The Theory of Money, Part 32

Photo by Nikolay Ivanov on

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!

Leave a Reply

Fill in your details below or click an icon to log in: Logo

You are commenting using your account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s

%d bloggers like this: