When I started this series, I never expected to get up to this many parts! Apparently I had more thoughts on money than I expected. But we are nearing the end of the series. There are still some more things to process with the change to 0% backed fiat money. And, of course, I will have a few things to say about crypto before the series ends. And then at the end I want to take a look back at how far we’ve come and discuss possibilities for improving our monetary policy. But diagnosis first, then treatment.
In Part 32, we got rid of the pyramided reserve structure and discussed how reserve pooling would work in the age of digital banking.
Let’s spend a little more time processing the change that allowed banks to use First Bank Notes as reserves.
Throughout this series, we’ve seen many expansions of what banks are allowed to use as reserves. It started out with cash assets (specie) only, and then it expanded to include non-cash assets, and then it expanded again to include using the fiat money itself (i.e., First Bank Notes) as reserves.
What’s the difference between real assets, like specie or cars or any other form of physical property, and First Bank Notes?
First Bank Notes are an intangible asset. Sure, technically the paper and ink that First Bank Notes are made from can be considered a real asset, but we don’t assign a value to a First Bank Note according to its paper and ink. Instead, we assign its value based upon the words written on it, which means we’re valuing First Bank Notes according to their intangible value as a unit of money. The thing about intangible assets is we can have as much of them as we want. Nothing stops First Bank from printing a note that says, “This note represents a bazillion First Bank Notes.” Easy–we instantly have a bazillion First Bank Notes. Doing this in a computer by simply changing the value in the government’s bank account would be even easier.
When Avaria first allowed banks to use First Bank Notes as reserves, that was still indirectly based on the foundation of real assets because the gold in the First Bank vaults was limiting the amount of new money that could be created. But then, when the backing to gold was broken (i.e., when they went completely off the gold standard, which happened in the U.S. in 1971) and Avaria’s money truly became a 0% backed fiat currency, the cap that gold placed on how much money could be made was removed.
So my point is this: When you start using intangible assets as reserves, there is no longer a cap on how much reserves you can create.
Think about it this way. There are two things that form a hard limit on the amount of money you can create when you are only using real assets as reserves: (1) the value of the real assets you have and (2) the reserve ratio you can get away with before you start triggering bank failures, especially from bank runs, and risk collapsing the currency.
But everything changes when you switch to using intangible assets, such as First Bank Notes, because you now have an unlimited value of reserves.
That doesn’t mean the central bank can just print an infinite amount of money without consequence. Induce too much inflation in a short period of time and the monetary system will collapse when people discover that the money they have been using isn’t holding its value, and then people revert back to barter and using real assets as money. But as long as the central bank keeps inflation to a reasonable level, the central bank can continue printing new money for the government to spend, forever. The government can keep taking small chunks of our cash wealth every year (without our consent) in perpetuity. This removes a lot of the sorely needed accountability on government spending.
What is a reasonable level of inflation? It’s the highest amount of inflation you think you can get away with inducing year after year in perpetuity without triggering a loss of public confidence in the monetary system.
So when you hear that the Federal Reserve targets an average annual inflation rate of 2%, I suspect that’s where that number comes from, although they’ll be quick to tell you that it’s actually the number they think will strike the right balance of stable prices and maximum employment.
But wait, there’s more. There’s another intangible asset that is often used as reserves these days: government debt. If you own debt, you own an intangible asset. And an infinite amount of government debt can be created with a 0% backed fiat currency.
For example, consider the case of a commercial bank buying a government bond. Remember that when anyone issues a bond, it’s basically a request for a loan from whoever will buy it. So the person who bought the bond now owns debt, which entitles them to annual interest payments and receiving their principal back when the bond expires. If a commercial bank finds itself with some excess reserves and wants to push their reserve ratio back down to the minimum required reserve ratio (still set at 0.2), it could make a loan to the government by purchasing a government bond, which usually would just entitle the bank to the interest every year and the principal back when the bond expires. But when government debt is allowed to be used as reserves, this means that the government bond now counts as reserves as well, which allows the bank to lend out an additional 5,000 First Bank Notes just (according to the money multiplier of 5) by owning that bond! So the bank gets the interest from the bond and it gets interest from 5 times the bond’s value in additional loans that it can make.
Wait, what? The bank, simply by loaning money to the government, gets interest on the loan and gets 5,000 more First Bank Notes to lend out?
Yes. And it creates an infinite appetite on the part of banks to buy government bonds.
Who would make such a policy? The answer is . . . (1) any government that is desperate to increase non-central bank buyers of its bonds (probably for PR reasons) or (2) any government that is strongly influenced by commercial banks. I guess a third possible option is that the banking system just got too confusing for all of the lawmakers to fully understand and they were hoodwinked by the bankers into adding such a policy to some giant and confusing piece of legislation. But I’m not sure a claim of ignorance is an adequate excuse.
This shouldn’t be too surprising. The owners of banks (i.e., bankers) are some of the wealthiest members of society. And that means bankers have lots of money to use to influence politics–through campaign contributions, lobbying, and even through threats of doing financial harm to the nation (which no politician wants to happen during their tenure because of how it will reflect on them). So of course governments make policies like this!
Therefore, allowing intangible assets–such as the fiat money itself and also government debt–to be used as reserves is great for banks and spendthrift governments, but it’s terrible for citizens, who are ultimately the source of all the wealth that is being taken.
Let’s end this post by looking at the implications of this on government finances.
Previously, President was stuck only getting money in two ways: taxes and borrowing. He didn’t like increasing taxes because it made him unpopular, and he didn’t like borrowing money either because ultimately he would have to increase taxes or cut spending to pay back the loans plus interest. So he invested in a bank, which has been generating some income for him. That helped a little bit, and then he finally gained the ultimate unlimited source of money when his bank turned into a central bank. Now, any time the government needs to borrow money, it can put some bonds on the market and be assured that they will be bought. And it can keep reissuing bonds to replace expiring ones as long as it wants until it’s ready to pay back the money.
This means there are four different ways for a government to earn money:
- Taxation
- Borrowing (i.e., future taxation)
- Printing money (i.e., taxation through inflation)
- Owning a profitable investment
I believe taxation is necessary for a government to function. Borrowing should not be necessary except in extreme and rare cases (most of which would be absent if the banking system would stop tampering with the value of money). Printing money has many issues, which I’ll summarize in the next paragraph. And owning a profitable investment could be acceptable, although if it’s an investment that the government is running, then I have serious concerns about its lack of being subject to market forces and, therefore, about the value it’s delivering to customers.
Here are my problems with inflation, in addition to the wealth-destroying and wealth-transferring effects it causes by inducing booms and busts, which I covered thoroughly earlier in this series:
Problem #1: People whose cash wealth is being taken from them through inflation usually don’t even know why it’s happening, so that’s why inflation is sometimes called “the hidden tax of inflation.” This means that the government isn’t being held accountable to the people for the money that it’s taking from them.
Problem #2: Since people with less wealth generally have a higher percentage of their wealth stored in the form of cash assets (e.g., they lack large investment accounts, don’t own their homes, etc.), that means that inflation hurts the poor even more than the rich from a percentage-of-wealth-taxed standpoint. For example, if I am poor and 30% of my wealth is stored in cash sitting in my bank account, and inflation is 100% one year, I lost 15% of my wealth. If my rich neighbour only has 1% of his wealth stored in cash (and the rest is in non-cash assets like a large investment portfolio, the value of which rises with inflation), then he only lost 0.5% of his wealth. So inflation isn’t just a hidden tax–it’s a regressive hidden tax.
Problem #3: When a government subsidizes its spending through indirect taxes–especially the most hidden one of inflation–citizens are blind to the full extent that taxation is costing them, which also skews their opinions about how much the government should do. For example, if citizens hear that their country’s entry into an ongoing foreign war will cost each family about $20,000/year in additional taxes, they may still support that policy. But if they hear that this war will cost them $20,000/year in additional taxes PLUS another $20,000/year through the hidden tax of inflation, suddenly many of them will be much more critical of the decision to enter that war because they will be questioning whether it’s really worth $40,000/year to them. I suspect we end up supporting many government policies out of sheer ignorance of their full cost.
Sooo, how do you feel about the government having a 0% backed fiat currency now that we’ve reviewed how it enriches government and banks at the cost of us, and how we can’t do anything about it, and how terrible permanent inflation is?
I hope this post has helped piece together many of principles we’ve discussed up to this point so that it can drive home just how much governments with their central banks and 0% backed fiat currencies are screwing us over. People back in the early 1900s knew some of this, and it’s probably why the Federal Reserve Act of 1913 didn’t say anything about a “central bank” in it, even though that’s exactly what the Federal Reserve is. Worse, the Federal Reserve is not owned by the government, so all that interest the government is paying to the Federal Reserve isn’t even flowing back to the government. Instead, it’s just enriching bankers.
It took us 33 posts to get here, so don’t be surprised if nobody you talk to has even an inkling of how bad modern monetary systems are, even though 0% backed fiat currencies are probably the biggest wealth-destroying and wealth-redistributing (to bankers and government) scam that has ever been orchestrated. Part 34 here.
Clear Thinking on Healthcare 