Category: General

The last few posts, we’ve been processing more about the change to a 0% backed fiat money. And then, in Part 34, we looked specifically at the state of the U.S. debt in the three main categories: bank, government, and individual.

In this post, I’d like to show you how our inflation is terrifyingly worse than what the simple annual inflation numbers suggest.

To start, let’s talk about the two specific factors that make simple measures of inflation completely misleading:

First, the value of money is determined by its supply and also by its demand. As an economy grows, the demand for money increases. Therefore, if we had a fixed supply of our 0% backed fiat currency that we call the U.S. dollar (USD), the purchasing power of each USD would increase each year that there is positive economic growth. We’ll assume foreign demand for the USD stays constant, although a healthy economy increases foreign demand as well, which would further strengthen the USD. Thus, money prices should be going down every year, and it should generally track economic growth; 3% average annual economic growth would equal a 3% increase in the purchasing power of money (assuming stable money velocity). So thinking that stable prices during a period of positive economic growth means the Federal Reserve has not induced any inflation is false. [Sidenote: Continually increasing value of money is not optimal. It would be better if the value of money (i.e., the Wealth Unit:money exchange rate) stayed constant, like when you have a commodity money subject to supply and demand, as I explained early on in this series.]

Second, remember how we made a distinction between the money price and the wealth price of something? Let’s think about wealth prices for a second. Each year, new innovations decrease the cost of things, so we should expect ongoing wealth price reductions in most goods and services. Thus, if money prices aren’t falling along with wealth prices, that means the Wealth Unit:money exchange rate is getting worse, which is inflation. So this is a second reason why thinking that stable prices means the Federal Reserve has not induced any inflation is false.

If you were paying attention earlier in this series, you know that those are the only two ways for the money price of something to fall: (1) the Wealth Unit:money exchange rate improves and (2) the wealth price falls. What I’m arguing here is that both factors should be independently lowering prices nearly every year.

And any time the money prices of things decrease–whether it’s because the WU:money exchange rate has improved or because the wealth price has decreased–that translates into greater purchasing power (i.e., the ability to buy more stuff with the money we have), which ultimately is what matters.

Can you imagine a world where the purchasing power of money regularly increases and, along with that, the wealth price of things decreases? It would mean that each year that my pay from my employer stays the same, I’m actually getting more wealth per dollar and that wealth goes further when I use it to buy things. It’s kind of unfathomable to me. Instead, I worry about if I can continue to afford my lifestyle as my pay stays the same and the prices of everything I buy keep going up.

Here’s the summary statement of what I’m explaining here: When the inflation rate is calculated by comparing the price of a basket of goods from one year to the next, it’s falsely assuming that stable prices means there has been no inflation.

Really, there are two types of inflation. There’s “measured inflation,” which is based upon how much prices have increased (according to the Consumer Price Index, or CPI), and then there’s “unmeasured inflation,” which is how much prices would have decreased had there been no new money creation that year. And since nobody really talks about unmeasured inflation, the government gets away with not being held accountable for it.

How much should we expect prices to decrease each year? In other words, how much “unmeasured inflation” has the government been getting away with? We have to look at the two factors separately and then add them together.

Economic growth: Real GDP growth averages 2.7% since 1971 (in spite of an overly complex regulatory environment and a bad monetary system that definitely slows it down!). So economic growth should bring prices down by an average of 2.7% per year.

Innovation-induced productivity increases: As for estimating how much innovation would bring the wealth price of things down each year, we can use something called the Total Factor Productivity (TFP) growth, which is a measure of “efficiency and technological progress.” Since 1971, average annual TFP growth has been about 0.75% per year.

2.7 + 0.75 = 3.45%. But since some of the economic growth and some of the TFP growth overlap, we can round down to 3%. Thus, prices should decrease by about 3% per year.

Therefore, if the Federal Reserve stays consistent with its 4% or so average inflation per year since 1971, that means they realistically probably have caused around 7% inflation each year (4% of measured inflation and 3% of unmeasured inflation).

Seven percent. Every year (on average). That also doesn’t even count all of the money our government takes from us in the form of income taxes, capital gains taxes, sales taxes, property taxes, licensing fees, . . .

It’s a wonder we’re not all broke. Many of us are, and it’s not just from lifestyle creep (although that’s a factor too). And it should no longer be surprising why. The endemic financial challenges in this country should all but be eradicated by now, but the government’s 0% backed fiat currency has prevented that . . . plus persistent tax increases, but that’s not our topic today.

So . . . yeah. Even though technology enables a worker to generate more wealth per hour of labor today compared to any other time in history, and even though the wealth prices of things have been decreasing consistently for decades, poverty is not decreasing.

Let’s now bring everything back to how our 0% backed fiat monetary system allows that to happen and keep happening.

When a country is at least on the gold standard, the amount of new money that can be created is limited by how low the central bank thinks it can push the reserve ratio. Once it’s pushed it as low as it can go, it can’t create any more money without risking a currency collapse, so inflation has been maxed out. And when inflation/new money creation has been maxed out, measured inflation and unmeasured inflation both grind to a halt, and prices start falling every year.

But when a country is no longer on the gold standard, there is no long-term limit to the amount of inflation a government (with the help of its central bank) can cause. Inflation can never be maxed out. The only limit is the short-term limit of needing to minimize measured inflation to prevent prices from rising so fast that people lose confidence in the currency. But there’s no limit to the amount of unmeasured inflation the government can cause, even in the short term. This means that the government has the capacity to soak up all purchasing power increases that can ever arise from economic growth and innovation-induced productivity gains, and it can continue doing that for forever.

As another means of calculating the innovation/productivity aspect of unmeasured inflation, take a look at this graph:

Do you see how, even though worker productivity has persistently increased, real wages (note: real wages refers to the buying power of the money paid to workers) have stagnated? Normally, they should be closely linked because a worker who can generate more wealth for his company is worth more to the company and, consequently, will be compensated with more wealth. But the link between increasing productivity and increasing real wages broke around 1970.

Can you think of anything that happened around 1970? More specifically, 1971? If you said that the U.S. went off the gold standard, you would be correct.

Why did that link between productivity and real wage growth get broken by going off the gold standard? Let’s look at it step by step:

1. Innovation allows workers to enhance their productivity (i.e., generate more wealth per hour of work), so they get paid more per hour
2. From a real prices perspective, that means prices have just gone down
3. Any time prices go down, it creates an opportunity for the government to create more money to negate that effect without anyone noticing
4. No gold standard means it can create that new money without any limit or even any repercussions, and it usually does

Interestingly, check out what happens when we use the numbers that the above graph was created from to estimate the innovation/productivity aspect of unmeasured inflation.

Worker productivity has increased about 90% since 1971, but real wages have only increased by about 25%. That’s a loss of 65% of buying power over 50ish years and, when you do the math to compound the percent loss by year, it works out to about 0.9% unmeasured inflation per year. That’s very close to the 0.75% we calculated for the same factor above using TFP. Some nice corroboration there.

And what happens when we have a huge burst of wealth price-lowering innovation, such as from the impending AI revoluion? If AI is able to replace a large minority of workers–and every reputable source predicts it will–then the cost of making things will go way down. The average annual innovation-led decrease in prices will be much more substantial, maybe even up to 3-4% while the AI revolution is transforming the economy. And it is likely to fuel more rapid economic growth as well, which could be up to 4-5%. So that means prices should start dropping by a wild guess of 7-9% per year.

But what will actually happen? Yes, the government will leverage the opportunity to induce unmeasured inflation and spend like crazy without inducing any measured inflation. People will believe that the government has somehow finally found some fiscal prudence and cheer the few years of 0% inflation. Then, when that AI-fueled revolution driving such rapid economic growth and wealth price reductions dies down, the government will have a hard time cutting back its spending, and measured inflation will soar.

Meanwhile, Americans will continue to struggle financially because they won’t receive any major purchasing power increases from all that innovation and economic growth. Add to that the unemployment spike while the economy retools, and there’s a good chance people will see AI as the worst thing that ever happened to the economy. That’s in spite of AI likely being the greatest wealth-increasing opportunity in generations.

Catch the vision of what I’m explaining here: When a government has no limit to how much money it can create, it has the ability to soak up all worker productivity gains and economic growth gains for the rest of forever. In other words, it has the ability to divert all purchasing power gains to itself and to banks as long as the 0% backed fiat currency remains.

And in case you try to look at how central bank debt has increased to estimate how much new money has been created, don’t forget that that’s only part of the story. New money is also created from allowing new intangible assets to count as reserves, lowering reserve ratios, and lowering the discount rate, the benefits of which accrue to the banks rather than the government.

Before I end this post, I want to make one more important point:

Up to this point in this series, I’ve always confined inflation to affecting our cash wealth. For example, I wrote in earlier parts that the price of our non-cash assets will rise with inflation, so focus on holding non-cash wealth if you want to become “immune to inflation.”

But now it’s time to revise that in the world of a 0% backed fiat currency. Now that you know there are two forms of inflation, I can clarify what I wrote before and say that that “immune to inflation” comment only applies to measured inflation. Unmeasured inflation, however, is completely different . . .

When we perform labor, that labor is generally compensated in the form of cash. And only after we’ve received that cash can we turn around and buy non-cash assets with it. But when the government has the ability to absorb for itself (and banks) every bit of purchasing power increase that cash would accrue over the years, that means the government has the ability to restrict the flow of wealth into our personal net worth. We end up not being able to buy nearly as many non-cash assets as we otherwise could have because the increases in purchasing power have essentially been capped (and instead diverted to government and banks) since 1971.

There is no immunity to that. Unmeasured inflation has been devastating Americans’ struggle for financial progress for over 50 years, and it will continue to affect all of us as long as our 0% backed fiat USD stands. And it does all of that without most of us even knowing about it.

So when people talk about how the Federal Reserve has decreased the value of our money by 97% since its establishment in 1913, now you know that that isn’t even the half of it; the impact the Federal Reserve has had, especially since 1971, is way worse than they realize.

How do you feel about a 0% backed fiat currency now?

Part 36 here.

In Part 33, we got even angrier about 0% backed fiat currencies because of the hidden transfer of wealth to bankers and governments that they induce, all facilitated by using intangible assets as reserves.

This week, let’s talk about the U.S. government debt!

Now that we understand that any government with a central bank at its disposal has three primary ways to get money (tax, borrow, create) and that the usual method of creating money involves the government giving the central bank an IOU in return, we now have all the tools we need to understand modern government debt.

So, how much of our U.S. government debt is owned by actual people who lent money that already existed, and how much is owned by the Federal Reserve (which means it was created for the purpose of lending to the government)?

According to fiscaldata.treasury.gov, the U.S. government’s debt is currently at approximately $31,460,000,000,000. For simplicity, let’s round down to a cool $31 trillion. [Update: That was originally written in March 2023. Now, in July 2025, just over 2 years later, the debt has increased to $37 trillion.]

The way the debt breakdown is reported, there are two categories: “intragovernmental holdings” (20%) and “the public” (80%).

Intragovernmental holdings is kind of weird. This explanation will be slightly oversimplified, but it will be accurate overall. When an agency takes in more revenue than it needs to immediately spend that year–such as social security, which collects taxes that it won’t need to pay back out in benefits until years later–the money immediately gets sent to the Treasury in exchange for an IOU that says, “You sent money to the Treasury. Thanks! But since that money still belongs to your department, we’ll pay you X% per year on that money while we borrow it from you. And when you need that money back, we’ll give it to you back and destroy this friendly IOU.” And what does the Treasury do with that money that was immediately sent to it? Yep, it spends it on other things almost immediately. So the intragovernmental holdings portion of the debt will have to be paid back (plus interest) with future taxation. It’s money the government shouldn’t have spent yet but did.

Now getting to the portion of the debt owned by “the public,” my first question is, Why are the Federal Reserve’s loan holdings lumped into that category? Because the Federal Reserve is not owned by the government. It’s owned by private regional banks. The implications of this will be made clear later. So let’s ignore that for now and be astounded at the fact that if the Fed holds around 20% of the total debt, that means that (in 2025 numbers) about $7.5 trillion was created by the Fed for the government to spend. How does an organization go through that much more money than it’s earning in taxation? It’s crazy.

Anyway, the majority of the rest of the “the public” category is owned by foreign investors (like foreign governments) and private individuals (especially through mutual funds). Commercial banks own about 5% of the total debt.

I can’t help but share one other detail from this fiscaldata website. Remember when I talked about societal defaults, and the big contributors to that were bank leverage, government leverage, and individual leverage? Let’s see how we’re doing with each of those categories: the current required reserve ratio is 0% as of 2020 (which means banks will be around 100% leveraged), the federal government’s percent of revenue that goes to servicing its debt is 19%, and our average household percent of income that goes to debt is 11%. Does all of this put us at particularly high risk of a societal default (i.e., another great depression)?

The reserve ratio is certainly scary, but the percent of income going to debt for the federal government and for households isn’t quite as scary. Although, regarding the federal government finances, when you consider that 60% of its spending is mandatory spending, that means debt payments are already eating up 35% of discretionary spending (and that number is rising quickly), it’s worrisome that debt payments will soon eat up all of the government’s discretionary spending.

Overall, looking at a snapshot of the current state of things, I don’t think the United States overall is at an alarmingly high risk of a societal default. But when you look at the trends, the outlook gets worse. At the rate the U.S. federal government is accumulating debt, it’s like a locomotive speeding faster and faster downhill toward a chasm with a broken bridge. And that, combined with the bank debt, does make me worried about our future. If things continue to go the same direction, I think the risk of a societal default is incredibly high in the next 20-30 years.

Part 35 here.

When I started this series, I never expected to get up to this many parts! Apparently I had more thoughts on money than I expected. But we are nearing the end of the series. There are still some more things to process with the change to 0% backed fiat money. And, of course, I will have a few things to say about crypto before the series ends. And then at the end I want to take a look back at how far we’ve come and discuss possibilities for improving our monetary policy. But diagnosis first, then treatment.

In Part 32, we got rid of the pyramided reserve structure and discussed how reserve pooling would work in the age of digital banking.

Let’s spend a little more time processing the change that allowed banks to use First Bank Notes as reserves.

Throughout this series, we’ve seen many expansions of what banks are allowed to use as reserves. It started out with cash assets (specie) only, and then it expanded to include non-cash assets, and then it expanded again to include using the fiat money itself (i.e., First Bank Notes) as reserves.

What’s the difference between real assets, like specie or cars or any other form of physical property, and First Bank Notes?

First Bank Notes are an intangible asset. Sure, technically the paper and ink that First Bank Notes are made from can be considered a real asset, but we don’t assign a value to a First Bank Note according to its paper and ink. Instead, we assign its value based upon the words written on it, which means we’re valuing First Bank Notes according to their intangible value as a unit of money. The thing about intangible assets is we can have as much of them as we want. Nothing stops First Bank from printing a note that says, “This note represents a bazillion First Bank Notes.” Easy–we instantly have a bazillion First Bank Notes. Doing this in a computer by simply changing the value in the government’s bank account would be even easier.

When Avaria first allowed banks to use First Bank Notes as reserves, that was still indirectly based on the foundation of real assets because the gold in the First Bank vaults was limiting the amount of new money that could be created. But then, when the backing to gold was broken (i.e., when they went completely off the gold standard, which happened in the U.S. in 1971) and Avaria’s money truly became a 0% backed fiat currency, the cap that gold placed on how much money could be made was removed.

So my point is this: When you start using intangible assets as reserves, there is no longer a cap on how much reserves you can create.

Think about it this way. There are two things that form a hard limit on the amount of money you can create when you are only using real assets as reserves: (1) the value of the real assets you have and (2) the reserve ratio you can get away with before you start triggering bank failures, especially from bank runs, and risk collapsing the currency.

But everything changes when you switch to using intangible assets, such as First Bank Notes, because you now have an unlimited value of reserves.

That doesn’t mean the central bank can just print an infinite amount of money without consequence. Induce too much inflation in a short period of time and the monetary system will collapse when people discover that the money they have been using isn’t holding its value, and then people revert back to barter and using real assets as money. But as long as the central bank keeps inflation to a reasonable level, the central bank can continue printing new money for the government to spend, forever. The government can keep taking small chunks of our cash wealth every year (without our consent) in perpetuity. This removes a lot of the sorely needed accountability on government spending.

What is a reasonable level of inflation? It’s the highest amount of inflation you think you can get away with inducing year after year in perpetuity without triggering a loss of public confidence in the monetary system.

So when you hear that the Federal Reserve targets an average annual inflation rate of 2%, I suspect that’s where that number comes from, although they’ll be quick to tell you that it’s actually the number they think will strike the right balance of stable prices and maximum employment.

But wait, there’s more. There’s another intangible asset that is often used as reserves these days: government debt. If you own debt, you own an intangible asset. And an infinite amount of government debt can be created with a 0% backed fiat currency.

For example, consider the case of a commercial bank buying a government bond. Remember that when anyone issues a bond, it’s basically a request for a loan from whoever will buy it. So the person who bought the bond now owns debt, which entitles them to annual interest payments and receiving their principal back when the bond expires. If a commercial bank finds itself with some excess reserves and wants to push their reserve ratio back down to the minimum required reserve ratio (still set at 0.2), it could make a loan to the government by purchasing a government bond, which usually would just entitle the bank to the interest every year and the principal back when the bond expires. But when government debt is allowed to be used as reserves, this means that the government bond now counts as reserves as well, which allows the bank to lend out an additional 5,000 First Bank Notes just (according to the money multiplier of 5) by owning that bond! So the bank gets the interest from the bond and it gets interest from 5 times the bond’s value in additional loans that it can make.

Wait, what? The bank, simply by loaning money to the government, gets interest on the loan and gets 5,000 more First Bank Notes to lend out?

Yes. And it creates an infinite appetite on the part of banks to buy government bonds.

Who would make such a policy? The answer is . . . (1) any government that is desperate to increase non-central bank buyers of its bonds (probably for PR reasons) or (2) any government that is strongly influenced by commercial banks. I guess a third possible option is that the banking system just got too confusing for all of the lawmakers to fully understand and they were hoodwinked by the bankers into adding such a policy to some giant and confusing piece of legislation. But I’m not sure a claim of ignorance is an adequate excuse.

This shouldn’t be too surprising. The owners of banks (i.e., bankers) are some of the wealthiest members of society. And that means bankers have lots of money to use to influence politics–through campaign contributions, lobbying, and even through threats of doing financial harm to the nation (which no politician wants to happen during their tenure because of how it will reflect on them). So of course governments make policies like this!

Therefore, allowing intangible assets–such as the fiat money itself and also government debt–to be used as reserves is great for banks and spendthrift governments, but it’s terrible for citizens, who are ultimately the source of all the wealth that is being taken.

Let’s end this post by looking at the implications of this on government finances.

Previously, President was stuck only getting money in two ways: taxes and borrowing. He didn’t like increasing taxes because it made him unpopular, and he didn’t like borrowing money either because ultimately he would have to increase taxes or cut spending to pay back the loans plus interest. So he invested in a bank, which has been generating some income for him. That helped a little bit, and then he finally gained the ultimate unlimited source of money when his bank turned into a central bank. Now, any time the government needs to borrow money, it can put some bonds on the market and be assured that they will be bought. And it can keep reissuing bonds to replace expiring ones as long as it wants until it’s ready to pay back the money.

This means there are four different ways for a government to earn money:

1. Taxation
2. Borrowing (i.e., future taxation)
3. Printing money (i.e., taxation through inflation)
4. Owning a profitable investment

I believe taxation is necessary for a government to function. Borrowing should not be necessary except in extreme and rare cases (most of which would be absent if the banking system would stop tampering with the value of money). Printing money has many issues, which I’ll summarize in the next paragraph. And owning a profitable investment could be acceptable, although if it’s an investment that the government is running, then I have serious concerns about its lack of being subject to market forces and, therefore, about the value it’s delivering to customers.

Here are my problems with inflation, in addition to the wealth-destroying and wealth-transferring effects it causes by inducing booms and busts, which I covered thoroughly earlier in this series:

Problem #1: People whose cash wealth is being taken from them through inflation usually don’t even know why it’s happening, so that’s why inflation is sometimes called “the hidden tax of inflation.” This means that the government isn’t being held accountable to the people for the money that it’s taking from them.

Problem #2: Since people with less wealth generally have a higher percentage of their wealth stored in the form of cash assets (e.g., they lack large investment accounts, don’t own their homes, etc.), that means that inflation hurts the poor even more than the rich from a percentage-of-wealth-taxed standpoint. For example, if I am poor and 30% of my wealth is stored in cash sitting in my bank account, and inflation is 100% one year, I lost 15% of my wealth. If my rich neighbour only has 1% of his wealth stored in cash (and the rest is in non-cash assets like a large investment portfolio, the value of which rises with inflation), then he only lost 0.5% of his wealth. So inflation isn’t just a hidden tax–it’s a regressive hidden tax.

Problem #3: When a government subsidizes its spending through indirect taxes–especially the most hidden one of inflation–citizens are blind to the full extent that taxation is costing them, which also skews their opinions about how much the government should do. For example, if citizens hear that their country’s entry into an ongoing foreign war will cost each family about $20,000/year in additional taxes, they may still support that policy. But if they hear that this war will cost them $20,000/year in additional taxes PLUS another $20,000/year through the hidden tax of inflation, suddenly many of them will be much more critical of the decision to enter that war because they will be questioning whether it’s really worth $40,000/year to them. I suspect we end up supporting many government policies out of sheer ignorance of their full cost.

Sooo, how do you feel about the government having a 0% backed fiat currency now that we’ve reviewed how it enriches government and banks at the cost of us, and how we can’t do anything about it, and how terrible permanent inflation is?

I hope this post has helped piece together many of principles we’ve discussed up to this point so that it can drive home just how much governments with their central banks and 0% backed fiat currencies are screwing us over. People back in the early 1900s knew some of this, and it’s probably why the Federal Reserve Act of 1913 didn’t say anything about a “central bank” in it, even though that’s exactly what the Federal Reserve is. Worse, the Federal Reserve is not owned by the government, so all that interest the government is paying to the Federal Reserve isn’t even flowing back to the government. Instead, it’s just enriching bankers.

It took us 33 posts to get here, so don’t be surprised if nobody you talk to has even an inkling of how bad modern monetary systems are, even though 0% backed fiat currencies are probably the biggest wealth-destroying and wealth-redistributing (to bankers and government) scam that has ever been orchestrated. Part 34 here.

In Part 31, I used a couple examples to explain how the true number of Wealth Units in the world did not increase when President liberated all the gold from its reserve status and then sold it off. I also explained how the Avarians won’t bear the cost of him taking those gold coins from them until (or, if ever) they decide to get back to commodity money/100%-backed receipt money. I will soon show why that may be a worthwhile effort, but first there are some other changes to process now that gold isn’t in the picture anymore.

First, do we still need this two-layer pyramided structure of reserves, where the reserve credits at First Bank act as the reserves for some lending and the First Bank Notes stored in commercial banks’ vaults act as the reserves for even more lending?

That seems unnecessarily confusing. (Although, it is banking we’re talking about here.)

Really, it doesn’t matter either way whether reserve credits and First Bank Note reserves are all combined into one reserve pool. If President wants to do away with reserve credits altogether, he simply has to zero out each bank’s reserve credits by figuring out how many First Bank Notes to print and send to each bank and then set the new unified reserve ratio.

So, from then on, to calculate what their reserve ratio is at the end of each day, banks would simply compare the total value of all customers’ deposits to the total value of money in their vault. And if they’re low, they would still look to other banks for an overnight interbank loan. And if no banks have enough excess reserves to lend, then they would go to the “lender of last resort” (First Bank) and borrow some reserves from the “discount window.” This could all work automatically and instantly if everything is electronic and there is a centralized system where all the banks send their information each night. The charging of interest for borrowing reserves could also be automatic, and a physical transfer of money would rarely (if ever) be needed.

Strange that banks originally got their reserve credits by sending tons of gold to First Bank, and eventually they get those reserve credits back in the form of stacks of paper. But they don’t mind–they are still making lots of money off of loans, so the gold no longer matters to the commercial banks.

Don’t forget, though, that if a commercial bank ever makes some really bad investments or loans and loses a ton of money, they are still at risk of a currency drain and subsequent bank run. The modern version of this, however, would not involve lines at teller windows. Instead, it would probably involve a viral news story about how a bank is going under, which would then lead all of the bank’s customers to log into their accounts and transfer their money elsewhere. This would drive a bank into bankruptcy within minutes or hours because there would be no way for the bank to pay the interest on the reserves it would have to borrow. That is, of course, assuming the government doesn’t choose to intervene, which we’ll talk about in a future post.

A mass withdrawal like this could happen, but it’s exceedingly unlikely, so bankers feel like they have entered a new era of banking system security.

Part 33 here.

In Part 30, we finally arrived at a fully unbacked fiat currency. Wasn’t that exciting? Let’s process some of the impacts of that major change.

First, let’s talk about a strange phenomenon that you may not have noticed in Part 30.

We’ve talked many times about how Wealth Units don’t come out of thin air, not matter how sophisticated the accounting trick or monetary manipulation. But did you notice that there was a seemingly free lunch (i.e., extra Wealth Units from thin air) when President was able to spend all of that gold without any repercussions on the monetary system?

Let’s see if I can clarify that quandary with an example.

Say a society is using exclusively receipt money (bank notes), and they’re 100% backed by gold coins being stored in the society’s single bank. Nobody ever exchanges a bank note for a gold coin. They only use bank notes for every transaction. If they have an aggregate of 40,000 bank notes, there are 40,000 gold coins sitting there in that bank’s vault. And, for simplicity, let’s say that the Wealth Unit:gold coin exchange rate is 1:1, so there are 40,000 WUs worth of gold sitting in that one vault. And because nobody ever actually exchanges a bank note for a gold coin, the banker never even opens his vault.

And then something terrible happens. In the middle of the night, a burglar digs a tunnel under the bank, drills into the bottom of the vault, and empties out all 40,000 gold coins, which he takes to a foreign country, melts down, and sells for 40,000 WUs worth of the local currency.

Meanwhile, society continues on as usual. They have no idea that all their gold is gone. Overnight, they went from using 100% backed receipt money to using 0% backed receipt money, but nothing has changed, and they continue transacting as they always have with bank notes.

Has the perceived number of Wealth Units temporarily doubled? Yes. The people still have all their 40,000 WUs worth of cash in the form of bank notes, and the burglar now has 40,000 WUs worth of gold coins (or the foreign currency he exchanged it for).

Then a missionary comes along and converts the entire society to a new religion that believes that using paper is a sin, so they decide they will all shift to using exclusively gold coins again. They hold a big ceremony in the middle of the town. Each person counts out the total number of bank notes they own and the banker makes a note of it, and then they all throw their bank notes into a big bonfire and go together to distribute the gold coins from the vault according to the records the banker kept during the ceremony.

To their horror, they find the vault empty, with a big hole in the bottom that makes it clear that they were burgled. Suddenly, their perceived cash wealth is now 0 WUs, so the total number of Wealth Units arising from those gold coins is back down to 40,000–the burglar has all of them, and the people have none of them. (Fortunately, the people in this society have plenty of non-cash wealth, so it’s not like they are instantly poverty stricken.)

And so the people are faced with a choice. Do they print all new bank notes (out of synthetic paper this time) and go back to how they were, using intrinsically worthless bank notes to conduct their business? Or do they want to get back to using an intrinsically valuable commodity as their money?

For them to be willing to choose to start using gold or some other intrinsically valuable commodity again, it would cost them a lot because the moment they decide not to use unbacked bank notes anymore, they lose all their cash wealth. For them to be willing to do this, the benefits of shifting back to using commodity money again would really have to be significant! And on the other hand, continuing to use unbacked money would require everyone to re-enter their illusion of those worthless pieces of paper each storing 1 WU, in which case the paper money will continue to work just fine as a means of storing and exchanging wealth.

Basically what we have with any 0% backed fiat currency is this illusion going on. People believe they have actual wealth in their currency, but it’s not true. Someone else has that wealth (assuming the gold that originally backed the currency has already been sold out from under them). But, as long as the illusion holds, their worthless money continues to do just fine facilitating trade.

Here’s another (somewhat off-the-wall) example of this: Let’s say a guy named Friendly Frank goes on vacation and leaves his car at home in his garage. And the very day that he leaves, some guy named Stealy Steve goes to Friendly Frank’s garage and steals his car. Friendly Frank now has the false belief that he has a car, and Stealy Steve has the correct belief that he has that same car. One car, two people believing they own it. Did the number of cars get doubled? Of course not–additional wealth doesn’t come from nothing. In reality, there is one car. But, in the minds of the humans, there are two cars because one person is under the illusion of still having that car. And that imaginary existence of two cars only collapses back down to the reality of one car when Friendly Frank gets home from his vacation and discovers that he doesn’t have a car anymore.

In that example, unfortunately Friendly Frank can’t continue to pretend he has a car. He can’t draw a picture of the car he used to have and use that as a “receipt car” to drive to and from work.

Money, on the other hand, is different. As long as everyone maintains the illusion, money can still carry out its two purposes of (1) acting as a common medium of exchange and (2) acting as a store of wealth.

So, no. No new Wealth Units were magically created when President broke First Bank Notes from their gold backing and then started selling off the gold. It’s just that the Avarians have the illusion of still having that wealth.

But there’s no harm in continuing to live this shared money illusion is there? Yes there is. There is great harm, which I will show starting in future parts. The question is, is the harm great enough that it is worth the cost of getting us back to commodity money? About that, I’m honestly not sure. Part 32 here.

In Part 29, we saw Avaria start allowing non-intrinsically valuable assets to be used as reserves, which kicked off a second phase of inflation.

Now let’s see how that change triggers the next evolution of Avaria’s money.

First, as context for what happens next, let’s take a look at how people thought of Avaria’s money prior to that new round of inflation. By this point, First Bank Notes (usually the electronic form) have been used for so long and have been proven to be so reliable compared to other countries’ currencies that they have become an international commodity in their own right. Sure, First Bank Notes have been subject to some inflation over the years, but it has been pretty low and stable since centralizing the currency (at least prior to this new phase of inflation). Thus, even international trade no longer requires the use of specie directly if First Bank Notes are being used.

Now let’s talk through the events that will occur in response to this new round of inflation that was kicked off by President finally allowing First Bank Notes to be used as reserves. I’ve explained the process already in this series, so I won’t rehash it in depth, but here’s the brief sequence of events:

1. Newly printed money flooding the economy gives the illusion of wealth because prices haven’t yet adjusted to the new WU:money exchange rate.
2. People believe they’re rich and start spending like it. And banks start investing in riskier ventures as they seek for more people to whom they can give loans.
3. Prices slowly adjust upward as merchants discover that they’re getting less wealth per First Bank Note than before.
4. As prices rise, people realize they shouldn’t have been spending like they’re rich because, it turns out, even without the additional spending, they actually have less wealth than they did before (since their cash wealth has become worth less from the inflation).
5. Many businesses–especially the new risky ventures that were predicated upon people continuing to spend like they’re rich (remember Posh Muffler)–go bankrupt or downsize. Unemployment soars. In this uncertain environment, people start spending even less money because they worry that they, too, will soon need to have some money saved for a rainy day. Some banks go bankrupt when their default rate gets too high and they suffer the inevitable currency drain and subsequent bank run. The inevitable post-boom bust has hit, and the entire economy is struggling.

The severity of the bust depends on how much inflation was caused by President’s new policy. If the bust is severe enough, it could result in a full-blown societal default. Even if it doesn’t, these conditions could endanger the entire banking system, as you will see . . .

As a result of all of this government- and bank-induced inflation and economic turmoil, people start to recognize how valuable gold is compared to their First Bank Notes, which supposedly represent gold coins. They start to hoard any gold coins they come across, and they even start to go to First Bank and request gold coins in exchange for their First Bank Notes.

That’s when the situation finally becomes an imminent threat to the entire banking system–the banking system, remember, that is benefiting the government and banks so handsomely. President needs to take some serious and immediate actions to preserve those benefits and the economy as a whole.

First, he makes it illegal for Avarian citizens to own gold, with a few exceptions related to jewelry. But certainly all of the gold coins need to be brought back to the First Bank vaults, and he spins this move (honestly) as a means of preserving the banking system and the economy. He also spreads the propaganda that hoarding gold to oneself is selfish and that, for the good of the nation, everyone should comply. This helps create a stigma of selfishness/being anti-Avarian to owning gold and adds an aspect of cultural enforcement to this new law.

Second, he artificially sets the price of gold in Avaria to be way lower than the market-based price. The rationale for this price-setting maneuver is that he needs to buy back the gold that the Avarians own, so he’s setting the price low for himself, which will minimize how many extra First Bank Notes he will have to print to pay for all of it. So he can justify this to himself as a good thing–he’s trying to limit inflation! An additional benefit of the artificially low price of gold is that, for the gold coins themselves, the value will be similar enough to one First Bank Note that he can get away with exchanging them 1:1.

Over the next few months, President succeeds at seizing nearly all the gold in Avaria. Once that has been completed, he keeps the gold ownership restriction in force (to prevent people from taking his gold reserves again) but removes the artificially low price of gold, once again allowing it to float along with the world market price for gold, and the price of gold immediately doubles.

And then a change is quietly made to the new First Bank Notes being printed: They no longer say they are redeemable for gold at First Bank. This was foreshadowed at the end of Part 27.

And there you have it. Avaria has just transitioned to a true “fiat currency,” which means it has no official link to any specie. Instead of being 16% backed by specie, it is 0% backed. Sure, the government still has all that gold in the First Bank vaults, but that gold is no longer acting as reserves for the monetary system. The government now has full control over the value of the currency without any further inconvenient restrictions or risks imposed by its gold backing and the archaic issue of ensuring adequate reserves of gold. It can change the value of its currency at will by adjusting the total amount of First Bank Notes in circulation, which it does through setting reserve ratios, the discount rate, and by deciding how much money it will print.

Along with this transition, First Bank has now become a true “central bank,” which I define as a bank that has been granted a monopoly over printing true fiat money.

With time, the economic depression eventually resolves as prices adjust to be accurate to the new Wealth Unit:money exchange rate and as people recover from the wealth they lost through inflation, job loss, etc. And the banking system has come out intact. President pats himself on the back for that one with his quick thinking and decisive action, which has led to him coming out of this with what he feels is an even more secure banking system now that gold is no longer holding it back and inducing risk of collapse.

And now, when President stops by his First Bank vaults and looks in at the piles of gold in there, which represents his entire country’s supply of gold, he rightfully recognizes that it is just “sitting there doing nothing” (we’ve heard that a couple times before, haven’t we?). In this case, it’s actually true though; that gold isn’t even acting as reserves. It’s truly just sitting there.

This thought lies dormant in President’s mind until, sooner or later, some financial challenge occurs. Maybe the weather will cause another bad crop. Or maybe there another war starts. Let’s say it’s another war. And now President is forced to come up with a lot more money to be able to pay for it. Not only does he have to pay his soldiers, but also he has to pay other countries for some of his war supplies.

Initially, he tries raising taxes, but that hurts his approval ratings, which are already hurting from his conscription policies. So he tries borrowing money to pay for the war, proclaiming it an act of patriotism to lend the government your money by buying a government bond to support the war. But he knows this is only going to require him to increase taxes even more in the future because he will have to pay the money back plus interest. And, anyway, even with the advertising, there aren’t enough government bond buyers to buy all the bonds he needs to sell. So, he decides he probably needs to resort to using First Bank–his central bank–to print more First Bank Notes.

The first problem is that, predictably, printing more money will cause more inflation. And the people have only recently recovered from a terrible boom and bust that was induced by inflation. So if anyone finds out that the government is the one causing this inflation by simply having its central bank print more money without any strings attached, it could lead to a rebellion against his fiat currency, which would put his whole banking system at risk (again).

Always clever, President comes up with two solutions to his war financing challenges.

First, he decides that he can use some ingenious accounting tricks to get away with printing more money in a way that doesn’t incite rebellion against First Bank Notes. These accounting tricks will not stop the money printing from causing inflation, but they will at least obscure the cause of the inflation. And for the people who do figure out where the inflation is coming from, these accounting tricks will convince them that there are sufficient restrictions in place to prevent the government from taking too much advantage of this fiat currency power.

Here’s what President does. He will continue to issue bonds any time his tax revenues fall short of his government expenses, and those bonds will be up for sale in the open bond market like always. And if private individuals buy them, then he’s got the money he needs. But, invariably, when the demand for those bonds is too low and he would have to pay an unacceptably high interest rate on them to induce more buyers, he will simply keep the bond interest rate low and have First Bank buy them with newly printed money.

For example, if President needs 10,000 more First Bank Notes, he will put 10 new bonds on the market, each with a value of 1,000 First Bank Notes. And since he’s tired of paying so much of his annual revenue in bond interest, he sets the interest rate (coupon rate) nice and low at 3%. At that low rate, he only gets 2 buyers from the private market. They are lending their own money, which already exists, so there’s no inflationary effect from this transaction. But the other 8 bonds go unsold, so First Bank prints 8,000 new First Bank Notes and uses them to buy the other 8 bonds. This transaction was definitely inflationary because new money was created and then added to the aggregate supply, but it’s hard for people to understand why that transaction is inflationary without a thorough explanation. Why? Because, on the surface, it just seems like the government is simply borrowing money from First Bank.

And for the people who do understand that First Bank is buying those bonds with newly printed money (and how that still induces inflation), their concerns are alleviated by the fact that the government will have to pay off those bonds, which would involve using future tax revenue to get 8,000 First Bank Notes and then giving those to First Bank when the bonds come due. And First Bank would then be required to shred those 8,000 First Bank Notes to reverse the inflationary effect of printing them in the first place.

What a PR-savvy accounting trick, right? And it’s through this trick that the Avarian government successfully quells any public outcry that may have arisen from shifting its monetary system to a true fiat currency.

After that, government debt starts to increase, and inflation increases along with it since most of the debt is owed to First Bank. And President is fine with this because First Bank is always happy to buy a new bond to replace any maturing bonds, which means the debt will never come due before the government has the ability and desire to pay it off. In fact, the government can delay paying off its debt to First Bank for forever, and the only cost of that will be that it will continue to have to pay interest to First Bank.

In the case like this of the government owning the central bank, paying debt interest to the central bank does not impact government finances at all because that interest the government is paying goes straight to the central bank’s profits. And since the profits of an organization go to the owner of that organization, all of the central bank’s profit immediately gets sent back to the government. It’s like taking a loan out from yourself and then paying yourself the interest on that loan; it’s all accounting gimmicks that result in a wash from the standpoint of your overall financial situation. The only difference here is that this loan-and-interest-payment scheme allows the government to get away with having its central bank print more money whenever it wants and potentially never paying that debt off again.

But in a case where the central bank is privately owned by bankers, all of that interest doesn’t go straight back to the government. Instead, it goes straight into the bankers’ coffers. Thus, if bankers can find a way to get a government to allow them to privately own the nation’s central bank, that will become a permanent source of ever-flowing riches on the order that only few others can achieve in this world.

(Incidentally, the Federal Reserve, which is the central bank in the United States, is privately owned. So when the U.S. is racking up government debt, even the portion of the debt owned by the Federal Reserve is costing us a bundle and enriching the owners of the Federal Reserve, which are regional banks.)

That completes my explanation of President’s first solution to financing this war. As clever as it was, the problem with it is that it will cause inflation. . . . Which brings us to President’s second solution to financing this war.

Remember all that gold just sitting in the First Bank vaults? President decides to spend some of it! All that gold was liberated from its role as reserves for the financial system, so spending it will have no direct impact on Avaria’s monetary system. It’s like the government received an enormous inheritance when it broke First Bank Notes from its gold backing and also forced everyone to sell their gold to the government for below-market prices. This gold would be especially perfect for using to pay all of the government’s international suppliers for various war supplies, all without inducing any inflation. Realistically, President probably won’t spend it all on this war. But, over the years, many uses for this gold will arise, and it will slowly drain from his ultra-secure and ultra-secret First Bank vaults. He will have to maintain the security at all of his First Bank vaults even if they are storing less gold so nobody will notice what’s happening.

(Yes, I suspect this is what has happened in America as well, which is probably why no full physical audit has been performed on the gold in Fort Knox since . . . we don’t know when, although the last partial physical audit was apparently performed in 1953. And even Presidents of the United States have not been able to initiate a full and transparent audit since then.)

Does it really matter if people know the gold has been spent? Technically, that knowledge would have no direct effect on the monetary system. But it would definitely have an indirect impact on the monetary system by altering how much people trust the monetary system, especially because they believe their money is still somehow backed by all those tons of gold hidden in those secretive high-security vaults. Learning that the gold has been spent would also turn many people against the government because they believe the gold is rightfully theirs as owners of First Bank Notes. That would not be a good PR day for President if everyone finds out he sold that gold out from under them simply because he was unwilling to be brave enough to either cut spending or increase taxes to cover his government debts.

In Part 31, we will analyze a few other effects of this. But we have, finally, after 30 parts in this series, gotten to the usual final evolved state of money: fiat money. Well, technically, we got to fiat money when President passed the legal tender law. But now we are at the type of fiat money that is normally thought of when the term is used–the kind that is not backed by anything of intrinsic value and that allows the government full power to print as much as it wants. And now we have seen the whole process of how money evolves from its initial state as commodity money all the way to unbacked fiat money. You should now have a thorough understanding of why, in our modern day, people use nearly worthless pieces of paper (or their electronic representations) as their common medium of exchange, and why that’s a bad thing.

In Part 28, we clarified some extra details about the fairly complicated impact of transitioning to a uniform currency.

This week, let’s add some technology to our banking system!

Up to this point, banks have been keeping paper records. But what if technology develops in Avaria to the point that electronic money transfers become possible? This opens up a new world of money convenience!

Let’s say, for simplicity, that the internet is invented and immediately all banks and merchants become able to transfer money electronically. This is so exciting for all the citizens that they each go to their bank of choice and deposit the majority of their First Bank Notes. And now they are able to log in and see the total value of their bank accounts. They also all receive new plastic cards in the mail, which are called debit cards because they allow merchants to debit money directly from their account. Credit card companies also crop up, allowing people to pay now with money borrowed from the credit card company and then pay that money back later.

From this point on in Avaria, when someone buys something, instead of using physical First Bank Notes, they usually just present a card to the merchant. The merchant swipes the card, which directs the issuing bank to transfer the purchase amount from the customer’s (or credit card company’s) electronic bank account to the merchant’s electronic bank account. Merchants are still set up to accept physical First Bank Notes, but they’re long past the days of knowing what to do if someone tries to pay with gold coins.

Avaria has just transitioned to a new form of money! A very thorough name for this type of money would probably be “electronic centralized fractional reserve receipt money” or something like that. But the fundamentals of the banking system haven’t changed, it’s just that people are, more and more, relying on electronic representations of their money rather than physical First Bank Notes.

The major implication of this is that now commercial banks are accumulating even bigger piles of First Bank Notes in their vaults, “just sitting there doing nothing.” And remember that they’re also still frustrated by their capped reserve credits.

So let’s do something crazy and allow the next monetary transition to happen right now.

After a lot of lobbying to President to find a way to allow commercial banks a way to grow their loan-based income, President makes a new law: He says that banks are allowed to use the First Bank Notes that are stored in their vaults as reserves for lending.

This is a huge deal, the reasons for which I’ll explain shortly. But, first, let me build out the details of this change so I can give an example of what this looks like, and then we’ll do some processing after that.

So, along with that new law, President sets a new reserve ratio of 0.8 (money multiplier of 1.25) that applies only to loans backed by First Bank Note reserves. This doesn’t change the existing reserve ratio of 0.2, which still only applies to lending against reserve credits.

Why is the new reserve ratio initially set so high? Because President shrewdly recognizes that this is going to set off a new wave of inflation, and he wants to keep the inflation low enough that it will only set off a small economic boom (fueled by the illusion of newly increased prosperity) and its inevitable subsequent bust. If the boom and bust can be kept small enough, it will prevent the bust from triggering a full-blown societal collapse, which would economically set Avaria back several years at least.

Now for the example: If Veritas Bank has 6,000 reserve credits in its account with First Bank and also has 40,000 of its customers’ First Bank Notes stored in its own vault, then it will continue to loan out the 6,000 x 5 = 30,000 First Bank Notes based upon its reserve credits, and it can also start lending out 40,000 x 1.25 = 50,000 First Bank Notes based upon the First Bank Notes stored in its vault.

Wow. even with a reserve ratio that high, this increased Avaria’s money supply by a lot. Let’s do a quick calculation to see how much.

If there were a total of 50,000 reserve credits, 50,000 x 5 = 250,000 First Bank Notes were circulating. And assuming that, now that Avarians are primarily using electronic money to transact, almost all of those First Bank Notes are stored in commercial banks’ vaults, that means all 250,000 will be multiplied by the new money multiplier of 1.25, so the total number of First Bank Notes increased almost immediately from 250,000 to 250,000 x 1.25 = 312,500. And if there were 50,000 Wealth Units being stored in those 250,000 First Bank Notes, the WU:money exchange rate has just changed from 50,000:250,000 (or 0.2 Wealth Units per First Bank Note) to 50,000:312,500 (0.16 Wealth Units per First Bank Note). So buying something with a wealth price of 10 WUs just increased the money price from 50 First Bank Notes to 62.5 First Bank Notes. That’s an inflation of 25%! Ouch.

To be clear–Avarians are not getting any new wealth from this extra money. In fact, they just lost 20% of their cash wealth (and I’ll not get into the math that explains why they only lost 20% of their cash wealth when they experienced 25% inflation). To whom has that wealth been transferred? Temporarily, it’s been transferred to all the people who got those new loans. But those people will be paying that wealth back, plus interest, to the banks that gave them the loans. So the beneficiaries of this new law are the banks, which are now taking even more of other people’s wealth to lend and then earn interest on. The banks are making even more exploitative loans than before, and the people being exploited are the bank customers storing their money in commercial banks.

Not that any Avarian can avoid the effects of this. If someone figures all of this out and decides to keep their piles of First Bank Notes in their big gun safe at home instead of in a bank’s vault, it will have a negligible effect on how much inflation was induced overall, so basically their money will still depreciate just as much even though it wasn’t in a bank. And now, without storing their money in a bank, they lose out on all the conveniences that electronic money confers. So there’s no fighting this. The government just took more of the Avarians’ cash wealth and essentially gave it to the banks to profit off of. And, short of forcing the Avarian government to change its monetary policy, the citizens of Avaria can’t do a thing about it.

The reason I said above that this was such a major change is because, for the first time ever, something other than intrinsically valuable assets has become allowed to be used as reserves in their fractional banking system. Their reserves have actually become pyramided into two levels: There’s the base layer of gold backing the first 250,000 First Bank Notes, and there’s a second layer of reserves–the First Bank Notes themselves sitting in commercial bank vaults–backing the additional 62,500 First Bank Notes.

In aggregate, then, this fractional reserve currency is really only 16% backed by specie (50,000 gold coins / 312,500 First Bank Notes = 0.16).

And the scary thing is, the accountability that specie provides on the banking industry is disappearing.

For example, think about what would happen if people got worried that their First Bank Notes were somehow being squandered by a bank, and all of the bank’s customers lined up to get their money out. Yes–that bank wouldn’t have enough First Bank Notes to supply everyone, and it would go bankrupt (assuming the reserve pool interest rate was high enough that it couldn’t afford to borrow all the needed reserves from other banks). But would that spread generally to all of the other commercial banks and lead to the collapse of the entire banking system? No. Because First Bank could just print more First Bank Notes to give to everyone until they stop trying to withdraw all of their money from the banks. Crazy inflation might happen for a time until people gain trust in the banking system again and re-deposit their money, but the banking system itself wouldn’t collapse. The house of cards is calcifying.

At this point, the only way the entire banking system would collapse–which would cause people to go back to using intrinsically valuable stuff as their common medium of exchange–is if for some reason the Avarians became worried that there is no longer enough gold for the entire system, so they start taking their First Bank Notes to First Bank and requesting to exchange them for gold coins. But, even then, President would just step in and cease all banking transactions until the panic subsides and people are convinced that it’s selfish to try to get their gold back.

But the likelihood of that happening is incredibly low because Avarians don’t even think of gold coins as money anymore. As long as they can get their First Bank Notes out of their account at their commercial bank whenever they want, they generally don’t worry about their money and continue to happily use electronic money as their primary common medium of exchange.

To wrap up this post, let’s consider what the regular citizens of Avaria would think about these last few changes in their banking system. The amazing thing is, even with bank reserves being switched from gold to paper, and even with paper being allowed to be used as reserves for other paper, they have been minimally impacted. In fact, they probably love how convenient money has become in this modern Avaria. No more carting around heavy gold coins like in generations past. They can just fill their wallets up with a few plastic cards (or load them into their smartphones) and not worry about a thing. Their only complaint would be that pesky persistent inflation, although inflation has been a part of Avarian life for enough decades now that most Avarians assume by now that continually rising prices is just the normal way of things. And, if asked where inflation comes from, they would shrug and say the monetary system is too complicated for them to grasp. So they’re happy to leave dealing with that mystery to the economists and the bankers and the government, all of whom are working hard on their behalf to use the most modern mathematical models to figure out how to stabilize this very complex monetary system.

But you know better: Inflation is not an automatic part of a monetary system, and its source is absolutely not a mystery. It’s a predictable and direct result of the actions of banks and governments. And don’t forget inflation’s wealth-destroying and wealth-redistributing effects we discussed earlier in this series, and how it fuels the business cycle’s booms and busts, which Avarians (and other modern humans, including me up until a few years ago) also assume are a normal and automatic part of modern economies.

I hope you’re a little bit angry at modern monetary systems by now. And we haven’t even gotten to the worst versions of money yet! You’ll get angrier, I promise.

On that note, I should probably ask the same question I’ve asked before: Does this mean the banks (the government-run one and the commercial ones) are bad?

They haven’t broken any laws or manifested any nefarious intentions (unless you count wanting to earn a profit as nefarious). All they’ve done is respond rationally to the incentives the system has given to them at each stage of the evolution of money. And responding to incentives in a way that maximizes profit is what capitalism is all about.

So I would answer that the banks aren’t bad . . . the incentives are bad. Monetary systems are one major case where the natural progression of human civilization does not tend toward an optimal rational order. Unfortunately, we have found this out too late to bake into our governments’ constitutions the restrictions necessary to prevent banks and governments from colluding to take our cash wealth from us and induce all of the economic inefficiencies that come along with that.

Capitalism sometimes creates bad incentives like this, too. That doesn’t mean capitalism is horrible and should be forsaken; it just means there is a role for government to identify issues like this and then enact laws that create better incentives. That challenge when it comes to monetary systems is that the government stands to gain so much from allowing its nation’s monetary system to go in this direction that there isn’t a lot of motivation for it to stop it. In fact, governments often become the leader of the money bandits, as you’ll increasingly see in the rest of this series.

I wish this story of Avaria’s monetary system were all hypothetical. But I am describing what nearly every modern government has done to its country’s monetary system.

Anyway, in summary, Avaria’s monetary system has begun its second phase of inflation. The first phase was inflation as a result of fractional reserve banking using specie as reserves(the money went from 100% backed to only partially backed), and the second phase is the result of the second layer of fractional reserve banking using paper as reserves (they money went from being only partially backed to even-less-partially backed).

There are some further major changes to Avaria’s monetary system that will result from this shift, which we will discuss in Part 30.

In Part 27, Avaria finally transitioned to a centralized currency. To be clear, its money is still 20% backed by gold (based on a reserve ratio of 0.2), but its receipt money is now uniformly First Bank Notes. And now the only way someone can get an actual gold coin is by going to a First Bank branch and trading a First Bank Note for one, which I mentioned people are doing less and less as the years pass and they get used to exclusively transacting using First Bank Notes.

For clarity in my terminology, I will now only use the term Goldnote to refer to the pre-centralized currency. And I will only use the term First Bank Note to refer to the post-centralized currency.

One other terminology clarification: To refer to the non-government-run banks, I’ve been calling them “private banks.” But, realistically, if they are owned publicly (with bank stock freely available to purchase on the stock market), then the term private bank is probably no longer appropriate. So, I will call them “commercial banks” instead.

All right, with those terminology clarifications aside, let’s see what happens next.

Since the transition to a centralized currency, transacting has become easier because now everyone is using the same notes instead of a bunch of different banks’ Goldnotes each with its slight difference in valuation (according to the reputation/riskiness of the issuing bank).

Importantly, gold (and some other non-cash assets maybe) is still the only form of reserves. That will eventually change, but for now reserves are still only intrinsically valuable assets.

So, now that the commercial banks are no longer able to issue their own currency, what do they do?

As we discussed with Astro Bank in Part 27, not much has changed. It still has its reserves (which are now “reserve credits” at First Bank rather than piles of gold coins in its own vault), and its sole revenue stream continues to be lending out money in accordance with how many reserve credits it has. But commercial banks no longer deal in gold coins. If a depositor comes to Astro Bank hoping to deposit a gold coin, Astro Bank refers it over to First Bank, where the customer will receive 1 First Bank Note in exchange for each gold coin they deposit. And then the customer could turn around and bring those First Bank Notes to Astro Bank to deposit them for safe keeping.

Annoyingly for the commercial banks, even if they do a great job enticing many new customers to deposit their First Bank Notes in their vaults, none of that will increase their reserve credits. So their income from a lending perspective is capped at what it was when the transition to a centralized currency took place.

They can still find other ways to earn money, such as by helping customers invest the money stored in their vaults and charging advisor fees, or by utilizing all that newly emptied space in their vaults to store other forms of valuables for customers. So there is some amount of competition between the banks to win customers so they can provide those extra services to them. As part of that competition, the banks want to make transacting with their bank more convenient, so they eventually invent checking accounts, which allow depositors to basically just write an IOU when spending money at any merchant, and the merchant will take that IOU to the customer’s bank and have the money deducted from the customer’s account and given to the merchant.

But, overall, the private banks are unsatisfied because their primary source of income–loaning money–is capped, all while they are accumulating huge piles of First Bank Notes in their vaults that are “just sitting there doing nothing” (this is a reference to what our original banker said in Part 10, and which should give you a hint about where this is going . . .).

I’ll get to that in Part 29.

And, to finish out this part, let me clarify a couple more changes that occurred as a result of centralizing the currency.

I first want to describe how the specie pool changed. Remember how banks would lend reserves to each other through the “specie pool” if, at the end of a day, a bank’s reserve ratio was below the agreed-upon minimum and another bank had excess reserves?

Well, the same thing still happens, but the process is slightly different.

At the end of each day, each commercial bank reports to First Bank the total value of its outstanding loans. If that number is more than 5 times its reserve credits, it is short on reserves and needs to borrow some reserves from another bank. First Bank will facilitate an overnight transfer (purely an accounting process) of reserve credits to the bank that is short from any bank that has excess that night, and the borrowing bank will pay some interest to the lending bank. Commercial banks negotiate over the interest that will be paid, and that interest rate is called the interbank lending rate.

However, if no bank has enough excess reserves, then the commercial bank that was short on reserves will have to borrow some reserve credits directly from First Bank (the “lender of last resort”), which has the authority to (1) create out of thin air new reserve credits for lending and (2) unilaterally set the interest rate on borrowing those newly created reserve credits. First Bank will set that interest rate fairly high so that it will discourage too many banks from being overly aggressive in how much they are lending relative to their reserves. Plus, as a nice perk, this is yet another way for the government (through First Bank) to get some of the profits that this banking industry is making!

For reasons that aren’t relevant to this discussion, the historical term for the place where a commercial bank employee could go to the currency-issuing bank to borrow overnight reserves like this was called the “discount window,” and the interest the commercial bank would pay for those reserve credits was (and still is) called the “discount rate.”

Let’s discuss one more change that will happen as a result of all the gold being consolidated in First Bank’s vaults.

Imagine having a bunch of vaults that everyone knows are packed with all of the country’s specie in gold. Kind of a scary thought, right? First Bank vaults have become a major target for anyone in the world looking to get rich quick by stealing tons of gold that they can make untraceable by melting it down and re-casting it.

Sooner or later, First Bank is going to need to find a way to store this gold more securely. It eventually determines that storing the gold in just a few super secure locations will be safer and more efficient. So, we can eventually (say, within the 20-30 years after centralizing the currency) expect at least one giant vault to be built, and a large percentage of the total gold will gradually be moved there.

Fort Knox, anyone? The U.S. formalized its centralized currency via the Federal Reserve Act of 1913, which induced the transfer of all the gold in commercial banks’ vaults to the Federal Reserve bank vaults. And, 23 years later, in December 1936, Fort Knox was completed, and by the end of 1937 a huge percentage of the gold reserves had been moved there.

Is the gold still there in Fort Knox? I suspect it isn’t, for reasons that will become clear later on.

One last thing for this post: Another benefit that First Bank now has is the fact that, with a monopoly over printing First Bank Notes, invariably some percentage of them will get lost or ruined each year, so First Bank can print new ones to introduce into circulation and prevent deflation from a gradually diminishing money supply. Who should it give these new First Bank Notes to? There’s no way to know who actually owned the First Bank Notes that got lost or destroyed, so it will simply give them to the government to spend. President really likes this new source of free money!

Phew. That was a lot of information to process from that change to a centralized currency.

As an aside, what a fun journey to be on, right? Figuring out money and banking, and also figuring out how to explain it in a comprehensible format, is much more interesting than I ever expected. Maybe because I’ve come to appreciate just how important these things are to understanding why our modern economies are getting messed up in serious ways. If you haven’t ever read anything on money and banking, you should try it. For example, try reading these speeches (PDF) made by some Ph.D. economists during a United States congressional hearing on fractional reserve banking in 2012. If you already understand what they’re talking about, their statements make sense. But if you don’t, man is it all befuddling (which I suspect is partly on purpose to help preserve the whole banking industry’s wealth-stealing scheme by hiding it behind Byzantine institutions and terminology). I’m sure I fail sometimes at demystifying it, but I hope my deliberate stepwise approach to this information (plus some simplifications that don’t alter the underlying mechanics) helps.

All right, in Part 29 I’ll add some technology into the mix and then jump right to transitioning to the next phase in the evolution of money.

In Part 26, I teased that President was about to make some changes to the laws to bring about a uniform currency. Let’s see what he does!

As a preface to this part, you should know that this was the most difficult transition in the entire evolution of money for me to figure out. The information on this specific aspect of the history of money is much less readily available. But I’ll do my best to explain how this has happened in the real world many times before, and I’ll attempt to do it in a logical order without skipping any steps.

With the goal of making First Bank Goldnotes the standard common medium of exchange countrywide, President creates two new laws:

First, there will be a tax on the lending of non-First Bank Goldnotes. So, from that point on, any time another bank loans out their own Goldnotes and earns interest on them, they have to pay, say, 5% of the total loan value to the government in the form of taxes. That’s pretty high, especially considering that most loans are probably earning less than that.

Second, banks are allowed to switch out their own Goldnotes for First Bank Goldnotes by sending all of their gold coins (and other acceptable assets) to First Bank. Non-cash assets that are being used as reserves for lending, such as the cars that Storybook Bank found itself owning back in Part 22, may or may not be accepted by First Bank, and the bank that owns those non-cash assets may just have to retire those assets from their role as reserves once the loans made based upon those assets have been repaid.

The first law makes it no longer profitable to lend out their own Goldnotes. It became much cheaper instead for banks to transact using First Bank Goldnotes, which gives them a big incentive to take advantage of the opportunity offered in the second law by switching over to First Bank Goldnotes.

Let’s see how this switch would occur with Astro Bank:

First, Astro Bank has to pack up its entire store of specie (gold) and cart it to First Bank. And when it delivers all of its specie to First Bank, in return it will be credited in its First Bank account with an equal amount of “reserve credits.” This dictates how many First Bank Goldnotes Astro Bank is allowed to lend out. For example, if the reserve ratio is 0.2 (money multiplier of 5) and Astro Bank just deposited 4,000 gold coins into First Bank, it will receive 4,000 reserve credits, and each reserve credit allows Astro Bank to lend out 5 First Bank Goldnotes. The details of this will be discussed further in Part 28.

Second, First Bank announces that all Astro Bank Goldnotes are now retired, and there will be an exchange period to allow any holders of Astro Bank Goldnotes to present them to First Bank and, in exchange, they will receive First Bank Goldnotes. For simplicity, let’s assume they just trade them 1:1 straight across. Any existing contracts denominated in Astro Bank Goldnotes will automatically be updated to be denominated in First Bank Goldnotes instead. Then, after that exchange period ends, any Astro Bank Goldnotes that haven’t been traded in will be officially worthless.

So if Astro Bank owned loans that were worth 20,000 Astro Bank Goldnotes, they now own loans that are worth 20,000 First Bank Goldnotes. And just like way earlier in this series (Part 18), whenever Astro Bank receives a loan payment, the interest portion of that payment will go into their Revenue stack of First Bank Goldnotes in their vault and the principal portion will go into their Money to Lend section. Once there are enough First Bank Goldnotes in the Money to Lend section, they can give a new loan. Thus is the ever-rotating cycle of the majority of Goldnotes.

This process turns out to be an offer the banks can’t refuse, and they all agree to it. From then on, they get to avoid the tax on lending non-First Bank Goldnotes, and they don’t even have to worry about finding the storage space for big piles of gold coins in their vaults anymore!

Pay attention to what just happened here. The government (through its bank) essentially seized all of the gold from all of the banks. But it did it through shaping bank incentives just right, no force required. And everyone, including the banks, are pleased with the outcome because Avaria now has a conveniently uniform monetary system.

And that is how Avaria shifted from a decentralized fractional reserve currency to a centralized fractional reserve currency. There are other ways this has been done, including simply by making the printing of receipt money illegal for non-government-approved banks, or by requiring a government license to print receipt money and then not granting any new licenses and letting the old ones lapse over time.

From now on, any time someone wants to exchange a Goldnote for a gold coin, they have to go to a First Bank branch to do so. And just like Peppercorn Bank discovered way back when it invented fractional reserve banking, a low enough percentage of people actually do that that there are always enough gold coins in the vault.

Incidentally, which bank’s “account” would the gold coins come from when someone comes to First Bank with a First Bank Goldnote requesting to trade it for a gold coin?

None. Those gold coins have been anonymized in First Bank’s vaults, so as long as there aren’t too many First Bank Goldnotes in circulation, they will always have enough gold.

But having enough gold in the vaults is becoming less and less relevant of a concern anyway because people are trading out First Bank Goldnotes for gold coins less and less often as they, with time, get used to transacting exclusively in First Bank Goldnotes and come to trust that they are a reliable form of money.

What does President do once all of the other banks’ Goldnotes are completely phased out? He creates a couple more laws to protect the ground he has won.

First, to forever prevent regression back to a multi-currency society, he declares that First Bank now has a permanent monopoly on issuing bank notes.

Second, to reinforce First Bank Goldnotes as the only form of acceptable money in the country (in the unlikely event of a banking fiasco that harms their reputation and tempts citizens to start using something else–such as another country’s currency–as their common medium of exchange), he passes a legal tender law (explained in Part 24) that requires acceptance of First Bank Goldnotes for all debts, public and private.

And to commemorate this change, all of First Bank’s subsequent Goldnotes will be printed with a new pithy name: First Bank Note.

*Moment of silence for the end of 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 still be exchangeable for one gold coin, which can be redeemed at any First Bank branch, so the country’s new official receipt money will still have an anchor to gold to keep its value from drifting arbitrarily.

Oh, one more thing. For simplicity, up to this point I’ve ignored fractions of gold coins, and I’ll continue to do so; but surely this society can have half coins, quarter coins, etc., and it can use any form of receipt money (either with paper or with “token coins,” which are cheap metal coins with their official monetary value stamped on them) to represent those smaller denominations. I just think talking about those smaller denominations doesn’t help the overall explanation and risks adding confusion.

Anyway, in summary, we have finally achieved a centralized (uniform) currency! It’s starting to seem like modern money, isn’t it? Believe it or not, First Bank Notes are still different than modern money in huge ways.

As a little hint about where this series is headed, check out a comparison of two American bills (which, interestingly, are now known as Federal Reserve Notes, which you will see printed on any bill today).

The United States transitioned to a centralized currency in 1913 after the passage of the Federal Reserve Act. Check out this 1922 ten-dollar bill with the following text printed on it: “This certifies that there have been deposited in the treasury of the United States of America ten dollars in gold coin, payable to the bearer on demand.” (Remember that the term “dollar” originally just specified a certain weight in gold.) It also has the legal tender inscription on it.

Now compare that to a more modern dollar bill. This one also has the legal tender inscription (rewritten to be more concise), but notice the change in text: “Federal Reserve Note, The United States of America, one dollar.”

There’s no mention of gold, nor any mention of it being exchangeable for anything else. Interesting, right? . . .

In Part 28, we will process more of the implications of this change before we finish with the last few major money transitions.

In Part 25, we saw President get his government into the banking business by shifting all of 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 specie pool, 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.

What happens next?

Something I have purposefully not yet acknowledged in this series is that, historically speaking, by this time there would have been a number of other exciting banking events in Avaria, such as bank runs that actually did culminate in a local or regional financial collapse, fraudulent banking practices, banks ceasing giving specie for various lengths of time, and myriad other unscrupulous business dealings.

Thus, realistically, the business practices and reputation of a bank is a big deal at this stage in the evolution of money. Consequently, Goldnotes from the different banks always end up being traded at different values according to the public’s image of the bank.

This would make for a very confusing monetary system! Can you imagine having a whole bunch of different currencies, all of which have different values, all being used at the same time?

I hope you can see where this is leading. It would make a lot of sense to simplify the monetary system by standardizing around a single bank’s bank notes. Importantly, this would make pricing and trade much more efficient. President knows this. And, for the first time ever, he has all the tools at his disposal to make it happen.

So how does he go about enacting it?

The obvious first choice is to standardize around First Bank’s Goldnotes. Not only would this be beneficial for First Bank (and, therefore, financially beneficial for the government) by strengthening First Bank’s presence in the financial community, but also First Bank’s Goldnotes are already, on account of them being backed by the full faith and credit of the government, seen as the most reliable Goldnote option. That is why First Bank’s Goldnotes have already started to become the preferred common medium of exchange.

Let’s wait until next week to discuss the specific laws that President enacts to make this transition.