The Theory of Money, Part 39

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In Part 38, I discussed the (very low) likelihood of cryptocurrency being co-opted as a nation’s official currency. And I also talked about my hopes for at least one cryptocurrency to eventually stabilize its price enough and become widely used enough to be elevated from the status of a speculative investment to an alternative common medium of exchange.

I ended Part 38 by promising to do a little clean up to make sure I’ve discussed all the main insights that I believe are needed to understand modern money, after which I will propose a method to get us back to commodity money. So that cleanup effort starts now.

One thing I didn’t mention last time was that even if a cryptocurrency does become a common medium of exchange (as an alternative to the country’s official currency), the value of it is not likely to be as stable as any actual commodity money. I explained how market forces will tend to push commodity money back to a default value way back in Part 9.

Another question that has arisen over the last few months of writing about 0% backed fiat money: What would happen to our money if the government pays off all its debt? Will all of it disappear? This has implications on whether it would even be fiscally safe for the government to pay off its debt!

To answer that question, let’s very briefly trace the origins of all the money we have.

First, people were using various commodities to facilitate trade. Ultimately, they landed on using gold because it was the most convenient commodity (again, check out Part 9 for details on the optimal form of money). Eventually, gold was being stamped into coins that were a standardized weight and were difficult to counterfeit. As individuals got wealthier, they were able to store any newly acquired wealth by buying more gold and having it stamped into coins. Let’s say there were a total of 5,000 gold coins at this time. And even when people started using receipt money instead of the coins themselves, the receipt money was 100% backed by gold coins, so the only difference was one of convenience by switching to receipt money.

Then along came fractional reserve money, which, if the reserve ratio was 0.2, caused the amount of money to expand 5x, so then there were 25,000 gold coin receipts floating around but still only 5,000 actual gold coins.

Then the government decided to liberate all that money from its gold backing, so it took the gold and gave it to overseas companies for war supplies. And the government started printing out IOUs to back the printing of new gold coin receipts. Let’s say it prints 75,000 gold coin receipts and also has a debt of 75,000 IOUs to match that.

That’s basically the state we’re in today. There are 100,000 total gold coin receipts, 75,000 of which are created with counterbalancing government IOUs, and 20,000 of which are created through fractional reserve banking, and 5,000 of which are the original money.

So, if the government suddenly pays off its entire debt, then the only money left over will be the fractional reserve money and the original money.

And if we eliminate fractional reserve money and get back to only the original money, then we’ve eliminated 95% of all the money. We’ll never eliminate all of it, because we had money before implementing fractional reserve banking and government money-and-debt creation.

But remember that the big difference here is that this original money is actually different than how it started because, when it started, every gold coin receipt had a gold coin backing it. And now none of them do.

Would there be a benefit to doing all this?

Well, there’s a benefit to the government getting out of debt so that we can break the intergenerational pyramid scheme of one generation overspending and sending the bill to the next generation. And there’s a benefit to getting rid of fractional reserve banking to avoid all the expansions and contractions and bank runs and their associated detriments (explained especially in Part 15). But even with those two major changes, we’ll still have gold coin receipts that are 0% backed fiat money; we’ll just have fewer of them than before.

Does this mean we’d be broke?

Absolutely not. I explained this in Part 12, but I think explaining it again here using details from the example above will be easy. And it’s always nice to understand a principle in a new context.

Let’s say, in the beginning before shifting to fractional reserve money, there were 5,000 total LUs worth of wealth stored in the 5,000 gold coins. 1 gold coin was therefore worth 1 LU.

Then, over the ensuing decades as the money was slowly diluted more and more, people were still earning greater wealth and storing it in the form of money. So even though the total amount of money was increasing a lot faster than wealth was aggregating, there was still wealth aggregating. Maybe, by the time we were up to 100,000 0% backed gold coin receipts, there were actually 15,000 LUs worth of wealth stored in the aggregate money supply. This increasing wealth was tempering the inflationary effect (money-devaluing effect) of creating so much new money.

And then, if we got rid of all the newly created 95,000 gold coin receipts and were back down to only 5,000 of them, we’d still have 15,000 LUs worth of wealth stored in our aggregate cash supply, it’s just that they would no longer be diluted over such a large supply. So now each gold coin receipt would be worth 3 LUs.

In other words, we haven’t destroyed any wealth by getting rid of the government debt-backed money and the fractional reserve money, we’ve just concentrated the wealth into a smaller number of gold coin receipts (plus gotten a bunch of other benefits by eliminating the government debt and fractional reserve banking).

Thus, the answer to my question earlier about whether it would even be safe for the government to pay off its debt is YES. It would be completely safe. It will cause some deflation, which can mess with prices, and it can also mess with international trade (which we haven’t gotten into), but these are short-term effects. Once the supply of money and prices stabilize, there are much greater benefits because now prices can be more predictable, so long-term contracts will be safer and wealth will more effectively be achieved. Part 40 here.

As of Yesterday, I’m Expanding My Social Media Presence

Pardon the brief interruption in my Theory of Money series. This isn’t a money blog anyway, but it IS a healthcare and economics blog, and the modern money and banking system is one of the most interesting applications of economics outside of healthcare! So I will be completing that series, I just wanted to share a timely something else this week.

For the longest time, I’ve just been blogging my way through my passion for healthcare policy as I’ve worked on figuring out how to fix the healthcare system. I have advertised the blog a little bit here and there simply by syndicating on a handful of other healthcare blogs plus sharing the link to posts on LinkedIn and Twitter, but that’s about all I’ve done to expand my reach. This has mostly been because I didn’t want to spend time on that kind of project–I wanted to instead spend my limited health policy time each week reading and writing, which strengthens my understanding of and ability to explain the healthcare system. But, with a recent job change (still working as a full-time hospitalist, just at a different hospital), I now have a little more health policy time each week.

That is why, over the last few months, I have gotten some help to plan how to broaden my reach. Initially this will be through sharing health policy content on Instagram, and the first post was yesterday! I’ll be posting about 4 times per week, including a weekly video (with the help of my wife’s filming equipment and skills) on Wednesdays that will feature me explaining healthcare policy principles in under 1 minute. I’ll be cross-posting those videos to YouTube for people who want to watch them there instead, but so far I haven’t planned to do any YouTube-specific (longer) videos. That may change as I learn and adapt to what seems will be most effective.

So, I hope you’ll engage with me on those platforms! I recently added the links to my Instagram page and YouTube channel to the sidebar of this blog: @DoctorTaylorJay.

(I’m working on getting that handle for Twitter as well, but some guy named Taylor Jeff McDonald created a Twitter account in 2016 with that handle and hasn’t used it once, which is probably why he hasn’t responded to my message on there. If any of you have insights into how to solve that little quandary, please let me know.)

As always, I encourage feedback to help me improve the usefulness of my content. I also love getting to talk to others interested in this space to connect over ideas and to hear your unique backgrounds. So I hope you’ll reach out to me sometime on social media or directly via email (see my About Me page for that). Talk to you all soon!

The Theory of Money, Part 38

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Last week, I discussed “too big to fail” and how that predisposes to bank bailouts by governments, which is yet another example of how the government’s power over our 0% backed fiat money leads to them making policies that hurt us in the long run more than they help us in the short run.

This week, let’s see where money could go from here.

One intriguing idea that is already being tried in many countries is central bank digital currencies. This is basically just the same as 0% backed fiat money, but now the money would be only digital–there would be no more physical cash. There are lots of ways to accomplish this, but every application of it involves people having to use a card or phone-based digital payment method for every single transaction. We already do that for nearly every transaction in many industrialized countries, even when we are sending money to friends, so it’s not too huge of a jump to move us to this kind of digital-only cash.

The big downsides of this, though, are that we would be completely dependent on the internet being up and running to enable every transaction, and it also allows the government to track every transaction, which interferes with privacy and also gives the government greater taxation power (or maybe I should say greater tax law enforcement power–no more under-the-table transactions!). There’s also been talk of central banks finding ways to reclaim money by simply having it “expire” (i.e., disappear). With the background already discussed in this series, you can see how that would be an attractive option to enable the government to make money disappear, which would allow the government to create more new money without as much of an inflationary effect.

And what about cryptocurrencies? Will any of these private currencies ever become a country’s official currency?

I highly doubt it. Sure, you could put a central bank digital currency on a blockchain, but that’s probably the only way any form of crypto will be an official currency.

But as for a government co-opting one of the private cryptocurrencies as their country’s official currency, can you imagine any country’s government willingly giving up their power over money? If they did so, they would instantly lose their ability to create new money for spending. And suddenly the true cost of so many of their policies would become known when taxes have to be increased significantly to account for the loss of their means of “hidden taxation” (through inflation).

Switching over to a private cryptocurrency may also take away much of a government’s power of taxation/tax law enforcement because so many more transactions would be completely anonymous. Remember, for a government to be able to tax a transaction, they need to know about its occurrence and know who was spending the money. But if a transaction is anonymous, there’s no one to send a tax bill to!

So is there a point to investing speculating in cryptocurrency? (Please refer back to my definition of speculation in Part 20.) Now that we’re all the way to Part 38, I hope you have a more complete understanding of why I said that cryptocurrency ownership is solidly in the realm of speculation. So, sure, if you want to gamble with your money, that’s an exciting way to do it. And if your goal is to have some fun, which I think is the only rational goal of gambling, then go right ahead and speculate in cryptocurrency. But if your goal is to invest money for the future with the hope that it will grow over time, cryptocurrencies are a terrible investment from a risk-reward perspective.

By the way, I’m not trying to argue that no private cryptocurrency will ever stabilize in its value and become more widely accepted. I hope at least one does! And I think it’s very likely this will happen sometime in the next decade, although take that prediction with a grain of salt because I am not a crypto expert. But if we get at least one private cryptocurrency to accomplish those two feats, that would elevate it from being a speculative instrument to an actual form of money, which would offer us a great alternative to transacting in our country’s 0% backed fiat money. So, until one like that emerges from the pack, I have no interest in owning crypto of any form.

Overall, then, I guess I’m saying that I think our money has pretty much reached its final stage of evolution at 0% backed fiat money (whether that includes physical cash or not).

Next week, I’ll look over my notes from some of the books I’ve read on this subject of money and banking to see if there are any other important topics to cover. And once I’ve done that cleanup effort, I’ll move on to the final topic of this series: how we could possibly get back to commodity money.

The Theory of Money, Part 37

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Last week, I summarized the control a government has over its country’s money when the money is 0% backed fiat money. And we saw that governments tend to leverage that control to try to help the country, but these efforts probably help us in the short term but harm us even more in the long term.

Now that we have a thorough enough background in how modern governments control money, let’s look at what the government might do when a bank is about to fail. This situation may be somewhat reminiscent of the U.S. in 2008 . . .

Let’s say that a bank is looking for the most lucrative places to lend money, and it finds that there is a particularly high demand for mortgages at that time. Maybe demand went up up as a result of some new government policies that are encouraging people to buy a house . . . they loosened the financial requirements for people to qualify for a mortgage, for instance. The bank sees this spiking demand for mortgages and recognizes it as a potentially lucrative investment opportunity.

Unfortunately, the new prospective borrowers were not allowed to get a mortgage before due to bad credit or too much debt, so even though now they can qualify for a mortgage, that doesn’t change the fact that they’re risky borrowers. But the bank is okay with this because higher risk means it will be able to charge higher interest rates. And, at this time, the economy is booming. Housing prices have been going up consistently for many years, and now they’re going up even faster due to the new policy. And with the booming economy, loan defaults are relatively low, and the few who are defaulting are able to sell their house for a higher price than what they originally bought it for even months before, meaning banks will most likely get their money back even in cases of default.

Taking all these factors into account, the bank feels like it can charge high interest rates and not have the default rate that such risky loans typically have. It’s a perfect opportunity to earn a ton of easy profit!

I hope by now you can see where this is going. These days with 0% backed fiat money, if there’s a relatively sudden abundance of wealth, you know it’s usually going to be from new money being created and injected into the economy, which means the perceived wealth is higher than the actual wealth. And in this perceived abundance, everyone jumps onto the speculation bandwagon to make some easy money. And then there’s an eventual correction as prices adjust to the new lower value of money.

As long as housing prices continue to rise like this, everything’s fine. All the parties–including the ones building houses, the ones getting mortgages, the ones doling out those mortgages, the ones flipping houses, the ones investing in repackaged mortgage investments from other banks, etc.–are counting on prices continuing to rise like this. And they are making investments accordingly, pushing their leverage as far as they can to earn as much as they can while there is still easy money to be made.

And then something changes. Maybe the influx of newly created money slows down, so prices finally start to adjust to this new lower value of money. The illusion of abundant wealth starts disappearing. The real price of a house starts to become clear as people realize their money isn’t worth as much as they thought. Demand starts to erode. Prices no longer look like they’ll keep increasing forever. Many businesses in the housing market were making big investments predicting continued rapid growth and big profits, but these investments no longer make sense given the slowdown, and many of them end up being lost. This puts some companies in financial trouble, and they start laying off workers. Things spiral from there, and soon the trickle of people losing jobs and being unable to pay their mortgage increases to a deluge. The tipping point has been reached, and tons of houses start going on the market as people are trying to get out before prices drop further.

Banks start having to foreclose on houses, and it’s them who are forced to absorb all the losses. How? Well, if they gave a borrower $800,000 to buy a house and then the market drops 50% and they foreclose on the house (becoming the new owner of the house), now they own a house that basically they bought for $800,000 and is now worth $400,000.

The banks all knew it was a risky market to invest in based on the risk evaluation of the people who were getting those mortgages, but they downplayed the risks based on the illusion of wealth and because of historical trends that they expected to continue. And who can resist investing in something that everyone else seems to be making huge profits investing in?

Part of the challenge here is the difficulty in pricing things like the land the houses are sitting on, which makes it easier for the prices in markets like this to lose touch with reality because there isn’t as reliable of an anchor to say what the things are actually worth.

Getting back to our bank, let’s say the required reserve is 0.2 and the bank has $20 billion in reserves, which means it is allowed to lend out $100 billion. This is a big bank! And of the $100 billion, it was pretty aggressive and invested (loaned) $40 billion of that money in the housing market.

We are back to the same situation Indie Bank was in way back in Part 17, except now it’s not a shortage of gold in a vault that is triggering panic. Let’s see how it works with modern banking in a 0% backed fiat money situation.

This can get confusing if I don’t make some simplifying assumptions, so I’m going to do that in the hope that it helps clearly illustrate the principle.

Let’s say the bank originated all $40 billion of its loans in the housing market at the same time, and immediately the bank had to foreclose all of those loans and then sell the houses. As long as it sells the houses for a total of $40 billion, it’s not a problem. The bank hasn’t lost any money. (Sure sure, there will be delays between loaning the money and getting it back after selling a foreclosed house, plus there will be a lot of bank employee time spent on all this stuff, but let’s ignore all that for now and say the bank breaks even.)

Now let’s say the bank makes the $40 billion in loans all at once and then it has to foreclose on all of them after 10% of the principal has been paid back. If the bank can at least sell those houses for 90% of the original purchase price, then it’s gotten 100% of the loans back (10% from the original borrower, 90% from the sale of the house), plus it earned interest while the loans were being paid on. This, too, is no problemo assuming inflation in the interim was 0%.

But what if the bank has to foreclose when only 10% has been paid back on the mortgages and then they can only sell those foreclosed houses for 50% of their original purchase price? The bank will only get a total of 60% of their loaned money back (10% from the original borrower, 50% from the sale of the house). So, of the $40 billion it loaned out, it got back $24 billion and lost the other $16 billion.

Where do you subtract this lost money? Does it come straight from the reserves?

Yes. Think about it this way. Before all this happened, the bank only had $20 billion of actual money. And this isn’t the bank’s money, remember. It’s customers’ money stored in the bank. Sure, the bank was lending out $100 billion, but that was money temporarily invented to exist until the loans get paid off, and then it disappears again.

The $16 billion that was just lost was actual money. So the bank’s reserve has now dropped to $4 billion. And remember that of the $100 billion in loans, $40 billion of that was in the housing market, none of which exists anymore, so it now only has $60 billion in outstanding loans.

Doing the math ($4 billion / $60 billion), this means that the bank’s reserve ratio just dropped to 0.07. To get its reserves back up to the 0.20 requirement, it’s going to need to borrow $8 billion. I doubt in this economic situation that the reserve-sharing central bank will have any excess reserves for sharing, so it’s getting all this money from the the discount window. Depending on what the discount rate is, the bank will very likely owe a ton of interest every single day until it gets back up to the minimum reserve requirement. So much interest, in fact, that its other revenues cannot cover this interest cost. And now we have a bank that is going down the drain quickly. It will have to declare bankruptcy.

And now it’s decision time for the government. Do they step in to help?

Remember, this bank is huge. It has an enormous effect on the economy. If it fails, this will hurt everyone in one way or another. And politicians don’t like to be seen as just standing by idly watching as things go bad. The public clamor will be for them to “do something!”

The government definitely has the means to bail out this bank with newly created money. So what is a rational politician to do? They know that actively working to help during a crisis will be very popular, and they can easily justify any bailout as being beneficial for the economy by deeming the bank to be “too big to fail.”

So of course that’s what they do. They end up creating a whole bunch more money, some of which will be a gift to this bank and some of which will be a loan to this bank with a very low interest rate (which is also a gift because it means the government is paying for the rest of the interest in one way or another).

As a result of this bailout, there has been a huge transfer of wealth. Wealth came from all people owning cash and it went to this bank (or, really, its owners). The cash-owning people just unwillingly and probably unwittingly had some of their wealth taken from them and given to this bank for the sake of helping the economy.

Just to make sure this is clear, the bank took a huge risk and initially made a lot of money. So they received the upside of this risk. But then, when things went bad, they got bailed out, so they experienced very little of the downside, and instead all the cash-owning people bore the downside of their risk. From a bank perspective, this is an amazing deal!

I don’t have the means of calculating how much this bailout would benefit the economy. But I suspect, based on all my other comparisons of similar situations (like in Part 15), the long-term cost of lost wealth to individuals and to the country as a whole will be much greater than the short-term economic benefit.

And this doesn’t even take into account the effects a bailout has on the future behaviour of competitors within the banking market. For every large bank, the incentives were just changed as soon as they saw that the government will bail out any bank that is big enough to hurt the overall economy if it fails. Large banks now know that they can make risky investments and not worry so much about major losses. This skews investment behaviour. It also skews bank merger decisions (“We gotta get too big to fail!”). Basically the government has incentivized mergers and is subsidizing risky investments, which leads to overinvestment in those risky investments and underinvestment in more solid investments.

And even if one bank wants to play it safe, they will be earning a lot less profit, and sooner or later their investment strategy will be changed to put them more in line with other banks.

I have a strong preference toward free markets, but I also believe government assistance to help markets run efficiently is important. Unfortunately, intervention in a market in this way does not help the market run efficiently; instead, it skews incentives and leads resources to being dedicated to different purposes than the market would otherwise direct them to, which leads to inefficiencies in ways that are often impossible to calculate. It’s the same principle as administrative pricing that I discussed last week.

So, for this reason, bank bailouts represent yet another way that the government leverages its control over our monetary policy in an attempt to help but that harms us financially. If we let banks fail, regardless of their size, the economy will hurt in the short term, but we will avoid all the adverse effects of creating even more money, and we will also foster the right incentives in the market, both of which will lead to greater wealth and financial security in the long run. Part 38 here.

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