In Part 24, 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 (now using non-cash assets as reserves too) and a specie pool, 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: The First Bank of Avaria. We’ll call it First Bank for short.
President then gradually 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 reliably 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 yet 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 taking 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 region-wide specie pool.
Next, he uses his legislative power to require the daily interest rate for all specie pools to be fairly high to discourage the need to use them (but not so high that it will cause the borrowing bank to bleed money so fast that it ends up having to declare bankruptcy anyway, which would also reflect poorly on/decrease trust in the banking industry).
Next, he establishes a country-wide 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 part. 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 (i.e., it will affect how likely the government is to bail out a bank).
In Part 26, 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!
We’ve spent a lot of time processing the impact of fractional reserve banking on our fictitious society. In Part 22, we saw the bankers get creative and start using non-cash assets as reserves, which brought the illusion of prosperity back to society (through inflation) and the people are happy again for the moment (until prices catch up). In Part 23, 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 offer a service 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 minimizes the risk of counterfeiting and coin clipping, then that is a huge contribution to efficient commerce and, thus, 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 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.
But taxing is unpopular.
And, as for borrowing money, it’s 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 government borrowing is 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 can either be narrow–applying 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 be broad, meaning they 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 specie pool to make it more sustainable. And he gets to thinking. We’ll see what he comes up with in Part 25.
In Part 22, 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 Avaria’s money.
First, I want to make sure I was clear about what monetary expansions and contractions do. They have a many effects, so this should not be considered 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) until prices adjust to the new value of money. Second, they increase uncertainty in prices, making long-term contracts more challenging and leading to more investments failing (loss of Wealth 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 about price uncertainty, 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 Wealth 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! Trials of administrative pricing (central planning of an economy) showed 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 huge inefficiencies due to this change in prices. And this inefficiency cost is incurred each time the rate of inflation or deflation changes, and it is probably even incurred (albeit to a lesser degree) when inflation or deflation is happening 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 systems. Part 24 here.
In Part 21, we talked about how expansions and contractions of the money supply don’t directly lead to a loss of Wealth Units, but they do indirectly lead to a loss of WUs due to the skewed purchasing behaviour and lost investments that those fluctuations 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 WU:Goldnote 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 Storybook 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 and depreciating. 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. He also recognizes that if anyone sees the small size of gold coins in his vault, they will flip out and maybe trigger another bank run, so he restricts access to the vault to only those who are trusted to keep it quiet how few gold coins are in there. And he explains to those trusted individuals that the number of gold coins is smaller because he has the rest of the reserves (like those two cars) stored elsewhere in the form of non-cash assets.
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 per se. 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.
In Part 19, we saw how the bankers came together to form a specie pool, which succeeded at avoiding that near-collapse when the bank run started. In Part 20, 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 Independent Bank’s experience, they set the reserve requirement to 20% and set the reserve-lending interest rate very high to discourage banks from going below that number. They also started being a little bit more parsimonious with who they would loan money to so that their fractional reserve banking system doesn’t topple (through a high default rata) at the slightest provocation. Remember, they don’t want to kill the goose that is laying their golden eggs! So they’ll make sure that goose lays a safe number of eggs.
So now the average reserve ratio increased from around 10% to around 20%. You know what the implication of higher reserve ratios is, don’t you? Let’s see what happens.
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. 50% of what it was before. This is a huge drop! And it is going to cause some serious issues.
First, let me first clarify what isn’t going to be a serious issue. If the total number of Wealth 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 WU:Goldnote ratio, which changed from 0.1 to 0.2. So, to be clear, no WUs were directly lost from the circulating Goldnotes decreasing.
But I said “directly” in that last sentence for a reason. A lot of WUs 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 the number of circulating Goldnotes. People setting prices would simply price their goods and services in terms of WUs and then use the moment’s exchange rate to determine the price in Goldnotes. That way, the price paid is always the wealth price, as expressed in WUs. They could even do this for loans, quantifying the size of the loan in WUs rather than Goldnotes.
Unfortunately, we don’t have a way of accurately knowing the up-to-the-minute WU:money 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 come to know that the value of money has changed. Or, sneakily, we keep the price the same and give less (shrinkflation) 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 WU:money 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 here and here.
How about an example?
Let’s say, in Avaria, 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 WU:Goldnote ratio, so prices had not yet 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 WUs 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 (because of lack of demand). So many of those WUs that were invested into Posh Muffler end up being lost.
That example helps illustrate how WUs 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 in Part 22.
In Part 19, I described the devastating impact of a societal default, and then I explained how the bankers averted it by creating a specie pool arrangement.
In this post, I’ll explain how societal leverage and societal diversification affect the risk of a societal default.
Societal Leverage
Remember the three kinds of societal leverage from Part 14? They are bank leverage, government leverage, and individual leverage. Let’s look at how each of these contributed to the near-societal default.
We haven’t added an Avarian government into the mix quite yet, so there was no government leverage at play here.
Next, take a look at individual leverage. 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 didn’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 cash wealth to keep them going, then it’s not such a huge issue when some of that money is lost. 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 high individual leverage and high bank leverage were the triggers of this near-catastrophe.
Those are my thoughts on how societal leverage contributed to this near-societal default, and, with that as context, it should be clear what the solution is. If you can avoid the sudden increase in bank leverage in the first place (optimally, by preventing the institution of fractional reserve banking), there wouldn’t have been the illusion of prosperity with a huge amount of surplus cash flooding the market, which means fewer high-risk loans and high-risk investments would have been made, individual leverage would not have ratcheted up so high, and society would have continued to generate wealth at a sustainable pace.
I think this is a good place to point out that booms and busts are not a “natural” part of an economic cycle. Sure, there are times when a natural disaster or a low crop yield can cause a loss of a lot of expected wealth from society, which will cause an economic downturn; and there are also times when a particularly high crop yield or something else can cause an unexpected influx of wealth to a society. But, as we just saw when I described Avaria’s societal default, these normal ups and downs are completely different from the economic torture incited by the booms and busts that come about from the wealth unit:money exchange rate rapidly changing as a result of human institutions (mostly banks and governments) tampering with the money supply. That tampering is what caused the initial boom through the illusion of wealth, and the aftermath of it is what caused the subsequent bust.
It’s like a spring that was pulled too far, and when the conditions that allowed it to be pulled so far like that went away, the spring contracted back suddenly. Normal economic growth and wealth generation build the spring to be longer, adding coils one by one. Sudden monetary expansion doesn’t add more coils; instead, it just stretches the spring. And the more strongly the spring is stretched, the more likely it is to suddenly recompress at the slightest provocation, the consequence of which is to rapidly destroy many of the coils that were slowly added one by one over many years of real economic growth.
Let me reiterate that point more concisely: Economic booms and busts are incredibly destructive of society’s wealth, and they are caused by human institutions tampering with the money supply.
Ok, now on to societal diversification . . .
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 a lower percentage of individuals in society would have lost all or part of their annual income when the crop was ruined, and that would have translated into a lower default rate, so the banks probably wouldn’t have been on the verge of collapse.
Income diversification is important for a society to help it weather unforeseeable drops in income streams.
These two factors–societal leverage and societal diversification–can help anyone evaluate the risk of a society to default. If a society is highly diversified and not highly leveraged in any of the three ways, it will be an economically solid society, and investments in that society would have a particularly favorable risk-return profile.
Honestly, I wish someone would start calculating these things for the different countries in the world. It would establish an incentive for countries to be prudent with their leverage and become well diversified because doing so would bring more international investment money in. Of course, other factors would also need to be evaluated, such as corruption and the degree of economic decentralization/freedom allowed.
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 the investment at the end 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, plus the deadweight loss of all the time and energy dedicated to the speculating.
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 in Avaria instituted fractional reserve banking and rapidly lowered their reserve ratios. These days, there’s enough excess wealth around that speculative bubbles can happen even without a sudden influx of cash to an economy. All they need is a sufficient amount of hype to get the bubble started.
Let’s briefly apply this discussion to a modern topic: cryptocurrencies. Most cryptocurrency “investments” these days are nothing more than speculation, and I’ll explain more in future parts of this series why an intrinsically worthless currency (even one that cost a lot of electricity to mine, *ahem, sunk costs*) 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.
In Part 18, I explained the financial details of Independent Bank to show more thoroughly how the financial shock led to a drain on the bank’s reserves and triggered the bank run. Here’s a quick recap of that to clarify it:
Avaria’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, a bank’s revenue may drop below its costs, which would mean it is stuck trying to pay its costs either with even more newly created money or by paying directly with specie it has in the vault, both of which result in the same problem–even lower reserve ratios, which always translates into even more severely depleted stores of specie
Depleted reserves trigger bank runs when word gets out and people get scared
Before I describe the ingenious solution the banking leaders come up with to prevent Avaria’s entire monetary system (the house of cards) from collapsing, how about I describe the likely outcome of this situation if the banking leaders did nothing? Yes, it’s time to see how damaging fractional reserve banking can be to a society when it leads to bank failures.
First, the people in line at Independent Bank see people from the front of the line walking away with bags of gold coins that they received in return for their Goldnotes. But then, finally it happens–someone gives the teller a pile of Goldnotes and requests they be exchanged for gold coins, and the teller comes back with only a few gold coins in hand, apologizing that these are the last of the gold coins from the vault, and the bank forces everyone out and closes its doors. The other customers who were in line freak out, realizing that their Independent Bank Goldnotes are now worthless. If only they’d gotten in line earlier, they could have avoided losing all that money!
What do they do? They immediately go home and collect all the Goldnotes that they own from the other four banks and send them with family members to the originating banks so they can get in line early enough to exchange them for gold coins. Soon, word spreads and long lines form at the other four banks. And, of course, since the other four banks don’t have enough gold coins in their vaults to redeem every Goldnote they have in circulation, they all close their doors as well.
Within a few hours, Avaria went from an illusion of prosperity to a financial panic. Some people lost all of their cash wealth because they didn’t get in line early enough, and now they’re worried about starving. Stores stop accepting those worthless Goldnotes and demand gold coins for payment. But prices are still so high from Avaria being flooded with money lately that few have the money to buy much, which furthers the economic upheaval. In the panic, mobs of scared people are entering grocery stores and looting whatever they can carry home.
Why are prices suddenly so “high”? Remember that the money price of a thing is determined by the WU:money ratio. Prior to fractional reserve banking, a gold coin or Goldnote was worth 5 WUs (see Part 12). But then, after the institution of fractional reserve banking, 33,000 Goldnotes were circulating, which diluted the same number of WUs over a much larger number, so each Goldnote came to only be worth 1.5 WUs. And with the recent banking competition pushing banks to decrease their fractional reserves further, it would have dropped lower than that even. For simplicity, let’s say that each Goldnote represented 1 WU when this panic started. So if the true price of all the food needed to feed a small family for a week was 20 WU, its money price listed at the grocery store would have been 20 gold coins (or, equivalently, 20 Goldnotes). But now that all the Goldnotes are deemed worthless and not accepted as a common medium of exchange anymore, the WU:gold coin ratio is back up to around 5:1. So if, on the day of this panic, someone actually paid the full listed money price with gold coins, they would be paying 5x too much! They should only pay 4 gold coins if the money price had adjusted instantaneously to account for the new WU:money ratio, but instead customers are being asked to pay 20 gold coins. And since money prices only gradually change as store owners slowly acquire information suggesting that money has come to be worth more again, those artificially elevated prices will stick around for a while. This is why people are panicking even when they have 40 gold coins–it seems like they only have enough money to feed their family for 2 weeks.
Even though money prices will gradually adjust to the new WU:gold coin ratio, the damage will already have been done. There was a horribly uneven redistribution of cash wealth because some people lost all of their cash assets and other people (who got in line at the banks early enough) found that they ended up with more cash assets than before. And others were stuck overpaying up to 5x for things they desperately needed. There was social upheaval. There was crime. There may have been starvation in spite of an adequate aggregate amount of food. Investment into new ventures screeched to a halt, and other new ventures failed. What I’m describing is the aftermath of a societal default.
In additional to all of that, the trust in banks as a whole was completely lost, which will probably last a generation or two until the societal memory of the event fades and new bankers find a way to brand themselves as wholly different than those “bad” banks of generations past.
Meanwhile, the Avarians still don’t clearly understand how it all happened–the banking system had become so obscure, perplexing, and incomprehensible. (Which is a myth! That’s why I’m writing this series!) So the Avarians will probably find themselves with fractional reserve banking again eventually, not knowing that a simple bank auditing system (as described in Part 13) could prevent all that damage from coming back and progressing to even worse damage as their monetary system once again travels down the natural evolutionary path of money.
Pretty bleak, right? It all seems so unbelievable to our modern sensibilities, doesn’t it? But here’s the thing–these very events (societal defaults, usually driven primarily by bank leverage and also government leverage, as we’ll see later on) have happened to many societies in the past, in the United States and elsewhere, and they happen in modern societies as well.
Unfortunately, societal memory fades so quickly that these things happen over and over again, often within even just a couple of generations. A little understanding of the history of money in the general populace can help prevent us from being “doomed to repeat” that history because people won’t support policies that they know will lead to these sorts of issues. That’s why I’m writing this series!
And now let’s get to what actually happened in Avaria.
The banking leaders decided to act as soon as they saw that long line of people at Independent Bank trying to exchange their Goldnotes for specie. Remember, the bankers know perfectly well that Independent Bank will run out of specie before the day is through, which will likely lead to lines at all of the banks and kill the goose that is laying the golden eggs for them.
First, they organize an emergency meeting. The leaders of all 5 banks are there, although the leader of Independent Bank is in the corner playing a morose song on a lute.
The other four leaders initially talk about allowing Independent Bank to declare bankruptcy and then spinning this to the public to convince them that Independent Bank was the only imprudent bank and that all the rest of them are very safe. Their hope would be that a strong and widespread PR campaign will prevent generalized distrust in the banking system (and the ensuing lines at their doors requesting specie) after Independent 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 reason with themselves, they can’t let that happen for the sake of society–think of how disruptive to society it would be if the banks go away! 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 Peppercorn 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 Independent Bank some of those gold coins–just for the short term–to help it avoid bankruptcy? We could make a big show of delivering cartloads of gold to Independent 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 waste all that time waiting 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 insinuate that it was selfishness on the part of the individuals who were at the front of the line requesting all those gold coins, and in that way we can 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 Independent 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 Independent 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 Independent 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 by the other banks. And, if that happens, there may not be enough reserves in the 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 Independent 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 applied to this arrangement because it is misleading and confusing when real central banks are discussed (we’ll get there). So I will refer to this solution they came up with as a mutual specie reserve agreement, or a specie pool for short.
Where is Avaria’s monetary system now? It still has fractional reserve banking, and now it also has a specie pool to help the banking system be a little more stable so the bankers can continue to milk the cash cow that is fractional reserve banking.
In Part 20, 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.
In Part 17, I described how Independent Bank’s shortage of gold coins led to Avaria’s first bank run. In this post, I’ll explain more thoroughly how Independent Bank started running low on gold coins in the first place.
So let’s look at a bunch of different details of the finances of these banks, which I hope will come together by the end of this post to make my point clear.
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 and then lend through fractional reserve banking. If you’ll recall, Peppercorn Bank originally charged monthly gold coin storage fees, but let’s assume the banks don’t do that anymore because they are competing to get as many depositors as possible, so instead they charge no storage fees in an effort to get as many deposits as possible, which they can use a reserves to lend out even more money.
Before looking at the other financials banks deal with, let’s take a moment to look more closely at the banks’ single revenue stream. How can they earn as much as possible from it? There are three ways: (1) get more deposits, which increases the total amount of money they can loan out, (2) push their reserve ratios even lower to lend out even more money, and (3) find a way to charge higher interest rates on their loans. And the way to charge higher interest rates is by making riskier loans.
Ok, now back to looking at the other financials . . .
Bank costs. These banks also have many different costs, including building maintenance costs, printing fees, other supplies, wages for security guards, wages for tellers, etc.
Bank profitability. Hopefully the income they earn from their single revenue stream (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 Independent Bank. And if someone gives them a Goldnote from Peppercorn Bank, they can simply go down the road to Peppercorn Bank and exchange it for a gold coin. Or maybe Peppercorn Bank has received some of Independent Bank’s Goldnotes as payments, so they could trade Goldnotes for Goldnotes. At this point in Avaria, 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 either way 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, money prices would marginally drift back to what they were before, etc. The only lingering evidence that those Goldnotes 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 additional 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 Independent Bank got itself into, so let’s jump into its situation directly.
Remember how Independent 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? Let’s also say that it was 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 Independent 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 very fast, which was not immediately a big problem–they just have to wait a little longer before making another loan. But the problem was that its Revenue section was also not accumulating money as fast as it normally does. And since most of a bank’s costs are fixed monthly costs, Independent Bank was still having to spend a lot of money from its Revenue section. Do you see the problem?
Soon enough, Independent 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 Independent Bank eventually chose to print more Goldnotes (less conspicuous that way), which predictably led to the usual percentage 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 Independent 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 too low and eventually trigger a bank run.
And just to be explicit about one of the lessons to be learned from this situation, I’ll say this: The lower the reserve ratio, the smaller the financial shock needed to drain reserves enough to trigger a bank run.
In Part 19, we’ll talk about how the bankers respond.
In Part 16, Avaria went from having one bank to having five banks in a pretty short time. We also saw that the bankers and their investors started getting greedy, pushing their reserve ratios down lower and lower. I described it as a house of cards.
So what will we do this week to give a little push to this house of cards?
Let’s say the farmer has a bad crop. Maybe there was an early frost. These things happen. And it means that one of the primary sources of new wealth for the society didn’t produce as much this year. Unfortunately, a lot of people were planning on that additional wealth coming into society, so let’s trace the ripple effects of this bad crop.
First, the farmer, ever since buying the tractor and expanding his farm, has been hiring a lot of farm hands lately. Suddenly he doesn’t need them for several months.
And then there are all of the people who are normally employed to help transport and process and re-sell all the food the farmer harvests. They all lose a large portion of their income as well.
When you start adding up all the people who just lost some or all of their annual income, it comprises a large minority of society. And what do people do when they are suddenly impoverished? They especially cut back on luxury items.
With business recently booming in society, primarily because of the influx of cash that gave the Avarians the illusion of greater wealth than they really had, a lot of companies selling luxury items were cropping up and growing quickly, and they were borrowing a lot of money to rapidly increase production capacity. But their sales started dropping as the money price of things adjusted, which caused that illusion of wealth to start to dissipate. And then their sales took a further plunge as a result of the bad crop and resultant shortfall of wealth in a large chunk of society. Those dropping sales led to those businesses defaulting on their loans. Some factories that were half-built had to be scrapped entirely. Many half-made products were never completed. Beautiful new stores were abandoned. What a waste of wealth! And this business-related waste of wealth is in addition to the loss of wealth (relative to expectations) that the bad crop instigated. It’s a powerful example of how damaging uncertainty in an economy can be. And the most potent inducer of uncertainty is when money doesn’t have a stable value because money prices no longer are accurate at indicating the wealth price of things, so nobody can accurately gauge how much wealth they have and how much wealth they are spending.
So now we have a lot of businesses that have defaulted on their loans, and surely a lot of families as well. Therefore, the default rate of commercial loans and private mortgages is rising quickly. And who do you think gets hit the hardest by all these loan defaults? Yes, of course, it’s the people who own all the loans–the bankers. They, after all, are the ones lending out the majority of money in society.
Let’s say the problems start with Independent Bank. As the newest bank, it was being extra aggressive to try to play catch up with the other banks and earn its fair share of the market, so it was pushing its reserve ratios the lowest by making as many loans as possible, including to risky borrowers. And then, when it stopped receiving payments on a large percentage of its loans, for reasons that will be explained in Part 18, its gold coin supply in its vault became critically low.
One of the employees walks into the vault and sees that the bank is almost out of gold coins. He runs home and tells his family members that they better exchange their Independent Bank Goldnotes quickly because the bank is going to run out of gold coins soon. So they all run to the bank and line up, asking for specie in exchange for all their Independent Bank Goldnotes. Other passersby see the line and ask what’s going on, and the people in line tell them the bank is running out of gold and that they better redeem their Independent Bank Goldnotes quickly. The people already in line are happy to share the news with others because it’s exciting and because it won’t hurt them if others get in line behind them.
In this way, the news spreads, and the line grows longer. Within another few hours, Independent Bank is going to be completely out of gold, which would mean telling its depositors that they can’t get specie anymore and then having to liquidate its assets to try to repay them. Independent Bank is on the verge of failure.
This is Avaria’s first bank run! How exciting, right?
Does this mean we have a societal default on our hands? There are a lot of people defaulting on loans, but I would say it hasn’t necessarily led to a full-blown societal default yet.
But never fear–the owners of all the banks see what’s happening. They see that this could go downhill for all banks real quick if people start worrying about the reserves in them as well and then start lining up at their teller windows too. That means their entire system of massive wealth generation for themselves (i.e., aggressive fractional reserve banking, which is the house of cards) could completely topple! They need a solution, and fast. In Part 18, I’ll further clarify Independent Bank’s financials to show how it ran low in gold coins, and then in subsequent posts I’ll move on to explaining the solution the bankers came up with.
As promised at the end of Part 15, in this post I will add a couple more thoughts to everything else I’ve written about fractional reserve banking, and then we’ll see what happens next in Avaria.
The first point I want to make is that bankers really love fractional reserve banking. Think about it: All wealth in society is stored either in the form of cash assets or non-cash assets, and the banker is earning interest on a large percentage of the entire cash assets in the society. In the case of Peppercorn Bank, he was earning interest on 23,000 of the total 33,000 Goldnotes in circulation, which is 70% of the entire cash assets of the society! Wow.
Here’s a new formula I’ll introduce to help you quickly calculate that:
Portion of Society’s Total Cash Wealth that Bankers Took from Others and Are Earning Interest On = 1 – Reserve Ratio
That formula does assume everyone has deposited all their gold coins into Peppercorn Bank, so the number ends up being a little less. But still, that’s why bankers can get very rich off of fractional reserve banking.
The second point I want to make is that I haven’t clarified exactly why unstable prices are so inefficient for an economy. I have, however, written before about the importance of prices being accurate, and there may be an opportunity to further illustrate that principle before this series ends. We will see.
All right, it’s finally time to get back to the story of Avaria and see what monetary changes arise next! (It only took 5 1/2 posts to unpack all the changes that came about as a result of instituting fractional reserve banking way back in Part 10, which I’d say isn’t too bad.)
Maybe you can guess what happens after the banker starts earning all that money from interest on the 23,000 Goldnotes he printed and lent out. People start seeing that he’s earning a lot of money. They eventually figure out what he’s done, and the clever ones figure out a great secret: They can start a bank and do the same thing!
The town storyteller decides he has lots of rich friends who pay him to tell them stories, and he’s not earning enough just telling stories, so he uses his persuasive speaking skills to get them to invest in a new bank. He names it Storybook Bank. He spends the investment money on a beautiful new bank building with a nice big modern and extra-safe vault in it, and he designs a more beautiful banknote that, for simplicity, he also decides to call a Goldnote (but there’s the seal of Storybook Bank on this one instead of the Peppercorn Bank seal).
Through all these efforts, plus on the recommendation from all the rich influential people who just invested in the bank, many people start choosing to store their gold coins in Storybook Bank instead of Peppercorn Bank.
Over time, other entrepreneurs in Avaria found additional banks. There’s the town preacher who founds Veritas Bank with the investment of his parishioners, and the Astro Bank founded by the industrious scientific community, and the Independent Bank founded by the antiestablishment community. All told, there are 5 banks at this point. Kind of overwhelming, really!
They all find their niches and start earning money for their investors by instituting fractional reserve banking. And they all closely track the variability in the amount of specie in their vault and lend out the maximum number of Goldnotes they can get away with, sometimes even pushing their reserve ratios down to below 15%. After all, their investors want as high of a return on their investment as possible, and the founders of all these banks made big promises to them.
I just want to pause briefly here and remind you what a 15% reserve ratio means. If all banks have a 15% reserve ratio, that means 85% of the money circulating is NOT backed by specie. The society’s money started out at 100% backing, then it dropped to 30% when Pepper Bank instituted fractional reserve banking, and now it’s at 15%.
Additionally, a 15% reserve ratio means banks are highly leveraged–85% leveraged to be exact. This is obviously pretty high.
Meanwhile, business is booming in society. There’s so much capital available that new businesses are cropping up all over the place, everybody is hiring, and there’s excitement in the air. Sure, prices are rising like crazy (from the total number of circulating Goldnotes continuing to increase as reserve ratios drop), but that’s a small concern because money seems so plentiful everywhere. People don’t ask why there’s so much apparent wealth everywhere. Why question such a wonderful thing? They know that they’ve worked hard for so long as a society, their reward was bound to come sooner or later.
You can see where this is going. This house of cards is set to topple at the slightest provocation. We’ll give it a little push in the next post and see what happens!
Clear Thinking on Healthcare 