The Theory of Money, Part 35

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The last few weeks, we’ve been processing the changes that happened in our fictitious society after President instituted 0% backed fiat money by breaking his country’s currency from its gold backing. As a reminder, this change allowed banks to start using debt as reserves, which means there is no limit anymore to how much additional money can be created. It also enabled the government to take additional Labor Units from the people whenever it wants because it can direct First Bank to print new money to give to it.

There are several minor details that have accumulated as I’ve been thinking about all these issues, so let’s go through those this week.

I’d like to define some terminology for the two different kinds of loans we have seen. I believe clarifying these terms will be useful for helping us think clearly about these ideas.

The first type is an assentive loan, which is when the person lending the money has the assent of the actual owner of the money to lend it. If the person directly lends their own money, obviously that’s assentive. But also a bank can lend someone else’s money if they have the assent from the owner of the money. We typically call that a certificate of deposit (CD)–the person who owns the money knows that their money has been lent out, so they can’t get access to it until the term of the CD ends.

The other type of loan is an exploitative loan. This is done without the assent of the actual owner(s) of the money, which means the owners are being exploited. This is what happens when a bank lends out money through the process of fractional reserve banking. This is also what happens when the government borrows money by having their money-creating central bank create new money in return for a government bond.

How is it exploiting anyone though? Because, technically, the money being lent out in these situations is newly created money, so it wasn’t anybody’s money. Remember that really we care about the wealth (measured in Labor Units) people own. When a bank creates new money, that money carries value, which comes from diluting the value of all the pre-existing money. So, people’s Labor Units are getting taken from them for lending without their assent through inflation.

I also have been thinking more about this fictitious society’s gold coins. From near the beginning, I’ve been saying that the government has been printing them to a standardized shape and weight and quality, but there’s really no reason it has to be the government. Yes, this idea may sound drastic since it’s so different than what we’re used to today, BUT if a society is truly using only commodity money in the form of gold, I don’t see why a market for coining gold couldn’t spring up. As long as each company printing coins makes them in a desirable way, they will flourish in the market. Typically this would mean the coins are printed in a way that makes them difficult to counterfeit, they’re convenient sizes, and they are ultra exact in their actual weight relative to their stated weight. This would mean that there could be a variety of different weights and types of coins made by different coining companies that people are using for exchange. Soon enough, some standardization would naturally arise as people find the preferred weights in the market. And any coining companies that prove to be unreliable in their coins’ actual weights will quickly be forced by the market to change or go out of business.

This would allow as many coins to be made as there is gold, and that’s fine. We’ve already talked about this earlier in the series, so I won’t rehash it here. But, to briefly describe how it would actually work, anyone would be able to take raw lumps of gold (or even other coins) to any coiner and have them melted and stamped into new coins. The coiner would charge a competitively priced fee for doing this, so maybe you give them 50 grams of gold and they give you 49 1-gram coins in return.

I’ve also never actually named the currency in our fictitious society. And, at this point of having 100% unbacked fiat money, I guess the currency would need a name. Unofficially, I’ve been calling it gold coins, so I’ll stick with that.

If the society had stayed with gold as the foundation of its money supply, then it might be simpler to just refer to prices in the weight of gold. So, instead of saying the cook pot is worth 1 gold coin, we could say that the cook pot is worth 2 grams of gold.

I’ve also never explained token coins. Most modern societies still use metal as money, but the stated value on the metal coins is much higher than the intrinsic value of the metal by weight. So, they’re not real coins that have full intrinsic value like the gold coins of our fictitious society, which is why we call them “token coins.”

I’d also like to review the three different ways the government and First Bank can manipulate the money supply.

First, it can change the required reserve ratio, which of course alters the money multiplier.

Second, it can change the discount rate. Increasing the discount rate makes banks more conservative in how much money they lend out because it will be more expensive for them to go below their required reserve, so increasing the discount rate decreases the amount of money. And you see the opposite effect when the discount rate is increased.

Third, it can create new money for lending to the government.

Generally the money creation mechanism is used according to government spending policies, so this one isn’t as free to be used as a mechanism for purposefully manipulating the money supply. But the other two are much more free for the use in money supply manipulation.

So, with those two tools in hand, the government has control over the value of money because they can deliberately induce inflation or deflation. This allows them to start leveraging this ability to try to stimulate the economy by increasing the money supply when the country is facing a hard economic time, or they can carefully induce deflation whenever inflation is getting out of hand. That’s why we hear about the Fed changing the discount rate or the required reserve ratio in their efforts to beneficially tinker. I think this topic bears further discussion next week.

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