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.

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