The Theory of Money, Part 33

Image credit: Bill Watterson

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 probably 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.

Last week, I introduced discount window lending into our fictitious society’s banking system. Discount window lending allows First Bank to create money to lend to banks who are still short on reserves even after they’ve gone through the reserve-sharing process with each other (through their “reserve-sharing central bank”). The fact that First Bank can now create money for lending means it has morphed into the kind of central bank people are usually talking about when they use that term. Specifically, it’s now what I call a “money-creating central bank.” I use that term to distinguish it from a reserve-sharing central bank.

Quick sidenote: First Bank could now be referred to as the “lender of last resort.” The first resort was the other banks, but if they don’t have enough excess reserves, then you move on to the last resort by borrowing through this discount window process.

Creating new money is a completely different beast from merely multiplying money through fractional reserve banking. You see, regular banks are limited in how much money they add to a society by (1) the amount of money people store in them and (2) their minimum reserve ratio. Money-creating central banks, on the other hand, have no limits; they can create new money as much as they need and whenever necessary. And, of course, if that money ends up in a bank using fractional reserve banking, then that newly created money can also be multiplied.

I have described how First Bank became a money-creating central bank for the sake of lending to banks any time they are short on collective reserves, but First Bank can lend newly created money to the government as well, and this is probably the more important aspect of its new power. So let’s talk about that.

First, though, why would the government want to borrow newly created money from First Bank? Why not just have First Bank create new First Bank Notes and give them to the government?

I think the issue is that it would be unpopular. If people start to wonder why suddenly inflation is skyrocketing, it wouldn’t take much investigation for them to figure out that the government is simply having First Bank print money and give it to them.

So, instead, the government will borrow this money. This is how they do it: Any time the government wants more money, it can put some government bonds up for sale. If people buy them with real money, it’s great! The government has borrowed money without causing inflation. But if there aren’t enough people with real money to buy all of them, then First Bank has an ongoing commitment to simply create the money necessary to buy all the rest of them.

This is easy to do with a computer, no printing necessary! Some entry-level First bank employee is assigned the task of checking at the end of each day to see if there are any unpurchased government bonds from that day. If he sees that there are 200 government bonds still up for sale from that morning, each one with a face value of 1,000 First Bank Notes, he will go into the special money creation account and adjust the balance from 0 First Bank Notes to 200,000 First Bank Notes. He then uses that account’s balance to purchase the 200 government bonds. Voila! Money was created and lent to the government with a few simple keystrokes!

The government likes this system because it can get all the money it wants anytime. It doesn’t even have to pay back the money it’s borrowing until it’s ready to do so! For example, if bonds mature before the government has the money to pay the face value back to the purchaser, it can simply issue new bonds to replace the maturing ones and use the sale price of the new ones to pay off the old ones. And it’s always guaranteed that all the new bonds it issues will be purchased because of the ongoing commitment from First Bank to buy whatever bonds are not bought by anyone else.

The bankers are pretty happy with this arrangement as well–they get to create new money and then earn interest on the bonds they bought with it!

But President, he’s extra generous to the bankers because he wants to thank them for helping him out like this. So what does he do? The answer is a short statement with a big implication: He says they can use those bonds as reserves.

Yes, this means President has allowed banks to use government debt as reserves. Let’s process this.

Remember when banks originally only used specie (i.e., cash assets) as reserves? And that they eventually expanded to using non-cash assets as well? That was all the way back in Part 22, and I explained how it increased the total amount of money quite a bit.

Let me run through the math of this briefly before we see how this expansion to using debt as reserves changes things.

Let’s pretend that a society has a total of 500,000 Labor Units worth of wealth, 20% of which (100,000 LUs) are stored in cash assets and 80% of which (400,000 LUs) are stored in non-cash assets. And let’s further pretend that currently they only directly use gold coins as money, and each gold coin is worth 1 LU.

Now let’s instantly introduce receipt money and fractional reserve banking into the society. All 100,000 gold coins will be placed into the bank’s vault, and we’ll set the reserve ratio at 0.2, which means the money multiplier will be 5.

Almost instantly, the 100,000 gold coins got multiplied into 500,000 bank notes. That’s a huge dilution of the value of their money (which is another way of saying that we just caused terrible inflation). But now let’s allow banks to use non-cash assets as reserves too. If banks only own 10% of society’s non-cash assets, that’s still 40,000 LUs worth of additional reserves, which in turn creates 200,000 more bank notes.

So, in a very short period of time, they went from 100,000 gold coins to 700,000 bank notes. This means that, once prices adjust to this new amount of money, each bank note will be worth approximately 1/7 as much as gold coins originally were. Or, said another way, each person just lost 6/7 of their cash wealth.

This was a huge amount of inflation, right? But even so, there is an anchor limiting how much inflation you can create when the system still requires some form of assets as reserves. Even if you lower the reserve ratio, there is still an anchor.

But what if you do away with requiring only assets as reserves and also allow government bonds to be used as reserves? To what extent can inflation occur now? If your answer was “infinity,” you were correct, because the only thing limiting more inflation is the government not wanting more money quite yet.

(Ahem, okay, technically, if the government overuses this power and causes too much inflation too fast, it may lead to a loss of confidence in the currency, which could lead to a collapse of the entire currency. But, short of that, if it uses this power carefully so as not to kill the goose that is laying the golden eggs, it could induce inflation indefinitely.)

Continuing with the example now that debt as reserves has been added into the mix, if the government decides to sell 10,000 gold coins worth of bonds, and the central bank buys all of them, then 10,000 additional new bank notes were immediately created. If all of those end up being stored in banks, then really 50,000 new bank notes were added to circulation after accounting for the money multiplier. But don’t forget that the central bank is allowed to use those bonds worth 10,000 as reserves, which leads to another 50,000 new bank notes circulating.

All told, that’s 100,000 new bank notes being added to circulation when the government borrowed 10,000. It’s like the money multiplier that applies (in an oversimplified world) when the government borrows created money is double the usual money multiplier.

So, let’s track the total number of circulating bank notes with each step:

Originally: 100,000 gold coins

Using only cash assets as reserves (reserve ratio 0.2): 500,000 bank notes

Using cash and non-cash assets as reserves: 700,000 bank notes

Using assets and now debt as reserves: 800,000 bank notes

And that final increase to 800,000 was only after a single round of borrowing. They could do that every month and increase the total number of circulating bank notes by 1,200,000 every year, forever. This dwarfs the inflationary effects that the only-assets-as-reserves type of fractional reserve banking can achieve.

Let’s end this post by looking at the implications of this.

Previously, President was stuck only getting money in two ways: taxes and borrowing. He didn’t like increasing taxes because it made him unpopular, but he didn’t like borrowing money either because ultimately he would have to increase taxes or cut spending to pay the loans back. Then he invested in a bank, which has been generating some income for him. That helped a little bit, but now he has the ultimate unlimited source of money. 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 as long as it wants until it’s ready to pay back the money.

Ignoring the investment income from the bank, from now on let’s be clear about the three ways government can get more money: taxing, borrowing (from people with real money), and creating.

I have two main arguments against the government using this new creation power to get more money:

First, creating money causes inflation, which means everyone’s cash wealth comes to be worth fewer Labor Units. In short, the Labor Units the government is spending are being taken from all people who own First Bank Notes, which I explained in Part 6. (Remember that this effect is limited to cash assets because non-cash assets’ prices rise with inflation, so they are generally immune to inflation, as I explained in Part 7.) I’ve also detailed all the other issues that inflation causes in Part 15 and Part 16.

A couple other things related to this first point. One is that people whose wealth is being taken from them through inflation usually don’t even know it’s happening, so that’s why inflation (when caused like this by governments creating money for spending) is sometimes called a “hidden tax.” Another thing worth mentioning is that since people with less wealth generally have a higher percentage of their wealth stored in the form of cash assets, that means this hidden tax 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), then he only lost 0.5% of his wealth.

Second, when government subsidizes its spending through this hidden tax, we are blind to the full extent of its expenditures. For example, if citizens hear that their country’s entry into an ongoing 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.

This was a heavier post, but I wanted all this information to be in one place, and I hope you see now why I have come to dislike money-creating central banks! By the way, we do have a money-creating central bank in the United States, and it’s called the Federal Reserve. They probably chose not to call it a bank due to the history of other unpopular central banks from earlier in our history. It took us 33 posts to get here, so don’t be surprised if almost nobody you talk to knows this stuff about central banks.

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