The Theory of Money, Part 41

Image credit: Bill Watterson

Over the course of 40 installments in this series (Part 40 here), I have tried to explain the theory of money as clearly as I can. Writing is a big part of my learning process, and before I started this series of posts I didn’t think that I would end up believing that the best monetary system is actually the most rudimentary one–commodity money and 100% backed receipt money. But I understand (and tried to demonstrate) why every major modern economy has gone down the path they have to 0% backed fiat money.

And now, let’s suppose I could design a monetary system from scratch. (I like designing systems from scratch–it’s an opportunity to imagine the idealized version of a system.) The from-scratch monetary system I outline in this post is based on the theory of money I have explained in the last 40 posts, and it’s also mixed with my personal biases toward simplicity and market-based solutions (for reasons I’ve described elsewhere). So I’m not claiming it’s the only form an optimal system could take. But, with the understanding I have now, it would be my preferred optimal system. If you’ve come on this journey with me, I hope you will easily be able to understand the rationale behind these choices.

Ok, where to start? The first important thing to recognize is that if a country’s monetary system is left to its own devices, it will sooner or later go down the path that terminates in 0% backed fiat money. Thus, to prevent that, some rules need to be outlined up front. And these rules also need to apply to the government so that it doesn’t succumb to the lure of manipulating the money supply to get more Labor Units for spending. Therefore, these rules need to be codified into the country’s constitution.

Here is my list of constitutional rules that would shape a country’s monetary system:

1. No national currency. This does not mean there will be no common medium of exchange–it just means the government will not give a special name to a specific weight of a specific precious metal. Instead of a national currency, prices will be dictated in weight of whatever precious metal is being used as the common medium of exchange. On this point, I don’t know if it’s best for the government to help solve a collective action problem and specify a preferred (but not required) precious metal, or if this could be left up to the market as well. I suspect people would end up using gold and/or silver, but other precious metals may work just as well or better.

On this topic of selecting the best precious metal to be used as a common medium of exchange, I didn’t mention this before, but if the demand for a precious metal is determined by its industrial use plus its monetary use, I suspect that the price of a precious metal that has a very large industrial demand will be fairly stable even if you add a monetary demand component to it (by starting to use that metal as money in your country). So, if other countries also start or stop using that precious metal for money, the price won’t be as significantly affected. And stability in price is one of the most important features of an optimal money.

The reason I don’t want the country even defining a specific weight of a specific precious metal as its national currency is because it adds conversion factors and complexity to the world market (which creates inefficiencies in the international market), and it may lock a country into a specific precious metal or a specific amount of a precious metal that ends up being less useful in the future.

Also, if people start thinking of money as anything other than a quantity of the commodity they are using to help facilitate exchange, it is the very first step down the path toward 0% backed fiat money. In other words, once you think of money as this specific thing that the government has defined, it is much easier for you to apply that same name to a piece of paper that represents the original money, and, given enough time exclusively using those pieces of paper, a society can eventually forget that those pieces of paper are not actual money. I demonstrated all of this already in this series.

2. No government involvement in coinage. If people want to use precious metals in the form of coins as opposed to lumps that need to be weighed, then businesses will form to provide that need to the market. This means different weights of coins will be produced by different companies, and it means any number of coins can exist in the market. Standardization will naturally arise around certain weights according to what people end up finding the most useful and therefore preferring. And those will be free to change (no pun intended) over time as the situation dictates.

3. Receipt money is allowed. This means people can pay for things using bank notes. A bank note will state its value in terms of the weight of a precious metal that it can be redeemed for. To get a bank note from that bank, it will be a simple process of giving the bank the appropriate quantity of precious metal, and they will give you a bank note in return. There would probably be a small fee associated with this exchange.

However, rather than using bank notes, people will probably actually just deposit their precious metal into their bank account (which would state the total weight of precious metal they have stored there) and then pay electronically, which would direct their bank to send the specified amount of metal to the payee’s bank and deduct that amount from the person’s account.

The risk here is that people start using bank notes and electronic forms of payment so much that they forget that they’re actually using a commodity to facilitate their exchanges. I suspect that coins would still be used regularly enough that that is unlikely to happen. Plus, all the accounts and bank notes will continue to be quantified in terms of weight of the precious metal being used as money.

4. No fractional reserve banking. In fact, no form of exploitative loans (i.e., where the person loaning some money doesn’t have the assent of the owner of that money to loan it out) will be allowed at all. This means that if a financial institution is overseeing someone else’s money, they will have to get the assent of the owner of the money before loaning it out. And this means that the owner of the money will expect the financial institution to tell them when they will have access to their money again and how much the institution will be compensating them for allowing it to be loaned out like that.

The implication of this is that fractional reserve banking is not allowed. All money substitutes will be required to be 100% backed, which will prevent those monetary expansions and contractions that are so harmful.

And to ensure banks are being honest and keeping 100% of the total demand deposits (i.e., deposits that someone can go and withdraw immediately, whenever they want) on hand, they would be audited randomly multiple times per year to make sure the amount of precious metal in the vault matches up with the total amount of demand deposits.

5. The government will be required to save up an emergency fund as I described last week. The specific details of the saving method and rate (such as a required 5% annual savings until the emergency fund is filled up) and what constitutes an emergency are important to define. But the important point here is that we have to acknowledge that if a government doesn’t have the ability to create money whenever it likes, it needs another way to reliably access more money in the event of an emergency, and saving up for the future makes the most sense here.

The government will also need to be allowed to borrow money in case a second emergency follows closely on the heels of the first emergency and the emergency fund is not yet replenished. This ability of a government to go into debt is undesirable, but it can be restricted to emergencies only, and I think it would be necessary because, for example, if an enemy country sees that the emergency fund is depleted and decides to attack, not being able to borrow any money to fund a defense in that war would be a huge problem.

6. No bank bailouts. This may be mostly a non-issue if there’s no fractional reserve banking, but it’s worth adding in here to make it clear that banks, like every other business, have a risk of failing. And if we don’t let the natural consequences of the market weed out the imprudent banks, the industry will be filled with imprudent financial decisions.

So, for an individual deciding where to store their money, they will also have to consider how risky a bank is before choosing to store their money in it. This forces banks to be prudent in their financial decisions because they know that nobody will want to choose them if they are overly risky. Standardized financial reporting requirements will be important so that everyone can compare the risk of different banks apples to apples.

Banks can go out and buy deposit insurance if they want to especially reassure potential customers, but this would not be government-sponsored deposit insurance, so the insurance company would have every right to deny the request for insurance, and they will probably want to analyze the bank’s level of risk very thoroughly and also employ risk management strategies prior to agreeing to insure the bank’s deposits. In this way, the price of the deposit insurance that the bank pays will be based on the bank’s true actuarial risk.

7. No government bank. To avoid various conflicts of interest, the government will not own any share in any bank. And, of course, the other rules above already make it clear that there will be no money-creating central bank either.

All right, I think that covers the main things that would be needed in a constitution to permanently establish my idealized version of a financial system. Let me talk about the expected effects of those rules.

First, they would force the government to get all its money through taxation and, in very rare emergency cases as discussed above, borrowing. But, ultimately, since the government would have to use taxes to pay back those loans, all money that the government receives ultimately comes from taxation. The overall effect of this is that government spending will be much more transparent because it will almost always be coming directly out of taxation instead of out of the hidden tax of inflation or the future tax of debt. And this is very important because only when citizens know the full cost of something (and are required to pay it in the near term) can they more rationally weigh the true costs of any policy against its benefits.

Second, these rules will make the financial sector much simpler and more stable. A lot of benefits come from those two characteristics. Simplicity keeps administrative expenses to a minimum and allows investments to be more comprehensible, so investors will be able to make more rational investment decisions. Stability encourages more investment, so domestic and international capital would flow in.

Third, the benefits to the economy as a whole would be even more significant. Booms and busts would be minimized, and societal defaults would be done away with entirely; think of all the shattered lives and lost fortunes and ruined retirements that that benefit alone would prevent. The economy overall would also be more efficient and would facilitate the generation of greater wealth. And there wouldn’t be so many forms of incidental and destructive wealth redistribution.

It’s hard to adequately describe the protean benefits, large and small, that people would experience on a day-to-day basis if we could get to a monetary system like this, but I hope that gives you a glimpse of it at least.

And to close this post, I want to emphasize that maximizing the generation of wealth is not the only goal an economy has. There are many reasons that policies can be enacted that decrease the generation of wealth in favor of other priorities, whether it be to secure various human rights that the culture has agreed upon or to promote ecological sustainability or others. And those priorities are perfectly compatible with a monetary system like this. In fact, I believe this monetary system would secure a more firm foundation for pursuing other non-wealth-increasing purposes than any monetary system currently existing on earth.

And now is probably a good time to say that I don’t believe this monetary system is realistic at all–at least not in the U.S. in the near future. So, next week, in what may be the final installment in this series, I’ll describe the simplest course I can imagine that could at least get us close to a system like this.

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