In Part 28, we clarified some extra details about the fairly complicated impact of transitioning to a uniform currency.
This week, let’s add some technology to our banking system!
Up to this point, banks have been keeping paper records. But what if technology develops in Avaria to the point that electronic money transfers become possible? This opens up a new world of money convenience!
Let’s say, for simplicity, that the internet is invented and immediately all banks and merchants become able to transfer money electronically. This is so exciting for all the citizens that they each go to their bank of choice and deposit the majority of their First Bank Notes. And now they are able to log in and see the total value of their bank accounts. They also all receive new plastic cards in the mail, which are called debit cards because they allow merchants to debit money directly from their account. Credit card companies also crop up, allowing people to pay now with money borrowed from the credit card company and then pay that money back later.
From this point on in Avaria, when someone buys something, instead of using physical First Bank Notes, they usually just present a card to the merchant. The merchant swipes the card, which directs the issuing bank to transfer the purchase amount from the customer’s (or credit card company’s) electronic bank account to the merchant’s electronic bank account. Merchants are still set up to accept physical First Bank Notes, but they’re long past the days of knowing what to do if someone tries to pay with gold coins.
Avaria has just transitioned to a new form of money! A very thorough name for this type of money would probably be “electronic centralized fractional reserve receipt money” or something like that. But the fundamentals of the banking system haven’t changed, it’s just that people are, more and more, relying on electronic representations of their money rather than physical First Bank Notes.
The major implication of this is that now commercial banks are accumulating even bigger piles of First Bank Notes in their vaults, “just sitting there doing nothing.” And remember that they’re also still frustrated by their capped reserve credits.
So let’s do something crazy and allow the next monetary transition to happen right now.
After a lot of lobbying to President to find a way to allow commercial banks a way to grow their loan-based income, President makes a new law: He says that banks are allowed to use the First Bank Notes that are stored in their vaults as reserves for lending.
This is a huge deal, the reasons for which I’ll explain shortly. But, first, let me build out the details of this change so I can give an example of what this looks like, and then we’ll do some processing after that.
So, along with that new law, President sets a new reserve ratio of 0.8 (money multiplier of 1.25) that applies only to loans backed by First Bank Note reserves. This doesn’t change the existing reserve ratio of 0.2, which still only applies to lending against reserve credits.
Why is the new reserve ratio initially set so high? Because President shrewdly recognizes that this is going to set off a new wave of inflation, and he wants to keep the inflation low enough that it will only set off a small economic boom (fueled by the illusion of newly increased prosperity) and its inevitable subsequent bust. If the boom and bust can be kept small enough, it will prevent the bust from triggering a full-blown societal collapse, which would economically set Avaria back several years at least.
Now for the example: If Veritas Bank has 6,000 reserve credits in its account with First Bank and also has 40,000 of its customers’ First Bank Notes stored in its own vault, then it will continue to loan out the 6,000 x 5 = 30,000 First Bank Notes based upon its reserve credits, and it can also start lending out 40,000 x 1.25 = 50,000 First Bank Notes based upon the First Bank Notes stored in its vault.
Wow. even with a reserve ratio that high, this increased Avaria’s money supply by a lot. Let’s do a quick calculation to see how much.
If there were a total of 50,000 reserve credits, 50,000 x 5 = 250,000 First Bank Notes were circulating. And assuming that, now that Avarians are primarily using electronic money to transact, almost all of those First Bank Notes are stored in commercial banks’ vaults, that means all 250,000 will be multiplied by the new money multiplier of 1.25, so the total number of First Bank Notes increased almost immediately from 250,000 to 250,000 x 1.25 = 312,500. And if there were 50,000 Wealth Units being stored in those 250,000 First Bank Notes, the WU:money exchange rate has just changed from 50,000:250,000 (or 0.2 Wealth Units per First Bank Note) to 50,000:312,500 (0.16 Wealth Units per First Bank Note). So buying something with a wealth price of 10 WUs just increased the money price from 50 First Bank Notes to 62.5 First Bank Notes. That’s an inflation of 25%! Ouch.
To be clear–Avarians are not getting any new wealth from this extra money. In fact, they just lost 20% of their cash wealth (and I’ll not get into the math that explains why they only lost 20% of their cash wealth when they experienced 25% inflation). To whom has that wealth been transferred? Temporarily, it’s been transferred to all the people who got those new loans. But those people will be paying that wealth back, plus interest, to the banks that gave them the loans. So the beneficiaries of this new law are the banks, which are now taking even more of other people’s wealth to lend and then earn interest on. The banks are making even more exploitative loans than before, and the people being exploited are the bank customers storing their money in commercial banks.
Not that any Avarian can avoid the effects of this. If someone figures all of this out and decides to keep their piles of First Bank Notes in their big gun safe at home instead of in a bank’s vault, it will have a negligible effect on how much inflation was induced overall, so basically their money will still depreciate just as much even though it wasn’t in a bank. And now, without storing their money in a bank, they lose out on all the conveniences that electronic money confers. So there’s no fighting this. The government just took more of the Avarians’ cash wealth and essentially gave it to the banks to profit off of. And, short of forcing the Avarian government to change its monetary policy, the citizens of Avaria can’t do a thing about it.
The reason I said above that this was such a major change is because, for the first time ever, something other than intrinsically valuable assets has become allowed to be used as reserves in their fractional banking system. Their reserves have actually become pyramided into two levels: There’s the base layer of gold backing the first 250,000 First Bank Notes, and there’s a second layer of reserves–the First Bank Notes themselves sitting in commercial bank vaults–backing the additional 62,500 First Bank Notes.
In aggregate, then, this fractional reserve currency is really only 16% backed by specie (50,000 gold coins / 312,500 First Bank Notes = 0.16).
And the scary thing is, the accountability that specie provides on the banking industry is disappearing.
For example, think about what would happen if people got worried that their First Bank Notes were somehow being squandered by a bank, and all of the bank’s customers lined up to get their money out. Yes–that bank wouldn’t have enough First Bank Notes to supply everyone, and it would go bankrupt (assuming the reserve pool interest rate was high enough that it couldn’t afford to borrow all the needed reserves from other banks). But would that spread generally to all of the other commercial banks and lead to the collapse of the entire banking system? No. Because First Bank could just print more First Bank Notes to give to everyone until they stop trying to withdraw all of their money from the banks. Crazy inflation might happen for a time until people gain trust in the banking system again and re-deposit their money, but the banking system itself wouldn’t collapse. The house of cards is calcifying.
At this point, the only way the entire banking system would collapse–which would cause people to go back to using intrinsically valuable stuff as their common medium of exchange–is if for some reason the Avarians became worried that there is no longer enough gold for the entire system, so they start taking their First Bank Notes to First Bank and requesting to exchange them for gold coins. But, even then, President would just step in and cease all banking transactions until the panic subsides and people are convinced that it’s selfish to try to get their gold back.
But the likelihood of that happening is incredibly low because Avarians don’t even think of gold coins as money anymore. As long as they can get their First Bank Notes out of their account at their commercial bank whenever they want, they generally don’t worry about their money and continue to happily use electronic money as their primary common medium of exchange.
To wrap up this post, let’s consider what the regular citizens of Avaria would think about these last few changes in their banking system. The amazing thing is, even with bank reserves being switched from gold to paper, and even with paper being allowed to be used as reserves for other paper, they have been minimally impacted. In fact, they probably love how convenient money has become in this modern Avaria. No more carting around heavy gold coins like in generations past. They can just fill their wallets up with a few plastic cards (or load them into their smartphones) and not worry about a thing. Their only complaint would be that pesky persistent inflation, although inflation has been a part of Avarian life for enough decades now that most Avarians assume by now that continually rising prices is just the normal way of things. And, if asked where inflation comes from, they would shrug and say the monetary system is too complicated for them to grasp. So they’re happy to leave dealing with that mystery to the economists and the bankers and the government, all of whom are working hard on their behalf to use the most modern mathematical models to figure out how to stabilize this very complex monetary system.
But you know better: Inflation is not an automatic part of a monetary system, and its source is absolutely not a mystery. It’s a predictable and direct result of the actions of banks and governments. And don’t forget inflation’s wealth-destroying and wealth-redistributing effects we discussed earlier in this series, and how it fuels the business cycle’s booms and busts, which Avarians (and other modern humans, including me up until a few years ago) also assume are a normal and automatic part of modern economies.
I hope you’re a little bit angry at modern monetary systems by now. And we haven’t even gotten to the worst versions of money yet! You’ll get angrier, I promise.
On that note, I should probably ask the same question I’ve asked before: Does this mean the banks (the government-run one and the commercial ones) are bad?
They haven’t broken any laws or manifested any nefarious intentions (unless you count wanting to earn a profit as nefarious). All they’ve done is respond rationally to the incentives the system has given to them at each stage of the evolution of money. And responding to incentives in a way that maximizes profit is what capitalism is all about.
So I would answer that the banks aren’t bad . . . the incentives are bad. Monetary systems are one major case where the natural progression of human civilization does not tend toward an optimal rational order. Unfortunately, we have found this out too late to bake into our governments’ constitutions the restrictions necessary to prevent banks and governments from colluding to take our cash wealth from us and induce all of the economic inefficiencies that come along with that.
Capitalism sometimes creates bad incentives like this, too. That doesn’t mean capitalism is horrible and should be forsaken; it just means there is a role for government to identify issues like this and then enact laws that create better incentives. That challenge when it comes to monetary systems is that the government stands to gain so much from allowing its nation’s monetary system to go in this direction that there isn’t a lot of motivation for it to stop it. In fact, governments often become the leader of the money bandits, as you’ll increasingly see in the rest of this series.
I wish this story of Avaria’s monetary system were all hypothetical. But I am describing what nearly every modern government has done to its country’s monetary system.
Anyway, in summary, Avaria’s monetary system has begun its second phase of inflation. The first phase was inflation as a result of fractional reserve banking using specie as reserves(the money went from 100% backed to only partially backed), and the second phase is the result of the second layer of fractional reserve banking using paper as reserves (they money went from being only partially backed to even-less-partially backed).
There are some further major changes to Avaria’s monetary system that will result from this shift, which we will discuss in Part 30.
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