The Theory of Money, Part 27

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In Part 26, our fictitious society finally transitioned to a uniform currency. To be clear, their money is still backed by gold, but their receipt money is now uniformly First Bank Notes.

Since that transition, transacting has become easier because now everyone is using the same notes, and they are each worth the same as a gold coin, which is much simpler than what they had to do before when they were trying to account for discounted Goldnotes from many different banks.

But a question arises about this system.

What happens if a bank has a ton of people come and request specie in exchange for First Bank Notes? Aren’t we risking banks running out of specie since there are many times more First Bank Notes than there are gold coins in any one bank?

The answer is that if a bank has to give up a ton of its specie, it is getting First Bank Notes in return, which it can then take and get specie from any other bank.

But this brings up another question.

What’s the point of a reserve-sharing central bank if any bank can get reserves from another bank simply by giving a bunch of First Bank Notes that it has on hand? It seems like all bank reserves have become shared since the receipt money now in use entitles a person to a gold coin at any bank.

This is true, and it means I haven’t perfectly thought through the exact steps that a banking system takes to get from there to here. Sure, these steps are just transitional steps, but I think it’s important to understand each one thoroughly nonetheless.

So this is what I’m going to do. I’ll stop here this week and do some more reading and thinking by next week. This is a great reminder of an important point: my knowledge is imperfect. I hope that’s not a surprise to anyone. I’ve written before about academic integrity, and I just re-read that post and still completely agree with everything I wrote. I recommend taking a look at it. It applies to my knowledge of money and banking just as much as any other topic.

The Theory of Money, Part 26

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Last week, we saw President get his government into the banking business by shifting all his government money into a newly created government-run bank that we are calling First Bank. President also implemented some safeguards to lower the risk of him losing this new revenue stream and his entire government savings in one fell swoop. These consisted of establishing a reserve-sharing central bank, establishing a minimum reserve ratio, and also giving himself the authority to suspend banking transactions temporarily in the event of a bank run or other financial emergency.

I’m going to now throw caution to the wind and move things quickly through the last several changes to this monetary evolution. But I don’t want it to seem rushed. I want each change to be shown as a logical and reasonable next step for the decision makers to make, given their circumstances. And once we get this money to the end of my planned state of evolution, then we can take some time to process the impacts of those changes after that.

We haven’t seen much bad banking behaviour in our fictitious society so far, but historically there probably would have been a number of exciting events by now, including some bank runs that led to bankruptcies, some banks that were on the verge of bankruptcy and stayed afloat by temporarily ceasing giving specie in exchange for their Goldnotes, and others that were forced to cease business or get bought out due to unscrupulous practices.

All these events commonly happen if a society is given enough time with fractional reserve banking. And an important result of it is that the bank notes from some banks end up being traded at a discount relative to their stated worth because of uncertainty about whether the bank will continue to be in business or continue to exchange its bank notes for specie.

For this reason, things have gotten confusing. There are a bunch of different banks issuing Goldnotes, and all of them have different values.

First Bank’s Goldnotes, on the other hand, are seen as more reliable. People believe that if the government is backing a bank, it’s more likely to come out all right in the event of a panic, so it’s quickly becoming the de facto currency for commerce.

President sees all this and decides it’s time for a change. He wants more uniformity in his country’s monetary system, which will decrease the frictions people are experiencing when they are transacting with different forms of receipt money. President hopes this change will “grease the wheels of commerce.” And, with a government-run bank at his disposal, he has all the tools necessary to finally do this.

So he declares that First Bank now has a monopoly on issuing bank notes, and he passes a legal tender law (explained in Part 24) backing that up. To symbolically demonstrate this change, all First Bank Goldnotes will be newly printed with a new pithy name: First Bank Note.

*Moment of silence for Goldnotes*

And on these new First Bank Notes will be the legal tender inscription: “This note is legal tender for all debts, public and private.” Each First Bank Note will be worth one gold coin, which means any bank will be required provide one gold coin when they are presented with one First Bank Note. This will establish a stable value (relative to gold coins) for the country’s new official receipt money.

The logistics of the Goldnote phase out would be relatively straightforward. Each bank’s Goldnotes will be assigned a value based on the current accepted value in the market. Then the issuing bank will be provided with the correct number of newly printed First Bank Notes to allow them to buy back all their circulating Goldnotes. People will be required to trade in all the Goldnotes in their possession within, say, 1 month, after which time no more buybacks will be allowed.

So if Indie Bank Goldnotes are trading at 0.9 their stated worth (a residual effect from the scare I described in Part 17), and they have 1,000 Goldnotes circulating, they would be given 900 First Bank Notes with which to buy back the Goldnotes with the Indie Bank stamp on them. I’ve ignored fractions of gold coins until now, and I’ll continue to do so; surely this society can have half coins, quarter coins, etc., and it can have receipt money that reflects those fractional coins as well. I just think talking about that doesn’t help explain anything and risks confusion.

Anyway, we have finally achieved a uniform currency! If my planning is correct, there are three other big monetary changes that need to take place, which I will describe starting next week.

The Theory of Money, Part 25

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Last week, we introduced a new character, who we named President. He is the representation of the government over our fictitious society. And we introduced his quandary as well: He (his government, really) is limited on how much he can tax people, and he is limited on how much more he can borrow as well because he still owes money from his last war. He’s worried about another war arising, which he would have no way to pay for, so he’s vulnerable. Therefore, he has been looking for a solution to this concern. That’s when his economic advisor tipped him off to this part of his country where there are five banks that have implemented fractional reserve banking and a reserve-sharing central bank, all of which seems to be bringing a lot of wealth to the area while the bankers are making a killing lending out other people’s money. So what does President do about all this?

His first thought is that he needs to get into the banking business. Currently, when the government gets paid taxes, he is storing it in several different local banks (he knows about diversification), and he realizes now that these banks may actually all be lending out his government money and earning interest on it!

So he passes a law chartering a brand new bank. I guess since we haven’t ever actually named our society, I will say that the new government-owned bank is called The First Bank of Our Fictitious Society. We’ll call it First Bank for short.

President then takes all the government’s money (in specie) out of those other banks and deposits it all into First Bank. First Bank now has 50,000 gold coins in it, which can all be used as reserves to establish fractional reserve banking and earn the government some money! If he chooses a reserve ratio of 20%, that means the money multiplier is 5, so 50,000 gold coins can act as the reserve for 250,000 Goldnotes.

If he is lending out all that money at market rates, let’s say he is earning 5% on it, which means he now has a new income stream of 12,500 gold coins every year. He just increased his income substantially! This alone could pay off his war bonds if he puts all of it into them over the next 10 years. What a relief. This will probably persuade banks to lend him more money next time (and persuade more citizens to buy war bonds) if another war happens and he has a larger revenue stream plus a history of repaying his government bonds.

Unfortunately, he has no idea the costs he is inducing on society as a result of this seemingly flawless financial trick. But all this banking stuff is so new that there really aren’t many people who have figured out all its effects yet, so we can’t blame him. And, realistically, he may not be inducing any new costs on society anyway because, chances are, all the banks that used to be storing the government money were already lending it out through the magic of fractional reserve banking. So really there are no new costs to society as a result of First Bank being created, it’s just that the government is now sharing in some of the profits of the banking industry.

But, now that he has stored all his government money in a single bank, he has to worry about bank runs. Remember, he understands diversification, so he knows that if his bank ever has to declare bankruptcy, he will lose all his government money, which is even scarier of a prospect than the threat of an enemy attacking him at this point.

So he implements some safeguards.

First, he gets all the banking leaders together in his region and establishes a reserve-sharing central bank.

Next, he uses his legislative power to require the daily interest rate for all reserve-sharing central banks to be fairly high to discourage the need to use it (but not so high that it will cause the borrowing bank to bleed money so fast that it ends up declaring bankruptcy anyway).

Next, he establishes a minimum reserve ratio, which will also minimize the risk of bank runs. You see, he’s not stupid–he knows that a bank run is the one thing that could take away his new revenue stream AND all his government money in one fell swoop.

Next, he gives himself the authority to suspend all banking in the case of a financial emergency. That way, he can stop a bank run in its tracks by sending all the lining-up people home and try to ease the public panic before re-opening all the banks, which he could potentially even do the next day.

In this way, he feels confident that he has adequately protected his bank, and all banks, from the risk of collapse.

I think we’ll stop there for this week. We have now established banking regulations.

One thing to bear in mind with this change is that, say a bank does end up still having to declare bankruptcy, whose fault will it be? If the bank was abiding by the government regulations, they will easily be able to pass the blame on to the government! So the government, by taking over the regulatory aspect of this, has now made itself susceptible to getting blamed for any banking fiascos, which will certainly affect how it responds to a banking fiasco.

Next week, we’ll see what President does next now that he has dipped his toes into this exciting new source of income. He is starting to feel like if he is creative enough, he may be able to squeeze a lot more money out of this system for his government!

The Theory of Money, Part 24

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We’ve spent a lot of time processing the impact of fractional reserve banking on our fictitious society. Two weeks ago, we saw the bankers get creative and start using non-cash assets as reserves, which brought the illusion of prosperity back to society and the people are happy again. Last week, we wrapped up a few more details about the impact of fractional reserve banking by looking at the negative effects of inflation and deflation.

This week, let’s finally introduce government into the narrative.

So far, I’ve assumed that this fictitious society has been mostly free to develop its monetary system on its own. The only involvement of government has been to mint standard-weight, standard-quality gold coins. And I don’t want to undervalue that contribution: If minted reliably the same size and quality and in a shape that prevents counterfeiting and coin clipping, then that may be the most important thing a government can do to contribute to efficient commerce and increasing wealth!

But now the government gets wind of what’s happening with all these banks, so its further involvement starts.

Let’s just simplify this government down to a single individual and call him President.

Sidenote: I have used all male characters to this point, and it’s because I am imagining this all to be taking place during the (illogical) time period when women were not often the tradespeople or banking leaders or government leaders. If my lack of anachronistic gender balancing offends you, I suggest you share this blog and all its injustices with everyone you know.

Anyway, back to this male president who we are calling President. He is struggling to figure out how to make government ends meet because his means of acquiring money are limited. Currently, he only has two: He can either tax the people or he can borrow money.

Taxing is unpopular. Borrowing money is limited by the number of people willing to lend money to the government. Borrowing money also means he has to pay it back, plus interest, which he doesn’t like because ultimately he’s going to have to tax more (or cut spending) to do it. He has enough foresight to recognize that borrowing is pretty much just deferred taxation.

By the way, how do governments borrow money anyway? They have two options. They can do what everyone else does and ask a bank for a loan. Or they can simply sell government bonds.

So far, President has been able to limit borrowing money to emergency situations only, but he nearly lost his most recent war because he couldn’t get enough people to buy government bonds to finance the last part of the war, and no bank would give him a loan. His saving grace was actually a stroke of genius on his part–he resorted to paying his soldiers and suppliers in short-term government IOUs near the end of the war, promising to redeem them for gold coins within 12 months, and at the same time he passed a law that required merchants to accept them the same as if they were gold coins. (President’s economic advisor is still trying to figure out why prices suddenly shot up at the same time . . .) But he’s hesitant to try this again because the people didn’t like it.

Let’s pause at this point to talk about this law just for a paragraph. A law that requires something to be accepted as money is called a legal tender law, and the piece of paper that is being required to be accepted as money will have a statement printed on it declaring that it is legal tender. Legal tender laws can apply only to public debts (meaning only the government is required to accept the piece of paper as money, such as when people use it to pay taxes), or legal tender laws can apply to everyone. When they apply to everyone, it means all merchants have to accept the pieces of paper as money, so it’s legal tender for public and private debts as well. If the legal tender law applies to everyone, then the statement on the piece of paper would go something to the effect of, “This note is legal tender for all debts, public and private.”

So, ever since that war, President has been struggling under the weight of paying those short-term IOUs back. He even had to increase taxes and cut some spending programs to do it! And he hasn’t even gotten to the point of paying back those bonds yet. The taxes and spending cuts have all made him less popular, but more than that he’s worried about another war. He has become incredibly peaceable in an attempt to avoid any further expensive conflicts (he’s a pragmatic guy), but if a potential enemy sees his limited-access-to-funds weakness and decides to take advantage of it by invading his country and taking his country’s wealth for themselves, his country might not be able to defend itself. Borrowing opportunities are limited, and raising taxes would cause revolts and possibly an internal political conflict. For the good of the country, he needs some kind of surefire way to raise money in case of an emergency.

That’s when he hears about this whole fractional reserve banking system that has even developed a reserve-sharing central bank to make it more sustainable. And he gets to thinking. We’ll see what he comes up with next week.

The Theory of Money, Part 23

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This end-of-the-year holiday time is a busy one for most people, including me, so let’s see if I can make this a quick one!

Last week, we saw the banks start using non-cash assets as reserves, which opened up a lot more potential for expanding the number of circulating Goldnotes. Let’s just clean up a few topics related to that this week to make sure everything is settled before we move on to what happens next in the evolution of money in this fictitious society of ours.

First, I want to make sure I was clear about what monetary expansions and contractions do. They have a few effects, and this may not be a complete list. First, they skew purchase decisions by giving the illusion of wealth or poverty (depending on which way the money supply is moving). Second, they increase uncertainty in prices, making long-term contracts more challenging and leading to more investments failing (loss of Labor Units). Third, they cause a transfer of wealth from some people to other people; for example, when there is new money created, the first few people this money passes through get to spend it at pre-inflation prices, and thus they are getting additional wealth transferred to them at the expense of others further down the chain.

Now, related to that second point, let’s talk more about prices to show how destructive monetary expansion and contractions are.

Prices are super important as an indicator of the value of something in the market! Each thing’s price is derived from millions of individual decisions made by all the other participants in the economy. For example, some people decide one thing is too expensive, so they substitute something else for it. Others cannot substitute, so they are willing to pay that fairly high price. Others decide something is cheap, so they’re going to buy more of it or use it for additional purposes, which leads to changes in how much of other things they buy. And so on and so on.

The aggregation of all these millions of individual self-optimizing decisions is what forms the market price of a thing, which is what every other participant in the economy uses to figure out how to further optimize their own situation and needs. This is how things are put to their most effective uses. This is how an economy runs efficiently to generate as many Labor Units as possible and distribute them appropriately according to the value provided by someone.

We’ve seen government systems in the past try to have “experts” set prices for all or most things in an economy, and suddenly the value and efficiency derived from accurate prices became very apparent! They saw how inefficient an economy becomes when you lose the information that market prices provide with all those millions of points of data they contain. Administrative price setting was tried especially in communism experiments, although communism is merely the most widespread and famous effort at that. There are tons of other price setting attempts going on today, including in the United States, and the reasons for administratively setting prices seem compelling when policy makers don’t have a clear understanding of the cost of losing the information that market-generated prices provide.

So, putting all of this together, when we have monetary expansions and contractions, it is ruining the accuracy of the price of EVERY SINGLE THING in the market, which induces a communism-like effect on the efficiency of a market! Sure, this is a temporary situation that lasts only until prices adjust, and, sure, people can at least guess at what the true price of a thing is if all prices are rising generally a similar amount, but there will still be a huge efficiency cost to this change in prices. And this inefficiency cost is incurred each time the rate of inflation or deflation changes, and this inefficiency cost is probably incurred (albeit to a lesser degree) even when inflation or deflation is happening but at a relatively stable rate.

These are the reasons I don’t like inflation and deflation, and in this series we will soon get to how governments induce monetary expansions and contractions (inflation and deflation) in modern monetary policy. Let’s just hope 2023 brings less of that than how much we’ve had since the pandemic started! Part 24 here.

The Theory of Money, Part 22

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Last week, we talked about how expansions and contractions of the money supply indirectly lead to a loss of labor units due to the skewed purchasing behaviour and lost investments that they cause.

I also said that people were starting to throw some blame at the bankers for these economic challenges–after all, they had no problems like this until the banks came around. So what do the bankers do?

They see that their shift toward higher reserve ratios has caused a lot of deflation. The people are unhappy because, as prices are still adjusting down to reflect the new gold coin:LU ratio, everything seems so expensive. And the bankers are unhappy too because they want to get back to lending out as much money as they were before so they can start making a ton of profit like they were before.

The proprietor of Story Bank, being a storyteller with a big imagination, is pondering this problem one night when he comes up with an ingenious idea. He thinks, “The people want more money flowing again, and us bankers want to make that happen because it means we’re lending out lots of money again. But we can’t risk going down on our reserves like we did before. Hmmmm. So far, we’ve only been using cash assets as reserves for lending. What if we tried using non-cash assets? Only about 10% of society’s wealth is stored in the form of cash, and the rest is in all the other assets, then this would open up a huge new source of reserves for us!”

Let’s work through what might happen if he does this.

Maybe, during the near-collapse, when there were so many people defaulting on their loans, some of those loans were secured with collateral, and Story Bank ended up with a couple automobiles from debtors who couldn’t pay and had their collateral (their automobile) seized. He’s been wondering what to do with those automobiles. He’s been trying to sell them, but he hasn’t been able to yet what with the money scarcity and everyone being tightwads lately. So they’ve just been parked in a warehouse somewhere collecting dust. But he has the titles to both of them in his vault. Each automobile is worth 500 gold coins, which means the title is essentially receipt money worth 500 gold coins.

He could use the current money multiplier of 5 (based on the recently enacted policy of maintaining a 20% reserve ratio) and print 1,000 x 5 = 5,000 new Goldnotes for lending based on those two titles. More money in the economy! Just what the people want. And more money for him to lend! Just what he wants.

But if he only has 4,000 gold coins in his vault (and, therefore, 4,000 x 5 = 20,000 Goldnotes circulating), now he is going to have 25,000 Goldnotes circulating. And he knows that people have been requesting up to 15% of Goldnotes to be exchanged for specie on any given day lately (because they want to reassure themselves that they can still get it!), that means 25,000 x 0.15 = 3,750 gold coins could be requested on any given day. That’s dangerously close to 4,000.

But, worst case scenario, if he hasn’t sold the cars yet and his gold coin reserves drop dangerously low, he has a few options. He probably couldn’t give someone a car instead of 500 gold coins–that would look suspiciously like he is running out of gold coins, which could spark a bank run all over again. But he could at least quickly sell one or both of the cars for a bargain price. Or he might be able to trade the car titles for 1,000 gold coins (or a little less) from another bank. Or he could just borrow some specie from the other banks (at the fairly high interest rate that was set) through their new reserve-sharing central bank.

Ultimately, he decides that the risks are low enough based on the worst-case scenario options he has thought through, and he goes ahead and uses the car titles as reserves.

The other banks catch on soon and start doing the same thing, which stops the burgeoning deflation (with all its perceived relative poverty) in its tracks. The people are happy that money is flowing again, and the banks make sure to take credit for saving the day! If it weren’t for those banks, where would they be?

I guess I’m starting to portray banks as the bad guys, but I should be clear about this: They are not the bad guys. They are rational people seeking ways to leverage a situation to earn money, which is the basis for capitalism and the majority of welfare-improving innovations in society! What is bad is the incentives in the system. Good people can have honorable or even altruistic motivations, but if they’re stuck having to work within a system with bad incentives, their impacts on society may still be bad.

Anyway, to wrap up, I just want to state explicitly what happened in this post: Banks started using non-cash assets as reserves. If 90% of society’s wealth is contained in non-cash assets, that means 90% more intrinsically valuable things have just become potential reserves, which can be the basis for many new Goldnotes. Obviously, in this society where people are still expecting specie on a regular basis, the bankers are limited in how much of their reserves can be based on things that are not gold coins, but it’s one step closer to how our modern banks work. Part 23 here.

The Theory of Money, Part 21

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Two weeks ago, we saw how the bankers came together to form a reserve-sharing central bank, which succeeded at avoiding that near-collapse when the bank run started. Last week, we analyzed the situation further to show how a lot of societal leverage plus a lack of societal diversification is what led to the near-collapse of the banking system (one of the hallmarks of a societal default) in our fictitious society. So let’s see what happens next!

Because the banks all learned that hard lesson from Indie Bank’s experience, they set the reserve-sharing interest rate very high to discourage banks from having to use this safety net. They also started being a little bit more parsimonious with loans they were giving out so that their fractional reserve banking system doesn’t topple. (Don’t kill the goose that is laying their golden eggs!) As a result of all this, their average reserve ratios rose.

You know what the implication of higher reserve ratios is, don’t you? Let’s find out.

If, in all of society, there were 10,000 total gold coins, and nearly all of them (for simplicity) were stored in banks, and the pre-bank run average reserve ratio was only 10%, using our handy formula to figure out what the money multiplier was (Money Multiplier = 1 / Reserve Ratio), we get a money multiplier of 10, which means there were 100,000 Goldnotes circulating.

After the almost-collapse, if the reserve ratio increased to 20%, the money multiplier changed to 5, which means the total number of circulating Goldnotes dropped down to 50,000. This is a huge drop!

And this drop is going to cause some serious issues. Let’s finish up this week’s post by looking at those issues.

Actually, let me first clarify what isn’t going to be a serious issue. If the total number of Labor Units stored in the form of cash in society was 10,000, that number doesn’t change when the number of circulating Goldnotes changes. All that changed was the Goldnote:LU ratio, which changed from 0.1 to 0.2. So, to be clear, no LUs were directly lost from the circulating Goldnotes decreasing.

But I said “directly” in that last sentence for a reason. A lot of LUs get lost as an indirect result of this wild swing in the value of money. I mentioned this before when discussing the costs of implementing fractional reserve banking, but at that time I referred to it as unstable prices being inefficient for an economy. I never gave a full explanation of it, so let me provide a little more detail on that now.

If there were a magical way of people being able to know exactly what the total number of Goldnotes circulating at any given moment is, there would be no problem with changes in circulating Goldnotes. People setting prices would simply price their goods and services in terms of LUs and then use the moment’s exchange rate to determine the price in Goldnotes. That way, the price paid is always the true price, as expressed in LUs. They could even do this for loans, quantifying the size of the loan (and also the interest rate) in LUs rather than Goldnotes.

Unfortunately, we don’t have a way of knowing the money:LU ratio. So we set a price according to all the information we have at the time, and if the value of money changes, we adjust our prices once we know that the value of money has changed. Or, sneakily, we keep the price the same and give less hoping our customers won’t notice and will therefore think they’re getting a great deal!

During the lag time between the value of money changing and the prices being adjusted to reflect that new money:LU ratio, some prices are adjusting faster than others, and a lot of inefficiencies arise. I will summarize them all by saying this: When prices are no longer accurately reflective of the the value of things, people no longer have the information needed to put limited resources to the best uses. Hayek wrote most persuasively about this, as I have discussed before.

How about an example?

Let’s say, in our ficitious society, a posh driving muffler (scarf) company arose during the height of the money boom right before the bank run. Lots of people were buying those newfangled automobiles, and they wanted to look good (and keep warm) driving around showing off. This company, let’s call it Posh Muffler, was selling out each week. They borrowed a lot of money to build a big nice store and decorate it to be as posh as the mufflers they were selling.

This huge demand for automobiles and posh mufflers was a result of society suddenly having an abundance of cash (not knowing each Goldnote they owned was actually worth less). Posh Muffler, as well as the other sellers, didn’t have the magical way of knowing the Goldnote:LU ratio, so prices had not risen to account for the lower value of money, which meant that everything seemed so cheap. And when everything seems cheap, you start buying more luxury goods, like mufflers from Posh Muffler.

The company was selling so many high-end mufflers that it started sourcing more woven cotton from England, which was where the highest quality of woven cotton was being produced. Back then, it would take at least a week to send an order across the ocean. And then the factory would fill the order, which maybe took a couple weeks, and then they would send it across the ocean, which would take another week. So, there was at least a month lag time from placing an order to receiving a shipment. Realistically, it probably took a lot more time than that.

If Posh Muffler sent in a big order right at the peak of the boom, and then everything changed suddenly with the bank run, by the time they received their new bigger-than-ever order, the financial state of the company could be completely different. If they paid up front for all those mufflers, now they have no cash left because they’re not selling many mufflers anymore but they still have employees to pay and a big loan on their new store to pay as well. Soon, they have no cash left, and they have to declare bankruptcy.

Sad story, right? Think about all the LUs that went into that company. The planning phases, the new building, all those top-quality cotton mufflers that cost a pretty penny to acquire but are now worth very little. So many of those LUs that were invested end up being lost.

I hope this example helps illustrate how LUs are lost indirectly as a result of the number of circulating Goldnotes changing. And it happens both because purchasing behaviour was skewed when inflation was first hitting and because investments go bad when deflation is first hitting.

Now we have seen the initial backlash of the bank run. It was pretty bad. A lot of people found that they had bought things they couldn’t afford. A lot of companies went under. Many jobs were lost. And many jobs were at risk of being lost, so people were investing less and saving more, which caused economic progress to grind ever closer to a halt. The bankers came out okay because they averted a banking collapse, but people are starting to suspect many of these issues were caused by them. Blame starts getting thrown at them. But those ever-resourceful bankers, they always have a surprising response. We’ll see what they do next week.

The Theory of Money, Part 20

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Wow, 20 parts already! I wish I’d gotten all the way to discussing crypto already, since that seems to be a hot topic right now. But things have to go in order so they make sense. I will at least discuss a little crypto stuff at the end of this post though.

Last week, in Part 19, I said we’d discuss societal leverage and societal diversification, so let’s do that now.

Societal Leverage

Remember the three kinds of societal leverage from Part 15? Bank leverage, government leverage, and individual leverage. How did these contribute to the near-societal default?

If there hadn’t been so many individuals dependent on their expected income from that year to make good on their loans, the banks wouldn’t have dealt with such a high default percentage. But this is what happens when a society is suddenly flush with cash. People start making risky investments assuming money will continue flowing. There’s a generalized excitement that arises, neighbours seeing neighbours get rich quick and not wanting to be left behind, so they want to get in on the action to avoid being the ones who don’t ride the wealth bubble up with everyone else.

Now, if people are making all sorts of investments with cash that they can stand to lose because they truly do have plenty of stored wealth to keep them going, then it’s not such a huge issue when some of that money is lost. People can stand to lose it, as undesirable as it is. But, as a rule, when society is suddenly flush with cash due to a dilution of the currency (through fractional reserve banking, in this case) and prices haven’t yet adjusted, this is not money people can stand to lose in most cases.

And, as for the banks, if they hadn’t been so highly leveraged, the high percentage of loans in default wouldn’t have triggered a bank run.

So both high individual leverage and high bank leverage were needed to trigger this near-catastrophe. I haven’t gotten government involved in this fictitious society yet, but the impact of the government defaulting on loans would have had a compounding effect on all of this because even more people would have been suddenly not getting paid for their work.

Those are my thoughts on how societal leverage contributed to this near-societal default. Get rid of the bank leverage and there won’t be a huge amount of surplus cash suddenly, which means the big trend of making all sorts of risky investments (and taking out loans to do so, triggering the high individual leverage) would not have happened, and society would have continued to generate wealth at a sustainable pace.

Societal Diversification

If the society wouldn’t have been so dependent on a good crop every year to continue to make payments on their loans and keep up the house of cards, they could have weathered this much better. What if half of the new wealth coming into this society was from the farmer, but the other half was from exporting a product to other societies? Then maybe there would have been a lower default rate and the banks wouldn’t have been on the verge of collapse.

Diversification is important for a society just as it is for an individual to help weather unforeseeable challenges.

These two factors–societal leverage and societal diversification–can help anyone evaluate the risk of a society to default. If they’re highly diversified and not highly leveraged in any of the three ways, it will be a solid society to invest in.

Speculation

One last thing for this week. I want to give my definition of the word “speculation.”

I believe a risky investment crosses over into speculation when the investment returns are predicated primarily upon the price continuing to go up.

If the investment is not actually generating any wealth through providing goods and/or services, or it’s only generating a little bit of wealth relative to its price (and without any solid prospects of it increasing that wealth generation significantly), then the only way to earn a good return on that investment is for its price to continue going up, which requires people to be willing to buy it for more than you did.

At some point, the hype over this continually rising price will die down as people realize that there’s no way this investment can actually bring in earnings commensurate with its price (ahem, tulips, beany babies, Tickle Me Elmo), and that’s when the buyers disappear and the last ones holding the investment take the huge loss.

The end result of speculation is not an increase in total wealth. The end result is just a transfer of wealth from the people who got stuck holding it to the people who sold before the price started dropping. This is just like gambling. You’re making money off of others’ losses rather than from actual wealth generation.

Historically, the trigger for any speculative bubble is often a sudden influx of cash/perceived wealth just looking for a way to be invested, like what happened when the banks instituted fractional reserve banking. These days, there’s enough wealth around that they can happen even without a sudden influx of cash. But I hope you, my readers, know by now after 20 parts of this series that wealth is not created from nothing and, therefore, sudden influxes in cash are probably a dilution of wealth rather than an actual increase in wealth anyway.

Many crypto “investments” are speculation these days, and I’ll explain more later why an intrinsically worthless currency that doesn’t have a government requiring people to use it through legal tender laws is always going to be speculative in nature. Part 21 here.

The Theory of Money, Part 19

Image credit: Roberto Machado Noa

Last week in Part 18, we looked at the financial details of Indie Bank to understand more thoroughly how a bank run was triggered by the farmer’s bad crop. It was originally a pretty discombobulated post, so I just went back and edited it for clarity and flow. Check out the new version if you want, or just read this quick recap of what I was trying to convey:

  • Our fictitious society’s 5 banks are simplified banks with only one source of revenue: the interest they earn from lending out the money they created through fractional reserve banking
  • These banks have fixed costs (building maintenance, wages, etc.), which need to be paid for with the interest income they are getting
  • If a bunch of borrowers default at the same time, their revenue may drop below their costs, which would mean they are stuck trying to pay their costs either with even more newly created money or by paying directly with specie they have in the vault, both of which result in the same problem–even lower reserve ratios/even more severely depleted stores of specie
  • Depleted reserves trigger bank runs when word gets out and people get scared

All right, it’s finally time to see what the banking leaders do when they see the long line of people trying to exchange their Indie Bank Goldnotes for specie. Remember, they know perfectly well that Indie Bank will run out of specie before the day is through and that it will have to declare bankruptcy if they don’t do anything to stop it.

First, they organize an emergency meeting. The leaders of all 5 banks are there, although the leader of Indie Bank is in the corner playing a melancholy song on a lute.

They other four leaders initially talk about allowing Indie Bank to declare bankruptcy and then spinning this to the public to convince them that Indie Bank was the only imprudent bank and that all the rest of them are very safe. Their hope is that a strong and widespread PR campaign will prevent generalized distrust in the banking system after Indie Bank goes bankrupt. They would then have to prove how safe they are by being a little more conservative (at least for a while) with their reserve ratios and loan risk.

But after discussing this idea for a while, they are not convinced it would work. Even with a great PR campaign, there is still a reasonable risk that the panic will spread to the other banks, and they know none of them would be able to weather that storm. And they can’t let that happen–think of how disruptive to society it would be if everyone loses (the rest of) their savings! For the sake of the people, they tell each other, it is their duty to find a better option.

So, they hatch an ingenious solution. The society’s original goldminer-turned-banker, the proprietor of Pepper Bank, has a thoughtful look on his face for a while and then says, “What if . . . hmmm. Hear me out on this one because I just had an idea that sounds a little crazy but might work. You see, us other four banks still have gold coins in our vaults, right? What if we lend Indie Bank some of those gold coins–just for the short term–to help them avoid bankruptcy. We could make a big show of delivering cartloads of gold to Indie Bank. The people in line will see all that gold, and they’ll see the people at the front of the line walk away one by one with all the gold coins they requested, and eventually they’ll start to second guess their decision to wait in line when it seems that there are enough gold coins for everyone. Eventually, their panic will subside enough that the line will dissolve. We can then think of a clever marketing campaign to explain how what happened was pure unfounded public hysteria and reassure everyone that the banking system as a whole is rock solid.”

Eyebrows were raised, and then two concerns were also raised.

The first concern was that this could make one or more of the other four banks run out of specie. This concern was overcome easily by clarifying how much each bank could afford to lend and by realizing that the loan to Indie Bank would probably only need to be for a very short term, maybe even just for a day or two.

The second concern raised was more difficult to overcome. Someone pointed out that if they bail Indie Bank out like this, it will create bad incentives for all banks. It would essentially be taking away the consequence for too-risky lending and too-low reserve ratios, so all the banks would then have an incentive to engage in risky behaviour just like Indie Bank had been doing, knowing that they can get away with high risk and high rewards and, if anything goes wrong, they’ll simply be bailed out. But there may not be enough reserves in other banks to bail them out if everyone is behaving in such a risky way like this.

So they decided that there should be a price associated with needing to be bailed out. They would charge a high daily interest rate on any specie lent from another bank. This solution would actually turn out to be a win win because it alleviates the bad incentives while generously compensating the lending banks at the same time.

In the end, they collectively agreed to this solution and put it into writing. They then immediately sent word to the other four banks to start carting gold coins to Indie Bank. Within hours, their scheme had worked and the panic had dissolved. Crisis averted. Phew, that was really close to a societal default!

This solution was pretty tricky, right? The bankers just invented something new. If you’ve heard the term central bank before, you should be aware that I don’t like that term because it refers to multiple things; it’s not specific enough. So I will call this solution they came up with a reserve-sharing central bank. We will encounter the other kinds of central banks soon.

Where is our fictitious society now? It still has fractional reserve banking, and now it also has a reserve-sharing central bank to help the banking system continue to milk the cash cow that is fractional reserve banking.

Next week, we’ll look at how societal leverage contributed to this situation, and we’ll also talk about societal diversification as a means of reducing the risk of a societal default.

The Theory of Money, Part 18

Image credit: iastate.edu

Well I guess it wasn’t the “same bat time” this week because this post is a little late. If you recall, I left you with some suspense at the end of Part 17 when Indie Bank was on the verge of collapse due to a bank run getting triggered. But I’m sorry to say that that suspense is not going to be resolved in this post because, in reading through last week’s post, I realized I need to spend more time clarifying some of the details surrounding the whole Indie Bank financial situation.

So let’s look at a bunch of different details of the finances of these banks, which hopefully will come together by the end of this post to make my point.

Bank revenue. These banks in our fictitious society are simplified, so they only have one revenue stream, which is the interest they earn on the money they create through fractional reserve banking. If you’ll recall, Pepper Bank originally charged fees, but (something I never mentioned at the time) those fees mostly went away when it shifted to fractional reserve banking.

How can banks earn more from their one revenue stream? There are two ways: (1) they can push their reserve ratios even lower to lend out even more money, and (2) they can find a way to charge higher interest rates. The way to charge higher interest rates is by making riskier loans.

Bank costs. These banks also have costs. They have building maintenance costs, printing fees, other supplies, wages for security guards, wages for tellers, etc.

Bank profitability. Hopefully the income they earn (interest on their loans) is more than their costs. If so, then they have a profit, which either gets reinvested into growing the business or distributed to the owners of the bank.

Money the bank receives. Regardless of whether the debtors are paying their monthly loan payments in specie or receipt money, it’s all the same to Indie Bank. If someone gives them a Goldnote from Pepper Bank, they can simply go down the road to Pepper Bank and exchange it for a gold coin. Or maybe Pepper Bank has received some of Indie Bank’s Goldnotes as payments, so they could trade Goldnotes for Goldnotes. At this point in our fictitious society, it’s all the same. Every bank’s Goldnotes are equal in value to one gold coin.

Breakdown of the payments banks receive. Each time a debtor makes a monthly loan payment, some portion of the payment goes to paying interest, and the rest goes to paying down the principal. Let’s pretend each bank actually takes each payment and stores the interest portion in the Revenue section of their vault, and the principal portion will be put in the Money to Lend section of their vault.

What is this money in the Money to Lend section? It’s the extra Goldnotes they printed for the sake of lending and have now gotten back. Picture it as a big pile of Goldnotes. They could keep them in their vault (out of circulation) or even burn them, and it would be like they’d never printed them in the first place–their reserve ratio would go back up to where it was before, prices would drift back to what they were before, etc. The only lingering evidence that they had existed at all would be (1) the nice pile of money in the Revenue section of their vault, (2) whatever benefits accrued to society as a result of someone being able to borrow that money and do something with it, and (3) the aftermath of all the costs to society that that money induced (discussed thoroughly in Part 15).

Did I just suggest the banker could burn that money he got back? Let’s not be crazy. No self-respecting banker would burn perfectly good money when it could be used again to lend out and start earning interest for him and his investors again! This is why this section of the vault is called the Money to Lend section. The banker is just waiting for enough Goldnotes to accrue in there so he can lend it to a new debtor.

All right, I think those are all the details about bank finances that are needed to better understand the predicament Indie Bank got itself into, so let’s jump into Indie Bank’s situation directly.

Let’s say Indie Bank, in an effort to be particularly profitable, was pushing its reserve ratio extra low so it could lend out as much money as possible. And let’s say that it was also making fairly risky loans so that the interest it was charging on that loaned-out money was fairly high.

Then the bad crop happened, and a lot of people lost some or all of their annual income. Suddenly a lot of people were defaulting on their loans. And since Indie Bank was making the riskiest loans, it found itself with a higher default rate than its competitors.

This meant that its Money to Lend pile wasn’t growing as fast, which was not immediately a big problem (they just have to wait a little longer before making another loan), but it also meant that its Revenue section was also not accumulating money as fast as it normally does. But its costs are mostly fixed costs, so the bank was still having to spend a lot of money from its Revenue section. This was a big problem!

Soon enough, Indie Bank’s Revenue section ran dry, and its leaders had three choices. They could (1) default on their payments to suppliers and employees, (2) print more Goldnotes and pay them with those, or (3) pay them directly with specie from the vault. Options 2 and 3 are basically the same–either way, the reserve ratio goes down and the vault gets further depleted of specie.

The leaders of Indie Bank eventually chose to print more Goldnotes (less conspicuous that way), which predictably led to some of those Goldnotes being exchanged for specie, and the vault’s piles of gold coins became progressively smaller. This is what led the employee to conclude that they were about to run out of specie altogether, which is why he ran home to tell his family to exchange all their Indie Bank Goldnotes for specie before they become worthless.

Ok, I hope this clarifies how a bad crop (or any other financial shock) can lead to a bank’s reserves getting low and eventually trigger a bank run. Next week we’ll talk about how the bankers respond.

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