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.

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