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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