The Theory of Money, Part 10

We talked last week about the characteristics of optimal money and found that Goldnotes actually do a little better than gold coins.

This week, let’s move forward and see what further changes this shift to receipt money leads to.

First, let me add a new term. The general term for intrinsically valuable stuff being used as money (whether the society is using gold or corn or cigarettes or anything else intrinsically valuable) is specie. Not to be confused with species.

Ok, now let’s get back to our fictitious society to see what happens next.

Pepper Bank has become a very successful business. After the banker introduced Goldnotes, everyone in society started storing their excess gold coins in Pepper Bank because Goldnotes came to be preferable to having to carry around gold coins.

The banker, however, wasn’t finished with finding ways to make money. Now that Goldnotes were being used primarily instead of gold coins, he always had the majority of everyone’s cash wealth sitting in his vault, and he was charging them a small fee every month to do so. But he would look in his vault every day and think that all those piles of gold were just sitting there doing nothing. What a waste.

He, being a banker, was tracking pretty closely the day-to-day changes in how many gold coins he actually had sitting in his vault. He found that he was usually up around 10,000 gold coins, but it could go as low as 8,000 depending on the time of year and other factors. And he knows it has never gone below 7,000 ever since society shifted to primarily using Goldnotes. So he gets an idea. He says to himself, “Self, what if I lend out those extra 7,000 coins that are just sitting there doing nothing?”

They’re not his gold coins to lend out–they’re his depositors’ accumulated savings. But since nobody is going to need them, he figures it won’t hurt if they’re not in his vault for a while until the loan gets paid back. And he will still be holding in reserve in his vault enough gold coins to satisfy all the demands for specie. If his average is 10,000 gold coins and it has never dropped down below 7,000, he figures he only needs to keep about 3,000 gold coins in his vault at any given time and he’ll be perfectly able to meet any demand for specie.

Carefully, he starts testing this out. An entrepreneur recently moved to town and has been talking about a big idea to start building gas-powered cars, but he needs a ton of capital to first build the factory. The banker and the entrepreneur talk and, after working out the details, they agree to the terms for a loan and the banker lends those extra 7,000 gold coins to the entrepreneur. But they realize the entrepreneur is just asking for a highway robbery if he takes a big cartload of jingling coins, so instead the banker prints 7,000 extra Goldnotes and puts them in a bag for the entrepreneur to take home with him.

This is a great service to society. This new business venture, if it succeeds, is a big step toward enhancing the wealth of this society, and I’ll need to spend more time in future posts discussing why. But for now let’s stick to looking at the banking aspects.

When the banker prints those 7,000 Goldnotes and gives them to the entrepreneur, it is the first time that there are more Goldnotes out in circulation than there are gold coins in the bank. This is a big change. But nobody knows it; they assume the banker is rich enough from all the fees he’s been charging and from being a gold prospector before to lend out 7,000 of his own gold coins.

Fortunately, he was conservative in how much he was willing to lend out, so he always has enough gold coins in the vault to give people in exchange for Goldnotes any time they want, so they’re none the wiser.

In fact, something surprising happens over the next few months after he gave the entrepreneur those 7,000 Goldnotes. He now has 17,000 Goldnotes in circulation, and he finds that he still never has specie requests that total more than 30% of that (just like before), which means the maximum he ever has to redeem is 5,100 gold coins. But he still has 10,000 gold coins in the vault, remember? So he still has 4,900 excess gold coins in the vault just sitting there doing nothing!

So he goes out and again finds someone who wants to borrow some money. This time, he is willing to lend out 4,900 gold coins. So he does, and again he gives the borrower 4,900 Goldnotes instead of giving him a cart-full of gold coins.

He then again watches how his gold coin reserves look for several more months, and he finds that, again, demands for specie never exceed 30% of the total Goldnotes in circulation.

How many Goldnotes are now circulating? With his original 10,000 Goldnotes, plus the two loans, that makes 21,900 in circulation. And demands for specie never exceed 30% of that, which means he only ever needs a maximum of 6,570 gold coins in the vault. But he still has 10,000 gold coins in the vault, which means he still has 3,430 gold coins in excess just sitting there in the vault not doing anything.

This is the point where he realizes he could go through this cycle over and over, and each time the number of excess coins would be smaller. Ultimately, he gets mathematical and derives a formula, 1 / fractional reserve = the money multiplier. The fractional reserve is the percent of specie he needs to keep in the vault (he settled on 0.3, or 30%, as a safe number). The money multiplier says how many Goldnotes he can print for every gold coin in his vault. 1 / 3 = 3.3 (rounded), so 10,000 gold coins x 3.3 = 33,000. He can have in circulation up to 33,000 Goldnotes based on his 10,000 gold coins!

He only has 21,900 Goldnotes in circulation so far, so he decides to print another 11,100 of them and loan them out. Finally! His reserves get pretty low sometimes, but true to his historical trends, they never go below 0.

The banker is very happy. He ends up having about 33,000 Goldnotes out in circulation, and 23,000 of those are ones that he lent out, so he is earning interest on 23,000 Goldnotes every month! And he doesn’t have any more gold coins just sitting in his vault doing nothing.

This is called fractional reserve banking.

Is this wrong? Are new Labor Units being created? Certainly the society feels like it’s booming because it’s suddenly flooded with capital. There is a lot to process with this change, which we’ll do in the coming weeks, but my final point this week is that we just transitioned to yet another type of money!

We started with commodity money, which then shifted to receipt money when the banker created Goldnotes, and we decided this was an upgrade because even though the paper itself was almost worthless, it entitled the bearer to a gold coin, so it was still 100% backed by a commodity of intrinsic value. And now we have shifted to “fractional reserve money,” which still entitles the bearer to 100% of the stated value, but there’s only about 30% of specie actually in the bank compared to the total number of Goldnotes in circulation. So in an aggregate perspective, our money supply is only 30% backed at this point. If the reserve ratio had been set at 20%, the money supply would be 20% backed. The lower it goes, the riskier things become, which we’ll discuss in coming weeks.

The Theory of Money, Part 9

Last week, our gold prospector became a banker. And then he precipitated a change in the society to shift from commodity money to receipt money. (I originally named his receipts goldpaper, but I think Goldnotes is a better name, so I changed it.)

As is often the case, in the intervening week since writing the last post, I’ve been thinking about some things that I want to clarify.

First, I’ve never given my official list of all the characteristics of optimal money, and I think that will be useful moving forward. So, here’s my list so far:

  1. Intrinsically valuable: This requires two things. Whatever is used as money needs to have some use independent of its use as money. But that alone isn’t enough. If something is freely available without exerting any labor to procure it, it won’t necessarily cost anything even if it does have an important use. Oxygen at sea level, for instance. So the second requirement is that labor needs to be exerted to procure it, which now puts a price on getting it. The importance of this becomes clear when I get to the second characteristic . . .
  2. Value is stable over time: This requires supply and demand to be stable over time. Or, if one rises, the other will rise with it so that the value remains approximately the same after the adjustment. Of course, demand will change for all things over time as new uses–and also new substitutes–for it are found. Economic shifts also affect the demand for things (notably, luxury items will be less desirable when there’s a recession). But as long as labor needs to be exerted to procure the thing being used as money, the supply of it will be linked to demand through market effects: If the demand goes up (and price rises along with it), suppliers will work harder to procure more; if demand goes down (and price decreases along with it), suppliers will not procure as much because it may no longer be profitable to continue using the marginal capacity that they added.
  3. Nonperishable
  4. Easy to determine the quality/value of it: If metal is being used, this is easier to determine the purity and weight (and, therefore, the value) than, say, a cow, or a share in a new business.
  5. Can be precisely measured: This is similar to the last one, and these days there isn’t as much of a challenge in measuring things, although back in the day this would have been an important consideration, especially if the type of money being used had a very high value-to-weight ratio, because that would require especially precise measurement instruments.
  6. Easily divisible into the right amount for payment, and dividing it doesn’t alter its value: A live milk cow cannot be easily split into smaller values. Something like corn, on the other hand, meets this criterion perfectly. Or metal that can be melted and divided into different sizes, although that’s not as easy to divide as corn.
  7. Not too heavy: People would rather not be burdened by having to carry really heavy money.
  8. Value-to-size ratio is in the sweet spot: If buying something takes a whole wagonload of money, that’s inconvenient, even if it isn’t very heavy. On the other end of the spectrum, if you’re using diamonds for money, even losing a tiny diamond is a significant loss.
  9. Impossible to counterfeit

There might be other things I’ve missed, but that’s what I have for now. Obviously nothing will meet all those criteria perfectly, but it gives us a standard against which we can evaluate any money. So why don’t we do that right now and see how well gold coins and Goldnotes do?

I won’t go through every criterion listed above for each, but we can at least cover the highlights pretty easily.

Gold coins: Looking through the list, gold coins do a great job overall. They’re a little heavy maybe, but at least they’re fairly small (without being too small), and different-sized coins can be minted quite easily to suit different values. I said our blacksmith figured out how to counterfeit gold coins, but that was admittedly not super believable, and in modern times it would be very difficult to counterfeit gold coins and get away with it for long.

Goldnotes: Your first impression may be to think that it doesn’t meet the first criterion, but remember what I said last week–Goldnotes are directly backed by something that is equal to their stated value, so as long as you can reliably exchange a Goldnote for a gold coin then it’s not a problem. This is an important caveat, as will become clear over the next few blog posts. In some ways, Goldnotes actually do a lot better than gold coins. They’re lighter and easier to stack and carry. And their value is actually more reliable. Historically, when societies shift from metal coinage to receipt money, the banks automatically do an appraisal of each coin they receive to ensure its stated weight and quality is accurate. People couldn’t get away with clipping off the edges of a gold coin and passing it off as a full coin to the bank! Our blacksmith never would have gotten away with his counterfeiting had there been a bank around performing this service when it accepts deposits. Therefore, historically, because the receipt money’s value was more reliably known than the coins themselves, receipt money actually traded at a little bit of a premium compared to coins. So, because Goldnotes are lighter and more reliable in their value, I’m going to declare this shift from gold coins to Goldnotes an upgrade to a better currency! Thanks to the banker.

The other thing I’d like to clarify is standardization of gold coins. I’ve just been talking about them all along as if 1 gold coin was a set weight and quality. This doesn’t happen automatically of course. You could forego standardization and go around using little nuggets instead, but everyone receiving gold as payment would have to have the means of weighing them and assessing their purity. So standardization makes using metal coins much easier to use for exchange.

Historically, this is where governments would help. For example, the solidus (AKA bezant) was a gold coin minted by the Roman and Byzantine empires for several centuries. It weighed about 4.5 grams and was 24 karats. So presumably someone who found a gold nugget could take it to a mint, where its purity would be verified and, for a fee, it would be stamped into a standardized hard-to-counterfeit shape.

I won’t get into how governments figured out that they could mint them with a little less gold for the sake of keeping some for themselves, but that happened too and generally led to the failure of the coins as reliable currency.

Clarifying these details took enough space today that I’ll save the introduction of “fractional reserve banking” for next week. That’s where things really start to get crazy.

The Theory of Money, Part 8

We’ve talked about a lot of stuff by now, and the reasons for all of it will start to become clear as we progress our imaginary society toward a more modern money society.

So, let’s say a gold prospector visits the region and finds a new gold deposit in the mountain right next to the town. He establishes a mining operation there and moves to the town himself. He wants to safely store all this gold he’s mining so it doesn’t get stolen before he can sell it, so he builds into his house a huge safe.

Meanwhile, tragedy strikes. The farmer, who was storing his extra gold coins under the floorboard in his room, had a break-in when he was out working in his fields. The burglar found his emergency stash of gold coins and took them. That was several weeks’ worth of labor that he lost!

Suddenly everyone in town is a little more hesitant about storing their hard-earned Labor Units in their house. And they have all been doing that because they’ve been so industrious and have all accumulated some wealth that they’re storing primarily in the form of gold coins. That’s when they remember that the prospector has a large and secure safe in his house, so they make a proposal: “How about you store our gold savings in your safe for us? There’s excess capacity anyway in there. In return, we’ll pay you a small fee each month to do so.”

It’s a no-brainer for the prospector, and voila! Our town has a bank, and he has become a banker. And since he loves spices, he names it Pepper Bank.

Each time a person brings some gold coins to store, he carefully counts them out and makes two copies of a piece of paper. He gives one to the depositor and keeps one in the safe. The papers say how many gold coins that person has stored in Pepper Bank. And each time they visit him to put more money in the bank (or take some out), he updates the papers.

What a relief. The townspeople have a solution to their worries about break-ins. Because even if the burglar strikes again and steals someone’s deposit paper, it’s worthless. The burglar can’t show up to Pepper Bank and expect the banker to give him the person’s gold coins!

Then one day, the banker has an idea. It would be much faster for him to simply work with the town printer and make a bunch of little pieces of paper that each state, “The bearer of this paper is entitled to 1 gold coin at Pepper Bank.” And it would also be convenient for the townspeople because then they wouldn’t have to carry around bags of gold every time they wanted to buy something. They could instead use these pieces of paper for their transactions. The downside of switching over to this system is that those pieces of paper are steal-able, but at least a little stack of papers would be easier to hide in a house than a chest of coins, and the added convenience probably outweighs that downside.

The banker also thinks that if people start using the paper for transactions, more people will end up storing their gold coins in Pepper Bank, so he will earn even more money off storage fees!

What should he call these pieces of paper? Initially, he decides to call them gold coin receipts, but that’s too long and awkward to say, so it eventually gets shortened to Goldnotes.

So the banker visits every depositor and shares with them his new Goldnotes idea, and they love it, so he gives them each the appropriate number of Goldnotes to represent the number of gold coins they have already saved in his bank. And from that point on, he always gives Goldnotes in exchange for gold coins stored in his bank. He cautions everyone not to lose any Goldnotes because there will be no way to prove that they didn’t give the papers to someone else. But he does say that if a Goldnote is getting old and torn, they can bring it to him and he’ll exchange it for a nice fresh one.

Pretty soon, the townspeople are making exchanges both with gold coins and Goldnotes, because they have found that any time they present to the banker a Goldnote, he will trade it for a gold coin.

Well there you have it. We have finally made the transition to a new kind of money! We started with commodity money, landing on precious metals as the most convenient kind of commodity money, and now we have receipt money.

Is it ok that these Goldnotes are, themselves, nearly worthless? Yes, because they are 100% backed by a commodity equal to their stated value.

This is just like the title to a house. The title itself is nearly worthless (a piece of paper and some ink), but it is 100% backed by an asset, so whoever owns that title has claim to the asset that backs it.

Next week, we’ll talk about what the banker decides to do when he sees all that gold just “sitting there doing nothing” in his vault.

The Theory of Money, Part 7

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Last week, I talked about how storing Labor Units (LUs) in the form of an asset is risky because any asset is susceptible to shifts in value, so you could lose some of your LUs simply by the asset losing value. This is the risk of storing LUs, but it’s a risk worth taking in order to have some wealth saved away in case of an emergency (or for retirement).

Today I’m going to cover two more foundational ideas before I start building more on the foundation I’ve laid: (1) the cost of a lifestyle and (2) how to be immune to inflation.

The Cost of a Lifestyle

Let’s think about how many hours someone has to work to sustain their lifestyle.

Way back in the hunter-gatherer societies, people’s needs were pretty basic. Food, water, clothing, and shelter comprised the majority of their financially costly needs. There was no innovation to significantly augment the number of LUs per hour someone could generate, so when they went to work hunting and gathering and finding places to shelter, they were probably earning about 1 LU’s worth per hour. But because their needs were so simple, their total weekly cost to sustain their lifestyle was probably only around 50 LUs. So, they worked for about 50 hours, and the rest of their time was free to sleep and attend to social duties and recreate. They wouldn’t ever really work much extra like we do these days because they had no easy way to store additional wealth that they might have generated with that extra work. Storing too much extra food was pointless because saving it for too long would just make it go bad. They didn’t accumulate belongings because those were too difficult to carry around with their nomadic lifestyle. So they worked each week for what they needed and that was it.

Compare that to today. Our modern lifestyles cost way more than 50 LUs per week. Fortunately, innovation has enabled us to generate way more LUs/hour as well, so even those living below the poverty line can afford a lifestyle that is way more lavish than anyone who lived even a couple hundred years ago. But still, how much of it is necessary? Do we need to eat so much and spend to much on entertainment and travel and things? It’s this rat race of working so hard to just barely be able to afford a modern lifestyle. We also have the ability, as opposed to our ancient counterparts, to work extra to store some wealth in case of a time of need, but so many of us spend so much and work so much that there’s no leftover wealth to save or invest and no leftover time to work and generate more wealth either.

I work at the hospital an average of 4 12-hour shifts week, and I sometimes wonder how many of those 48 hours are generating LUs that simply go to sustaining my lifestyle that week. Maybe I could become more frugal and only need to work 3 12-hour shifts per week, and it would be enough to sustain my lifestyle and also invest for retirement. Then I could spend more time doing things that are more important to me. How many shifts/week would facilitate the greatest happiness and fulfillment?

How to Be Immune to Inflation

All right, so those were my thoughts on the number of LUs it takes to sustain a lifestyle and how it has changed over time. Now let’s talk about becoming “inflation proof.”

Remember last week when I talked about the blacksmith starting to counterfeit gold coins? The effect of that was that the number of LUs stored in the form of gold coins stayed the same, but the total number of gold coins had increased, so each gold coin represented fewer LUs. I’ve said this same thing in a few different ways now. Another way I’ve said it is that the LUs got “diluted” over a larger total number of gold coins. I’ve also given a ratio to express this same idea, which I inarticulately called the aggregate-number-of-gold-coins:aggregate-number-of-LUs-attempting-to-be-saved-as-cash ratio.

Understanding this principle is prerequisite knowledge to understanding inflation. We perceive inflation by seeing diffusely higher prices, but what is really happening is that the number of LUs represented by a unit of money is decreasing. So, when $1 only represents 0.049 LUs instead of 0.05 LUs, the money is worth less, which means you need to give more dollars to pay for something worth 1 LU.

There are lots of different factors that cause inflation, and I haven’t talked about most of them yet. But most of them alter the money:LU ratio by altering that inarticulate ratio above. Printing more money is one way to do it.

As a sidenote, I think this is a good place to mention that when a society uses money that has intrinsic worth (i.e., commodity money like gold or corn), it prevents a government from causing inflation (i.e., taking some of your wealth without your consent) by printing more money.

In this series, I’ve been distinguishing stored wealth as cash-wealth and non-cash-wealth for a reason. Cash wealth–if it’s the kind of cash that does not have intrinsic value–is susceptible to the government making more of it and thereby taking some of your LUs through inflation. On the other hand, non-cash wealth, such as a house or ownership in a business, doesn’t lose any value when inflation happens. Let me explain.

Let’s say the farmer has 100 LUs worth of grain that he’s stored to sell next year because he’s going to grow a different crop next year. Then, the blacksmith counterfeits a bunch of gold coins and causes 10% inflation in the intervening months. Has the farmer lost any LUs worth of grain? Nope. He still has the same amount of grain. And he’ll figure out the gold coin:LU ratio and price the grain accordingly. Maybe he would have sold it for 10 gold coins last season, but this season he sells it for 11 gold coins instead. Either way, he is getting paid 100 LUs worth of money.

In summary, cash assets are susceptible to inflation and non-cash assets are not because their prices simply change to reflect the new money:LU ratio.

So, you want to be “inflation proof”? Store your wealth in non-cash assets and you’ll be fine.

I believe this is the last of the foundation I needed to build to finally move on to more modern money things, starting with the invention of banks in our fictitious society, which is where everything changes.

The Theory of Money, Part 6

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Last week, I wrote about how the gold coin:Labor Unit (LU) ratio adjusts as the market demands depending on how many gold coins are available and how many LUs are needing to be stored.

I’ve been thinking about that topic since I wrote that, and, as is often the case, there’s something that bears clarifying.

This issue of stored LUs is a tricky one. How can you possibly store labor?

I did talk about this way back in part 1, but let me put it in different words this time.

Someone performing labor will typically be paid in accordance to the value they provided. It doesn’t matter so much what the laborer receives in compensation as long as they receive something in return that has a value approximately commensurate with the value they provided. In this way, labor gets turned into an asset. That asset could be gold coins or chickens or partial ownership of a business or anything else.

Historically, most societies have ended up using coins made of precious metals as compensation for labor. This is for many reasons, but the mains ones are that they are intrinsically valuable, they don’t rot or die easily, they’re easy to divide into different valuations, and their value to weight ratio is reasonable.

But what happens if the value of the asset you received in return for your hard-earned LUs suddenly goes down? Say, you got paid in corn, but you stored it in your damp cellar and it got moldy? Tough luck. It’s like you didn’t work as much to store as many LUs. Those LUs you earned are gone. This is why perishable things are not as handy for storing LUs. But non-perishable things are also susceptible to their value changing, so this isn’t a problem exclusive to perishable things. Even precious metals can have big swings in value depending on, of course, supply and demand, such as how fruitful the mines are, or how many other things people want to use them for.

The thing with gold (and other precious metals) is that it has built-in mechanisms to keep its value relatively constant. For example, if a society starts getting really wealthy and is trying to store more and more LUs in the form of gold coins (meaning people are starting to build up piles of gold coins in their houses), the demand for gold coins (and, therefore, its value) has increased. But in response to this, people will start acting differently. Fewer people will buy gold necklaces because they’re too expensive now. And gold miners will find ways to mine more gold, such as by adding a night shift to their mining operation or going after some gold deposits that were previously undesirable due to difficult terrain. The eventual result will be that more gold will be supplied and less gold will be demanded for other purposes, and the price will probably drop back down to close to where it was before.

My point is that market mechanisms will keep gold’s price relatively stable over time, which is very important when it’s being used to store Labor Units. Sure, innovations may end up decreasing the number of LUs it takes to mine new gold, which might make it cheaper over time, but it’s just as probable that over time more uses will be found for this unique metal, so its price may stay constant. Additionally, bigger changes in value are going to be the result of long-term changes in innovation and uses for gold (probably on the order of decades), so gold will be more reliable at storing LUs than other things that have more rapid swings in value.

I was trying to find the price of gold over the ages, but there’s no simple answer available. Even comparing the amount of gold someone would be paid for a day’s worth of unskilled labor in ancient Rome to a day’s worth of unskilled labor today, the number of hours would differ, the working conditions would differ, the quality of the gold may be different, and the quoted ancient prices of gold may have been influenced by government price setting (such as by anchoring a gold piece’s value to a set ratio with the value of a silver piece). So I don’t have any reliable information to show how stable the price of gold has been over the ages.

But I hope my point is clear: No matter what you use as money, it’s always going to be susceptible to shifts in value (meaning the LU:money exchange rate will always change), so the best we can hope for is something that meets the other criteria for an optimal money (i.e., nonperishable, easily carried, easily divided into different amounts, etc.) and that will also shift in value minimally or slowly or predictably.

Now, let’s consider an application of all this to our modern day. For the sake of simplicity, I’ll describe a scenario using our fictitious gold money-based society, and then I’ll talk about its application after.

Let’s say our blacksmith invents a way to counterfeit gold coins. He takes some worthless metal refuse, stamps it into the form of a coin, and paints it gold. The deception will be found out sooner or later (like when someone tries to melt down the coin to make a necklace, or when the paint chips), but until then, think about what would happen.

The total number of Labor Units that people are storing in the form of gold coins hasn’t changed, but suddenly gold coins are much more plentiful. This will make the value of gold coins drop rapidly. In other words, each gold coin will now represent fewer Labor Units. If someone has stored 1,000 LUs in the form of 100 gold coins (because the previous exchange rate was 1 gold coin:10 LUs), maybe now the exchange rate is only 1 gold coin:5 LUs, so their 100 gold coins are only worth 500 LUs now. Their purchasing power has been cut in half.

Things will self-correct once the counterfeits are found out, but what if those counterfeits are never found out? What if the blacksmith keeps counterfeiting more and more gold coins and they all stay in circulation?

The gold coin:LU exchange rate would continue to slowly adjust. What started as 1 gold coin:10 LUs would drop to 1:5 and then 1:1 and keep dropping as long as new counterfeit coins are entering circulation.

Prices would adjust along with the gold coin:LU exchange rate. If the blacksmith’s cook pot used to cost 1 gold coin (because it’s worth 10 LUs), with the new gold coin:LU exchange rate of 1:1, the price would have increased all the way up to 10 gold coins. People would say, “Remember 10 years ago when everything was so cheap? We could get a good quality cook pot for a single gold coin.”

But remember that the true price of things has not actually increased. In fact, I bet innovation in the intervening years would decrease the number of LUs that it takes to make things like cook pots. What’s happened is that the asset people are using to store their LUs in has lost value/purchasing power.

In most countries today, we use paper money, which has negligible intrinsic worth. The government (or, in the U.S., the Federal Reserve) can print as much of it as it likes. Each time they print* more money (like for a COVID-19 stimulus), the US Dollar:Labor Unit ratio has changed. Maybe in 2020 the ratio was something like 1:0.05, but now it’s dropped to 1:0.049. It’s a small change when I write it like that, but let’s think about this for a minute.

First question: Were any new labor units created when the government printed that money? No. So there are the same number of total labor units stored in the form of cash assets. But there are more total dollars now, which means each dollar represents less labor that it did before. The Labor Units stored as cash have all been diluted over a larger total number of dollars.

This is an important point. No new labor units were created! Printing money is not a way to make a society rich. It just dilutes the Labor Units already stored as cash.

So if someone worked hard and earned 1,000 LUs and chose to store them in the form of $20,000 (when the exchange rate was 1:0.05), now how many LUs do they have after the government printed a bunch of new money and changed the exchange rate to 1:0.049? They still have $20,000, but it’s now worth only 980 LUs. This is only a decrease of 2% of their cash-stored wealth, but if government is doing that every year, it will be slowly taking away this person’s savings of LUs without them even realizing how it’s happening!

In this way, the government is acting just like the blacksmith counterfeiting gold coins. They are not generating new Labor Units, they’re just taking them from others through dilution of the money supply.

One last interesting point. The government, when it creates this money, is the first one to spend it. The act of spending this new money is what introduces it into circulation. And prices will only adjust after the new money has entered circulation. So, not only does the government have all this new money that it can spend, but also it gets to spend it at pre-inflation prices!

Ok, this was a longer post than the others in this series, but I wanted to get to this stopping place. I have more to say about the theory of money–we haven’t even invented banks yet!–so this series will be continuing for several more weeks at least, after which I’ll get back to my usual health policy topics.

*I’m speaking metaphorically. Generally these new dollars are not printed, they’re created in a computer at the Federal Reserve by simply changing the listed value of an account. But the effect is the same.

The Theory of Money, Part 5

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Ok, part 5 already!

I’m going to explain what I promised at the end of part 4. But, first, I’d like to clarify a couple things so that my explanation makes sense.

First, I tried to describe this before, but let it sink in: The simplest way to quantify the true value of something is in Labor Units (LUs).

Therefore, when I am quantifying the true value of accumulated wealth a society has, I will tell it in terms of LUs. I could instead quantify it in terms of gold coins, but remember what I said in part 2 that this adds a conversion factor (the LU: gold coin exchange rate), which can muddy the waters when that exchange rate changes.

Second, wealth can be stored in many ways, but I’ll divide them into two broad exhaustive and mutually exclusive categories (my favourite): cash assets and non-cash assets. So someone’s total wealth is their cash assets plus their non-cash assets (minus any debts they have).

Great. Now let’s answer the question of how much gold our fictitious society needs to be able to store all its wealth.

Let’s say our society had one goldmine and that it collapsed, so there is no access to new gold. In other words, the total amount of the gold in the society has become fixed (apparently no one loses any gold either).

Everyone is working very diligently for a year and they all get bitten with the save-up-for-an-emergency bug, so they start trying to save some extra cash (in the form of gold coins, of course, since that’s the only form of money our society has so far).

As the total number of LUs attempted to be saved as cash increases, the demand for gold coins increases, so each gold coin comes to be worth more LUs.

This was a really short lead-up, but hopefully it’s enough to illustrate the principle that any amount of gold is enough to store the entire cash assets of a society because the gold coin:LU exchange rate will adjust to meet the market’s needs.

I guess this provides a new way to calculate the value of a gold coin. It can be determined by the aggregate-number-of-gold-coins:aggregate-number-of-LUs-attempting-to-be-saved-as-cash ratio.

This will be useful information when we talk next week about what might happen if someone figures out how to counterfeit gold coins, which will finally offer some (possibly troubling) insight into at least one modern money issue.

The Theory of Money, Part 4

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Let’s continue on with the theory that will help modern-day money issues make sense. In part 3, we talked about the options of what someone can do with their excess wealth that they have stored in the form of money: spend it, save it, or invest it. And that there are two types of investments: lending or ownership.

If society is continually getting new wealth introduced by wealth-gleaners, does that mean society is getting wealthier and wealthier?

No. Wealth is always being introduced into society, but it’s also being lost. When someone spends their wealth on something that depreciates/gets consumed, that wealth is slowly being lost.

For example, when the farmer eats some of the food he has grown (maybe his family consumes 1 Labor Unit’s (LU) worth of food every meal), that wealth has been consumed. It’s all gone.

Or, when the blacksmith paints his house black, that paint is slowly getting worn off and the house will need to be repainted in several years. If he paid a total of 20 Labor Units (LUs) to paint his house—5 LUs for the paint, and 15 LUs for the painter—how much was lost? The painter has 15 LUs in payment, so that was a simple transfer of wealth, not a consumption of it. And the paint got consumed, but maybe 1 LU’s worth of the paint’s price was profit for the paint maker, so that too was a simple transfer of wealth. Assuming the paint maker didn’t have to buy supplies from someone else, then we could consider the rest of the cost of the paint as being consumed. 4 LUs total.

This goes to show that when someone chooses to spend their wealth, not all of it is lost from society. But some of it is. Compare that to when someone chooses to save their wealth by stashing their gold coins under their floorboard. When they save their wealth, it’s preserved (assuming the price of gold stays constant). And when someone chooses to invest their wealth, the impact on the total wealth of society depends on what the investment is in.

If the investment is in a company that provides luxury items, then it’s one more thing that people can now consume their wealth on, so it will probably lead to a net decrease in society’s stored wealth. Maybe the paint maker invests wealth into the development of a new kind of paint—glittery black paint—which costs 10 LUs instead of 5 LUs. Even if 3 of those 10 LUs are profit for the paint maker, it’s still 7 LUs getting consumed on paint for the blacksmith’s house instead of only 4 LUs.

If an investment is in a company providing non-luxury items, it could lead to a net increase in society’s stored wealth. For example, maybe the paint maker invests his wealth into developing a new kind of paint that takes the same effort to produce but it lasts twice as long. He has just lowered the cost of living (assuming painting a house is necessary for the sake of preserving the wood so the house lasts). The blacksmith only needs to repaint his house every 10 years instead of every 5 years, so less wealth is being consumed to maintain his standard of living.

Or maybe the blacksmith invents a new kind of plough that decreases the time it takes the farmer to glean wealth from the land.

Whether the company is lowering the number of LUs it takes to maintain the same standard of living, or whether it is enabling more wealth to be gleaned from the land, it will be increasing society’s total amount of stored wealth.

One thing I haven’t already mentioned is the impact of war and natural disasters on the total amount of wealth a society has. These things cause a society to lose a lot of wealth. For example, if there is a flood that destroys the farmer’s crops, a ton of LUs worth of wealth has been lost from the society in the space of a few hours or days. Or, if the society starts having to spend a bunch of LUs on guns and ammo instead of on living essentials, it’s similar to black glitter paint; the investment into developing those things will not help decrease the cost of living or increase the efficiency with which new wealth can be gleaned from the land (assuming the innovations don’t cross over and help in other ways), and spending LUs on guns and ammo means those LUs will get consumed and therefore lost from society.

So now we’ve considered the main factors that lead to an increase or decrease in the total amount of stored wealth a society has.

Next week I’ll get to how much gold is needed for a society to store all its wealth in gold.

The Theory of Money, Part 3

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Links to part 1 and part 2.

Ok, so we’ve talked already about the purpose of money and then delved more into wealth and where it originates and is distributed, and I also introduced Labor Units (LUs) as a standard unit of labor and showed how it can also be used to quantify wealth and the true price of things.

This week, we’ll continue on with our early society to discuss what we can do with stored wealth/stored Labor Units.

Remember that blacksmith? Let’s say he’s been selling a lot of items and has accumulated a lot of gold coins that he doesn’t need to use in the near future. He has a three options of what he can do with that excess wealth/stored labor.

Option 1: Spend it. He can finally splurge on painting his house black like he’s always wanted. He is consuming his stored wealth, but it doesn’t just disappear out of society because it gets transferred to the paint supplier and the painter in compensation for them providing those goods and services.

Option 2: Save it. In other words, keep those coins hidden under his loose floorboard. Or maybe there’s a vault somewhere that he can rent space in to more securely store it.

Option 3: Invest it. My definition of the term “invest” is that you give up something now with the expectation of getting back more later. So he will give up that money now expecting to get it back plus some more later.

There are actually two different kinds of investments he can make: (a) He could simply loan his money to someone, or (b) he could purchase something that will earn money for him.

The loan option is straightforward. The farmer wants to buy a new plough, so the blacksmith loans the farmer 10 gold coins to buy a plough, and then the farmer pays him back 11 gold coins after the harvest. Hopefully the plough enabled the farmer to be so much more efficient that he earned enough to pay the blacksmith back the principal plus interest. The modern equivalent to this is investing in bonds.

The “purchase something that will earn money for him” option is more flexible, and it comes down to him putting his money into some kind of business venture. Maybe he has a passion for town news and wants to start a town newspaper with the new town printer who owns a printing press. Maybe he wants to own 30% of a new mail carrying venture that his neighbor is starting. These investments could be relatively active (with him contributing his own labor, like doing all that work with his printer friend to found a newspaper) or relatively passive (like buying 30% of his neighbor’s mail carrying venture, where the only thing he’s contributing is money and he is promised a share of the profit commensurate with the percent of the business that he owns). The modern equivalent to the active investment type is starting your own business, and the modern equivalent to the passive investment type is buying stocks.

So, as a society becomes wealthier, more people have more excess wealth stored up in cash, and then they can choose among those three options what to do with it. Note that choosing to save the money (as opposed to spending or investing it) is the only option that doesn’t put that stored wealth back into circulation to be used and reused in society.

Let’s stop there for this week. Next week, I’ll talk more about how wealth gets destroyed, how much money a society needs to be able to store all its accumulated wealth, and maybe we’ll even get into the origin of banks.

The Theory of Money, Part 2

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Last week, I talked about the origin and purpose of money and also how new wealth is introduced into a society. This week, I want to talk more about how wealth transfers from one person to another.

As I explained before, new wealth is always being generated using the land + labor combo (i.e., the natural resources from the earth, combined with human labor, produce new wealth). We could call the people doing this work the wealth-from-the-earth-gleaners (or maybe wealth-gleaners for short). Wealth-gleaners are the original owners of all wealth in society, and then they distribute that wealth to others in exchange for the goods and services they want. In this way, the wealth of a society is both generated and distributed.

I don’t want you to assume that just because someone is the original generator/owner of wealth that it means they will automatically be wealthier than all others. Think about a farmer working a particularly infertile plot of land. He may be only generating just enough wealth (in the form of crops) to have a roof over his head and clothes on his back and food on his table, and nothing extra. This is what Adam Smith called a “subsistence wage,” when you’re earning just enough wealth to continue subsisting and that’s it. This farmer’s wealth, as limited as it is, will still be distributed to others in society when he buys things he needs from them, such as clothes or a re-thatched roof.

An interesting effect of wealth-gleaners being the original generators of new wealth in societies is that the society’s growth of total wealth is limited by how much these wealth-gleaners are generating and introducing into a society. So, if you want the total wealth of a society to grow quickly, you want the farmers and other wealth-gleaners to be rich (i.e., generating way more than just bare subsistence wealth for themselves)!

The foundational nature of labor in the generation and distribution of wealth should be clear by now. So I’m going to take advantage of this by quantifying wealth in terms of standard labor units.

*Trumpets sound*

I hereby define a new standard unit of labor, which will be known as a Labor Unit (LU), as one hour’s worth of unskilled, low-risk, average-physical-intensity work.

Let me explain that a little bit. One LU could mean an hour’s worth of a farmhand picking fruit from the orchards, or it could be the blacksmith’s assistant carrying wood for the forge and pumping the bellows, or any other labor of that ilk. If the work is especially onerous and/or dangerous and/or if it requires training and expertise, then one hour of work could generate more than 1 LU. And if it’s super easy work, it could generate less than 1 LU/hour. This should all be obvious–when I work as a physician, I make more money per hour than when I worked at Costco as a teen.

One important use of this idea of a Labor Unit is that it can quantify the cost of production of anything. If a blacksmith’s time is worth 4 LUs per hour (he is very skilled), and it takes him 1 hour to make a cook pot, the cost of labor that went into that cook pot is 4 LUs. And if the cost of the metal plus the depreciation of his shop plus cost of wood for the forge plus cost of his assistant’s time etc. all totaled to be 2 LUs, then he will break even if he exchanges the cook pot for something else worth 6 LUs. If he sells it for 7 LUs because this pot turns out especially beautiful and round, then he has made a profit of 1 LU.

The beautiful thing about LUs is that their value remains constant over time because they are defined by a constant (1 hour of non-dangerous/average-onerousness/non-skilled labor). This means that if the price of cook pots goes down over time, it’s attributable to a change in the total amount of labor required to produce one (assuming profit is the same). For example, maybe the price of metal (in LUs) has gone down because a new innovation now allows it to be procured for less labor. This would be reflected in the price of cook pots going down (assuming profit is constant).

When we quantify the price of something in money instead of Labor Units, we add an additional confounding element. For example, let’s say an ancient society is using gold coins as money, and suddenly it’s all the rage to worship golden calf statues. The demand for gold has gone up, which means the price of gold has gone up as well. So maybe a single gold coin used to be worth 1 LU, but now a single gold coin is worth 1.2 LUs. Therefore, the price of that blacksmith’s cook pot has changed! He had a price tag on it that said “7 gold coins”, but he crossed out the 7 and wrote 8.4 instead. The customers might all complain, saying he’s gouging them! But really what’s going on is that the exchange rate from LUs to gold coins has changed. The cook pot is still worth 7 LUs (cost plus profit), but since prices are never displayed in my fictitious Labor Units, we have to quantify them in money, and therefore this additional LUs:money exchange rate is integrated into every price.

The upshot of this is that any time the price of something changes, it could be due to two different things. Either the LU:money exchange rate has changed (i.e., the “listed price”), or the amount of labor required to produce the thing (i.e., the “true price”) has changed, or both.

I feel compelled to add, for anyone who’s wondering what the point of all this is, that the real-world application of these principles of money may not yet be apparent, but these are the pieces of information that will allow later discussions on inflation and government debt and the role of cryptocurrencies to make sense. We’ll get there! Part 3 here.

The Theory of Money, Part 1

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I have many interests. The ones I write about on this blog are generally related to government in one way or another.

One of the government-related topics I am really interested in, but haven’t yet written about, is money. And since I’ve been thinking about it and trying to figure it out lately, I’ll share a few posts on the topic.

Let’s go back to the early days of human civilization. Farmers worked the land and were able to raise a crop and then sell the food. Blacksmiths made things and sold them. How did everyone obtain the things they needed that they couldn’t make themselves? Originally, it was through barter. For example, “I’ll give you one bushel of wheat for that cook pot.”

But simple barter of these self-produced items has a problem. If a blacksmith worked really hard and made more stuff than he could sell immediately, then he had to find space to store piles of nails and cook pots and horse shoes and swords. That’s inconvenient. Or, think of the farmer who has a nice big crop of perishable food but doesn’t need to use it to barter for anything just yet. The need arose for a more convenient way to store wealth.

Enter precious metals. They are easy to divide into smaller units, they are intrinsically valuable, they don’t spoil, they don’t take up a ton of space, their value stays remarkably constant over time. They are a great form of money! They very conveniently achieve that primary purpose of money–which is to act as a means of storing wealth. They also enable someone to conveniently transfer that wealth to others in payment for a good or service, which is another really important characteristic of anything people are going to use as money. For these reasons, many (most?) civilizations eventually landed on precious metals being the preferred commodity to use as money.

I’ll talk about the transition from precious metals money to the paper money we have today, and also how cryptocurrencies fit into all of this, in another post. But there is one more theoretical aspect of money that I want to explain in this post.

If money’s purpose is to store wealth, where does wealth come from anyway?

I’ve already said that the farmer generated his wealth from a combination of two things: the land plus his labor. This land + labor combo is the origin of all wealth. And then after that wealth had been gleaned from the earth through labor, it could then be transferred to other people, including those who didn’t glean their wealth directly from the land, through exchange. For example, the farmer would give food to the blacksmith in exchange for making him that cook pot.

These days, relatively few people are employed in direct wealth-gleaning-from-the-earth occupations, but this is still the true origin of any wealth that is had on this earth. Therefore, any money anyone has today is actually stored wealth that was originally gleaned from the earth (or, sun, in the case of solar)! Part 2 here.

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