The Theory of Money, Part 31

Image credit: fran_kie

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.

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