin, the banker never even opens his vault.

And then something terrible happens. In the middle of the night, a burglar digs a tunnel under the bank, drills into the bottom of the vault, and empties out all 40,000 gold coins, which he takes to a foreign country, melts down, and sells for 40,000 LUs worth of the local currency.

Meanwhile, society continues on as usual. They have no idea that all their gold is gone. Overnight, they went from using 100% backed receipt money to using 0% backed receipt money. But nothing changes, and they continue transacting as they always have with bank notes.

Has the perceived number of Labor Units temporarily doubled? Yes. The people still have all their 40,000 LUs worth of cash wealth in the form of bank notes, and the burglar now has 40,000 LUs worth of gold coins.

Then a missionary comes along and converts the entire society to a new religion that believes that using paper is a sin, so they decide they will all shift to using exclusively gold coins again. They hold a big ceremony in the middle of the town. Each person counts out the total number of bank notes they own and the banker makes a note of it, and then they all throw their bank notes into a big bonfire and go together to distribute the gold coins from the vault according to the records the banker kept during the ceremony.

To their horror, they find the vault empty, with a big hole in the bottom that makes it clear that they were burgled. Suddenly, their perceived cash wealth is now 0 LUs, so the total number of Labor Units arising from those gold coins is back to 40,000–the burglar has all of them, and the people have none of them. (Fortunately, the people in this society have plenty of non-cash wealth, so it’s not like they are instantly poverty stricken.)

And so the people are faced with a choice. Do they print all new bank notes (out of synthetic paper this time) and go back to how they were, using intrinsically worthless bank notes to conduct their business? Or do they want to get back to using an intrinsically valuable commodity as their money?

For them to be willing to choose to start using gold or some other intrinsically valuable commodity again, it would cost them a lot because the moment they decide not to use unbacked bank notes anymore, they lose all their cash wealth. For them to be willing to do this, the benefits of shifting back to using commodity money again would really have to be significant! Otherwise, it makes a lot more sense for them to simply keep using unbacked paper/paper substitutes as their money and just keep pretending they’re worth something. And as long as everyone keeps pretending and treating those worthless pieces of paper as if each one is worth 1 LU, they will continue to work as a means of storing and exchanging wealth just fine.

I hope that clarifies how the number of Labor Units wasn’t truly doubled when President converted the monetary system to unbacked fiat money and got all that gold for himself. It’s just that the perceived number of LUs in the world is doubled because half of them are imaginary. If that shared illusion goes away, the imaginary Labor Units immediately disappear as well, and the true number of Labor Units in the world goes back to what it was.

But there’s no harm in continuing to live this shared money illusion is there? Yes there is. There is great harm, which I will show in subsequent weeks. The question is, is the harm great enough that it is worth the cost of getting us back to commodity money? About that, I’m honestly not sure yet.

The Theory of Money, Part 30

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In Part 29, we saw our fictitious society shift from interchangeably using commodity money (gold coins) and receipt money (First Bank Notes) to exclusively using receipt money. People had mostly forgotten that they used to own gold coins that have intrinsic worth and that they believed that those little pieces of paper were merely a stand-in for the real thing. Instead, those little pieces of paper are so convenient and they’ve been using them for so long that they didn’t even want to deal in gold coins anymore due to their additional weight and inconvenience storing them and the difficulty finding someone who will accept them directly anymore.

Additionally, because First Bank Notes had been used for so long and were so reliable, they became a worldwide commodity in their own right. Thus, even international exchange no longer requires the use of specie directly if First Bank Notes are being used.

President, who apparently has a lifelong term in office, regularly stops by First Bank and looks in at the piles of gold coins in the vault. More and more, he feels like they’re just sitting there doing nothing (we’ve heard that before, right?). People don’t need or even want to use gold coins anymore. He realizes that very few would care or even notice if he stops guaranteeing a gold coin in exchange for a First Bank Note. After all, they’ve leveled up their form of money to something more modern–these very convenient pieces of paper–and it’s working perfectly well as a common medium of exchange.

All these thoughts lie dormant in President’s mind until, sooner or later, some financial challenge occurs. Maybe the weather will cause another bad crop. Or maybe there will be another war. Let’s say it’s another war. And now President is forced to come up with a lot more money to be able to pay for it. He has to pay other countries for some of his war supplies, and he has to pay his soldiers.

That’s when he makes a very important decision: He decides he will no longer guarantee a gold coin in exchange for a First Bank Note. And he can finally do this without causing too much (if any) public outcry. So he quietly changes the law to say that a gold coin will no longer be given in exchange for a First Bank Note. This helps him pay for this new war in two ways.

First, he can take all those gold coins that were “just sitting there doing nothing” and spend them. It’s like the government has just received a large inheritance! This is the perfect way to pay all of his international suppliers for various war supplies.

Second, he is no longer restricted by a silly minimum required reserve ratio that says how many First Bank Notes he can print. If he needs more money, he can simply print it, and he can do that without any risk of a bank run because the ultimate form of money in society is now First Bank Notes, not gold.

But he needs to be strategic in how he decides to print all these extra First Bank Notes. If he simply prints them directly, people might catch on to the fact that the inflation they’re experiencing is a direct result of President doing that. And people don’t like inflation if they know that it’s directly caused by the government printing money and thereby taking a portion of their cash wealth without their consent.

So this is what he does. To pay for his war, he first imposes whatever war taxes he can get away with. People don’t like taxes, so he is pretty limited in this regard. And then, to cover the rest of his war expenses, any time he needs more money, he puts some government bonds up for sale. If he needs another 500,000 gold coins worth of value, he puts 500 bonds for sale, each one being worth 1,000 gold coins. If the general public only buys 300 of them, then he will have First Bank buy the other 200. And how is First Bank going to pay for those bonds, which are worth a total of 200,000 gold coins/First Bank Notes? They will print them of course! And now the inflation caused by First Bank printing this money is hidden in the complexities of banking, which the general public can’t be expected to understand. They will see that inflation and just know that this is a fact of the world. Inflation happens. Especially during a war. (Ahem, or a pandemic.)

And voila! With this one simple change, President can be assured that he will always get all the money his government needs to pay for any financial challenge.

Next week, we will analyze the effects of this. But we have, finally, after 30 weeks of writing about money, gotten to the usual final evolved state of money: fiat money. Well, technically, we got to fiat money when President passed the legal tender law. But now we are at the type of fiat money that is normally thought of when the term is used. It’s the kind that is not backed by anything of intrinsic value, which gives the government full power to print as much as it needs. And now we have seen the whole process of how money evolves from commodity money all the way to unbacked fiat money, and why people in our modern day use as money these nearly worthless pieces of paper.

The Theory of Money, Part 29

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Last week, I clarified some details about how exactly President achieved a uniform currency with the new First Bank Notes. Now all the specie of all the banks is housed at First Bank, and all banks are limited to having outstanding loans amount to five times the number of gold coins in their First Bank account (calculated based on the current required reserve ratio of 20%).

One thing I didn’t mention last week is how a reserve-sharing central bank would work with this new system. It is much easier to share reserves if a bank goes below their 20% reserve requirement since all the specie is stored in the same place, but now that First Bank is controlling the dispensing of receipt money, is it even possible for a bank to lend out more than 5 times their gold coin reserve? Yes. Yes it is. Here’s brief example to show how.

Verity Bank lends 5,000 First Bank Notes to an entrepreneur. Instead of handing the entrepreneur a giant duffel bag with 5,000 First Bank Notes in it (not wise due to risk of it getting stolen), Verity Bank credits the entrepreneur’s Verity Bank account with 5,000 First Bank Notes. Then, whenever the entrepreneur wants to pay a supplier, he can simply write a cheque (or do the same thing electronically with a fancy plastic card issued by the bank) that allows the supplier to get the First Bank Notes directly from Verity Bank.

So we see that if banks have account balances for customers, it wouldn’t be too difficult for them to cross over that reserve ratio requirement, especially if they are aggressive at trying to stay as close to that 20% reserve ratio as possible. For example, if Verity Bank starts working through the process of originating that loan for 5,000 First Bank Notes one week before they actually have the money to give the entrepreneur, then they can sign all the paperwork in advance with a promise to give him the loan money in one week, which would be right after they have 5,000 to lend because they’re expecting several large loan payments to come in on that very day. But if, on that day, even one large loan holder doesn’t make their payment on time, Verity Bank may not actually have the money they promised the entrepreneur. But they will still credit his account for the 5,000, thereby crossing below the 20% reserve ratio requirement.

Fortunately, President accounted for this possibility by setting the reserve-sharing interest rate relatively high, so most banks will be discouraged from having loan policies that are that aggressive because they know that, on average, it will cost them more in interest paid to First Bank (the first-line reserve-sharing institution) than it will earn them.

All right, now with those details out of the way, let’s see what happens next.

Society seems to be growing wealthier. The inflation they initially faced as more and more banks shifted to fractional reserve banking has settled out now, and the efficiencies gained by having a uniform and predictably valued form of money is showing its benefits.

In fact, First Bank Notes are universally accepted domestically (thanks to the legal tender law) and have proven so reliable in their convertibility to gold coins–but are so much more convenient than gold coins–that people are using First Bank Notes almost exclusively. The only time people end up exchanging notes for specie is if they are conducting international trade, which is usually only businesses rather than individuals. And even when individuals go to other countries, First Bank Notes have become so well trusted and well regarded that merchants in other countries often accept them. Or, if someone travels to a place where merchants don’t accept First Bank notes, at least money exchange stores are always available to trade First Bank Notes for the local currency. Pretty soon, nobody is using gold coins directly anymore. Maybe every once in a while, someone will go to a First Bank branch to request to exchange a First Bank note for a gold coin, but this is mostly just to satisfy their curiosity about whether they can still do that.

Thus, within a decade or two, First Bank notes have functionally become the only currency. Even merchants don’t usually have an easy means of accepting gold coins anymore. Meanwhile, the number of gold coin withdrawals has steadily dropped, which has allowed President to slowly lower the required reserve ratio in an effort to earn more interest. Not that increasing the amount of money being lent out will automatically earn more interest for the bank–there are multiple factors involved that determine that. But, for simplicity, let’s assume that President has lowered the required reserve ratio to 10% and is earning even more interest for the government through First Bank.

Let’s stop there this week. We have transitioned from a system where commodity money and receipt money are being used interchangeably to a system where receipt money is exclusively being used. In other words, people have started thinking of these little pieces of paper that they call First Bank Notes as real money rather than think of them as a receipt for the real money, which is intrinsically valuable gold coins. We’ll see how President takes advantage of this next week.

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