Category: General

In Part 14, I added the idea of societal leverage to our foundation of knowledge so that I can use it in this post to give a final assessment of the overall impact of fractional reserve banking on a society.

To do that analysis, I will get back to comparing the factual scenario (fractional reserve banking) to the counterfactual scenario (sticking with 100%-backed receipt money).

The factual scenario was to institute fractional reserve banking. This created a ton of bank leverage that also allowed for greater individual leverage (because now more cash was available for borrowing). Individual leverage is all well and good–people need to borrow money sometimes, especially for big expenditures like business ventures–but it’s really the bank leverage that initially caused so many problems because it artificially expanded the total cash in society, which meant that the WU:money exchange rate had a sudden and drastic change, thus initially making people experience the illusion of wealth before money prices adjusted to the new WU:money ratio. And then later those same people realized that they had made a bunch of foolhardy expenditures that they really couldn’t afford because of that illusion of wealth. There are many more detrimental effects on an economy when there’s a sudden shift in the value of money (and, therefore, the money prices of things are all out of whack), and they will be explained in later posts. But suffice it to say for now that this sudden shift caused an upheaval in the Avarian economy, which always results in the loss of a lot of wealth.

The counterfactual scenario was for the banker not to institute fractional reserve banking (maybe instead the Avarians had the foresight to institute an auditing system so that he couldn’t), but he still was able to furnish some loans to individuals by facilitating an effort to get depositors to pool and invest their excess cash wealth. Basically, the banker invented a primitive version of Kickstarter–it’s crowdfunding. And it involves no bank leverage and no exploitative loans. But it does of course still involve individual leverage because individual people are still borrowing money. The big downside of this scenario is that there won’t immediately be as much money made available for lending. But the value of money will remain much more stable, which will encourage investment, and the investments made by loaning someone else money will be through assentive loans, meaning the owners of the wealth that is being lent have agreed to temporarily give up that wealth in return for earning interest. The fact that they have agreed to loan their money probably means that they were able to make an informed decision about the risk of complete loss of their principal, so even if the investment does fail it will not be financially catastrophic in most cases.

Compare that to the impact of all people unconsentingly (it’s a new word) having a large percentage of their stored WUs stolen from them when the banker implements fractional reserve banking. Many of those people probably couldn’t stand to lose any of their WUs. And then the banker uses that stolen wealth to make exploitative loans so he can earn a ton of interest off it. This leads to a substantial shift in wealth from everyone to the banker. He will start to become wealthier and wealthier, and the people will think he has become so well off simply because the gold mining and banking businesses are very profitable these days, not knowing that he’s living off the wealth he has siphoned from them.

Hoping that fractional reserve banking will go away on its own at this point is naive. Why would the banker destroy the extra Goldnotes when they are paid back to him in the form of loan payments? Nope. What he’ll instead do is accumulate them until he has enough of them to fulfill another loan request. The WU:gold coin ratio will never go back to how it was without some external intervention forcing it.

You can probably see that, even in the short term (before we add in all the extra long-term issues that fractional reserve banking leads to), the institution of fractional reserve banking is a terrible idea. What’s crazy is that I learned about it in economics classes in college, and it was presented to me as a normal and interesting and benign fact of life. But when you dig in and really look at how it affects the total amount of and distribution of wealth of a society, it becomes a stark villain.

I’m not blind to the big upside fractional reserve banking has, at least in the short term–it makes more money available for borrowing, which ultimately can push society’s wealth forward much faster by funding new inventions and innovations. But that comes at the cost of forcefully taking away from every owner of Goldnotes a large percentage of their cash wealth to gain that benefit, and they don’t even get any of the interest earned on the loans that are made to those entrepreneurs using their wealth. This potential benefit to society also assumes that the person choosing who deserves the loans will do a good job finding the best place for the money to go.

So that’s the short-term analysis. Longer term, there are two huge and unambiguously negative impacts of instituting fractional reserve banking.

The first is that fractional reserve banking opens up the gate to Avaria’s monetary system continuing down money’s evolutionary road to more and more destructive situations. That will be illustrated thoroughly in the rest of this series, and you will see that the amount of wealth lost (and redistributed through exploitation) due to these monetary system changes is astounding.

The second negative long-term impact of fractional reserve banking is that it introduces bank leverage (plus some more individual leverage as well). Ultimately, bank leverage is probably the most risky form of leverage because, from a historical standpoint, it’s the kind that most commonly leads to societal defaults, which also will be illustrated in subsequent posts.

Based on all of that, here is how I will wrap up my assessment of fractional reserve banking: When you look at the short-term and long-term impacts it has, fractional reserve banking is the worst. No society should ever implement it.

Before I end this post, I want to address one more question that has arisen in my mind about all this. If a prudent amount of government leverage and individual leverage can be used beneficially, what about a prudent amount of bank leverage? Maybe just keep the reserve ratio nice and high so a bank failure is nearly impossible?

This could work, but don’t forget about the guaranteed costs of any amount of bank leverage: the change in the WU:money exchange rate, which causes people to lose a percentage of their WUs that were stored in cash and that causes prices to become unstable. Government leverage and individual leverage don’t have these same guaranteed downsides (assuming the loans they receive are assentive loans). So I would say that bank leverage is a form of leverage that you cannot “use prudently” like the other two types because, by definition, it relies on exploitative loans. Thus, the guaranteed, significant, generalized downsides of bank leverage make it not worth whatever benefits you hope to get out of it.

All right, that’s it for this post. In Part 16, I’ll first add a couple more short thoughts related to the institution of fractional reserve banking in Avaria, and then after that I’ll finally share what happens next.

In Part 13, I explained how the introduction of Goldnotes had anonymized the specie stored in Peppercorn Bank, which shifted it from a Gringotts style to a McDuck style and, without an auditing system to go along with that change, opened up the way to instituting fractional reserve banking.

In this post, I’ll introduce the idea of societal leverage, which will be necessary to help us more completely evaluate fractional reserve banking’s effects.

We hear about personal leverage and business leverage fairly regularly in financial discussions, but nobody ever talks about the idea of societal leverage.

When people think of leverage, they probably know it generally has to do with borrowing money, which increases risk but also increases the potential for greater gains. Thinking about leverage like this is a good starting point, and I’ll avoid getting too much more specific than that because it can get unnecessarily complicated.

But I will introduce one way to calculate leverage. It’s pretty easy, especially when viewed from an individual-level example. If a person has a house worth $400,000 and he still owes $200,000 on it, his debt is $200,000 and his asset is worth $400,000, so 50% of his asset is borrowed. In other words, he is 50% leveraged.

The risk of taking on leverage is that you will not be able to make your loan payments. This is called “defaulting” on your loan. And the risk of defaulting goes higher as the amount of leverage goes higher. For example, if a person earning $10,000/month takes on a loan requiring a monthly payment of $300, it’s a fairly small payment relative to his monthly income. But if he takes on a much larger loan that requires a monthly payment of $3,000, it’s a huge chunk of his monthly income. All it would take for him to default on that huge loan payment is a loss of income for even a short time or a large unexpected expense such as his furnace dying in the middle of winter.

On a societal level, we could say that the amount of “societal leverage” is a measure of how much of society’s wealth is borrowed. And its risk for defaulting (i.e., having a large percentage of the loans that constitute that societal leverage not be receiving payments) goes up as the amount of leverage goes up.

The reason talking about societal defaults is important is because a societal default is financially catastrophic for a society–it will destroy a large chunk of the society’s wealth and make society very unstable overall as well–just as an individual default is financially catastrophic and makes life very unstable for an individual. I’ll illustrate exactly how this plays out in future posts, but for now I want to look at the factors that predispose to a societal default.

Should societal leverage be calculated based on society’s total wealth (cash and non-cash assets), or should it only take into account society’s cash wealth?

There’s no right or wrong answer here; there are just more-useful and less-useful choices for our calculation. And the usefulness depends on the question we’re trying to answer.

In our case, we want to know how at risk a society is of defaulting (i.e., the risk of a “societal default”). And since making a loan payment is difficult to do with most non-cash assets (even if the lender would be willing to accept a vehicle as a loan payment, the borrower still needs to get to and from work!), looking only at cash assets probably makes more sense.

So what could cause a societal default? There are three factors.

Factor 1: Bank leverage

Remember how Avaria originally only had 10,000 Goldnotes circulating, but then the banker eventually printed an extra 23,000 of them? After that, the bank had issued 33,000 total Goldnotes, 23,000 of which were basically money borrowed from depositors (see the explanation of this in Part 10), which leads to this calculation just like I illustrated above with the house example: 23,000 / 33,000 = 0.7. So Pepper Bank is 70% leveraged. Note that 1 – Reserve Ratio = Bank Leverage (specifically referring to the amount of leverage the bank has on the receipt money it has issued). So a bank with a 30% reserve ratio is 70% leveraged. Even if a bank has a lot of other assets, if those assets are not easily sold to get more cash to keep up with withdrawals, low reserve ratios can be a pretty risky proposition.

I did some searching about historical reserve ratio requirements, and this article written by some people at the Federal Reserve said they were originally instituted in 1863 with the passage of the National Bank Act. The initial requirement was 25% (75% leveraged, that is), but in 1913 with the passage of the Federal Reserve Act the reserve requirement was lowered to 15%, plus or minus a little bit depending on the bank type. Then the reserve requirement was lowered again a few years later to 10%. I won’t chronicle all the changes and how they may or may not be a causative factor in various booms and busts in America’s turbulent financial history, but think of the monetary expansion that would have caused! Speculation city when you’ve got that much cash suddenly available for borrowing! And we’ve all seen what happens when speculation-fueled bubbles pop.

In the 1980s, the requirement was 12%, then it was lowered to 10% in the early 1990s, and then finally in 2020 the Federal Reserve lowered the ratio again, this time to 0%. Yes. That means banks can legally be 100% leveraged (but have other inducements to maintain some amount of reserves–specifically, they get paid risk-free interest on all of their reserves). Wow. That’s just a taste of how banks have been able to shape U.S. monetary policy in ways that benefit them like crazy. Instead of only earning money on their exploitative loans, they’re earning money on those and on their reserves as well. And if that interest rate on their reserves is too low, reserves will drop as banks shift to making more loans instead of keeping money as reserves, and they could become 100% leveraged. This is just asking for bankruptcies or bailouts (we’ll get to those too).

Factor 2: Government leverage

This one should be calculated a little differently because the denominator (i.e., the total asset value) of the leverage calculation we’ve been using is difficult to ascertain for a government. So instead let’s use the same number that banks use when they’re deciding whether to give an individual a loan. They look at the individual’s monthly income and then add up all the debt payments they have to pay each month. They generally won’t give a loan so large that, when you add in the new loan’s monthly payments, the person has to pay more than about 1/3 of their total income each month to all their debts. So, the calculation would be Government Leverage = Total Monthly Debt Obligations / Total Monthly Income. This seems like a good measure to use when considering a government’s risk of default.

Currently (in 2022), the U.S. federal government spends about 10% of its revenue on loan interest payments (update in October 2024–that number has risen rapidly and is up to 18%) (update in July 2024–that number has risen even more rapidly and is now up to 27% according to Grok). This number does not include any payments on the loan principal, but, still, it’s historically not the worst position for a government to be in from a debt standpoint. [When I originally wrote that sentence in 2022, it was true, but now in 2025 it’s no longer true.] For comparison, state governments in the 1830s and 1840s racked up huge debts for infrastructure investments and were having to put a much higher percentage of revenues into their loan payments. The specific numbers are not readily available online, but they were sometimes greater than 50% of revenues, as documented in the book America’s First Great Depression by fellow Canadian Alasdair Roberts. Of course, those payments in the 1800s were not just interest-only payments–they included payments on the principal as well.

Depending on how much of a government’s annual expenditures are discretionary as opposed to mandatory, even 15% of a government’s revenue going to servicing the debt could be a big problem if revenues go down too much or if a war starts. [Translation in 2025: We’re in a really dangerous financial position from the standpoint of government leverage.]

Factor 3: Individual leverage

Maybe a more accurate name for this factor would be “average individual leverage” or “aggregate individual leverage,” but just calling it “individual leverage” is simpler.

The calculation of this one would be the same as government leverage: Individual Leverage = Total Monthly Debt Obligations / Total Monthly Income, only applied to an individual’s income and debt payments. If we really wanted to get into the nitty gritty of this one, we would also have to consider individuals’ assets (especially their cash assets and fungible assets) since some individuals have a low income but a wealth of assets that they could use to make loan payments, but I’ll leave that alone because that level of detail isn’t necessary to get my point across.

Individual leverage can come into play and contribute to a societal default if a large percentage of people in the society owe a lot of money and then the economy suffers a hit (from a bank default, a government default, a natural disaster, a war, etc.) in a way that decreases a lot of individuals’ income enough to cause them to default on their loans.

Ok, so that covers the three kinds of leverage–bank leverage, government leverage, and individual leverage–that could cause a societal default.

I’m sure there’s a really erudite way to precisely define what officially constitutes a “societal default” and then use a whole bunch of historical data and come up with a really cool calculation of overall societal leverage that integrates all three of those categories of leverage into a single number that closely correlates with the risk of a societal default (which would be really helpful for assessing the riskiness of making investments in a country), but that kind of sounds like a PhD dissertation, so I’ll leave that to someone else.

I don’t know what the “safe” amount of societal leverage is, but the intuition should be clear that the higher the leverage goes of any one of those three types, it represents a higher risk of a societal default. And if two or three of them of those types of leverage are high at the same time, it increases the risk of a societal default even more and increases the likely severity of that societal default.

Take a look at the great depression as a good example of how a societal default can set a society back years or even decades in its progression of increasing wealth for the populace.

Well, there’s an introduction to societal leverage. It touched on many principles that I haven’t yet explained in this series, but introducing it early like this will prove useful in the next post, in which I will wrap up the pros and cons of fractional reserve banking.

In Part 12, we talked about the counterfactual to fractional reserve banking, which led into a new discussion of comparing and contrasting those two options to see which is better for society. I will continue that discussion in this post by first discussing the two different ways banks can store specie. It seems like a random thing to talk about, but you will see that it has implications on how money evolves in the society.

First, for anyone who has read Harry Potter, you know about Gringotts Wizarding Bank. They store each depositor’s gold coins and other valuables in individual vaults.

The other way to store specie is by making one giant pile of coins in a single big vault–picture Scrooge McDuck’s room full of money.

So the two options for specie storage are the Gringotts style and the McDuck style.

Let’s imagine that Peppercorn Bank originally stored each individual depositor’s gold coins on their own separate shelf in the vault (Gringotts style). That specific stack of gold coins would have a receipt number next to it, and if the depositor brought in that receipt (issued specifically to them with their name on it, remember), the banker could go straight to that specific stack of coins and know that the number of coins in that stack was equal to the number stated on the receipt.

In a Gringotts-style system like this, each gold coin was allocated to a specific receipt and, thus, to a specific depositor.

But then Goldnotes came along and changed all of this. When the banker switched out all of those receipts for Goldnotes, all the coins allocated to each receipt were taken off their shelves and thrown into the giant pile of gold coins assigned to Goldnotes in general. I guess the banker could have found a way to stamp a number on each gold coin and then issue a Goldnote with the same number on it, thereby assigning each Goldnote to a specific gold coin, but that would have been a lot of work, and, from the banker’s point of view, there would have been no benefit to doing it.

That’s why, when Goldnotes were first issued, Peppercorn Bank’s banking style shifted from the Gringotts style to the McDuck style. Specific gold coins were no longer assigned to specific depositors–the gold coins had become anonymized.

The upshot of this is that there is no longer any direct accountability to ensure each Goldnote has a gold coin backing it. No person can walk into the bank and demand to be shown their stack of gold coins anymore. All they can do is bring in a stack of Goldnotes and request to see that there are at least that many gold coins in the vault. And they would never know if there were enough gold coins in the vault to redeem everyone’s Goldnotes.

Therefore, the introduction of receipt money in Avaria–which I’ve said was an upgrade to their money–also opened up the way to having less than 100% backing of that receipt money. And when the banker has the option of storing fewer gold coins than there are Goldnotes circulating, he has no barriers left to instituting fractional reserve banking.

Assuming the Avarians were savvy enough to anticipate this situation, is there a way they could have transitioned to receipt money without opening up the way for the banker to transition to fractional reserve banking with all its associated inflation and usurped wealth?

There are two options. The first is what I described above–each Goldnote would be assigned to a specific gold coin. When Goldnotes are all being used locally, that’s a reasonable option.

But if Goldnotes started to be used all over the country, then it’s possible that the vault that contains a specific Goldnote’s coin could be hundreds of miles away from the person who has the Goldnote, and that gets to be inconvenient if someone ever wants to redeem their receipt money for specie. So, in the case of anything other than a pretty localized receipt money circulation area, receipt money issuers need an auditing system.

This auditing system could be rather simple. The banker would be required to keep track of how many Goldnotes he has circulating, and then the auditor would compare that number to the total number of gold coins they count in all of the vaults. The two numbers should match.

An auditing system like this would have allowed Avaria to transition to receipt money (with its associated anonymization of Peppercorn Bank’s specie) without allowing Peppercorn Bank to institute fractional reserve banking.

By the end of this series, you’ll see that 100% backed receipt money is probably the best monetary system imaginable, and anything beyond it is a downgrade, which means that the simple auditing system I just described is the most important roadblock a society could create to stop its monetary system from going past that point on the evolutionary road of money.

In Part 14, I’ll get back into looking at the effects of fractional reserve banking. There’s still more to process with that one!

In Part 11, I wrote about the benefits of inventions and innovations to the wealth of a society, and I also mentioned that new ideas need capital to bring them to fruition, which is why the loans the banker made after instituting fractional reserve banking were potentially very beneficial to Avaria’s future overall wealth.

This week, let’s talk more about the societal costs of instituting fractional reserve banking.

Let’s first remember where Avaria’s monetary system is. It has evolved all the way to fractional reserve money (see Part 10), which means the receipt money (Goldnotes) that used to be 100% backed by specie is now, according to the banker’s self-imposed limit, only backed 30%. Avaria went from having 10,000 Goldnotes in circulation to 33,000 Goldnotes in circulation, the extra 23,000 of them being created out of nothing when the banker printed them to lend out.

Now on to the costs of doing this . . .

Let’s say each Goldnote (or, really, each gold coin that the Goldnote entitled the bearer to) originally represented 5 WUs before the transition to fractional reserve money.

(As a reminder, that means you would need to work for 5 hours performing average unskilled labor to earn one gold coin.)

5 WUs x 10,000 Goldnotes = 50,000 WUs stored in the form of cash assets in society.

And then the banker printed an extra 23,000 Goldnotes, so what happened to the WU:Goldnote ratio? No new Labor Units were generated when he printed those extra Goldnotes (wealth doesn’t come out of nothing–it comes out of the earth (and sun)!), so the number of total WUs saved in the form of cash by society hasn’t changed. Thus, our new WU:Goldnote ratio is 50,000:33,000, which means each Goldnote is now worth only about 1.5 WUs, which is about 30% of what they were worth before. This means that when the banker printed all those extras, he took 70% of everyone’s cash wealth from them! They didn’t know it at the time, but their hard-earned wealth was being taken from them to furnish all those loans. And the only one who will profit from all of this is the banker, who will be earning interest on all the loans he owns.

And what do you think will happen to money prices when Goldnotes are suddenly only worth 30% of what they were worth before? Yes, eventually money prices will adjust to be approximately triple what they were before. But, until then, Avaria is flooded with money, and people don’t know their wealth hasn’t actually increased as much as the amount of money suggests, so this will cause other problems we’ll discuss in future posts.

So, the loans were a potential boon to society, but they came at the cost of everyone losing 70% of their cash wealth, plus they imposed another major cost to society–that of some serious economic inefficiencies that arose from prices dramatically shifting. And also remember what I told you to remember in Part 6–when the value of money is unstable, it makes investments riskier, so investment (at least, investment by people who are investing their own money) will decrease.

There are some other costs to fractional reserve money that I haven’t discussed yet: One is booms and busts (and the bank failures that go along with them). And another is that fractional reserve banking acts as a gateway to the road that leads to fiat money with all of its attendant exploitations. I’ll be explaining these in due time!

Overall, will the benefits of the innovations fueled by those loans outweigh all those costs to society?

In the long term, it’s theoretically possible, and it depends on how much benefit to society those loans precipitate. But let’s consider a counterfactual.

What if the banker, instead of switching the society to fractional reserve money, instead said, “All this gold is just sitting around doing nothing. And there’s that entrepreneur who’s looking for a 5-year loan to start his gas-powered vehicle company. I’m going to ask my biggest depositors if they’re willing to allow me to lend any of their cash savings to the entrepreneur for those 5 years and, in return, I’ll pay them a portion of the interest I charge him.” So the banker asks around and it turns out that, in aggregate, his depositors are willing to lend out 7,000 gold coins.

How exactly would this lending work? Let’s say the farmer originally deposited 400 gold coins in the bank and still has all 400 of those Goldnotes in his possession. He agrees to lend out 300 of his Goldnotes, so the banker takes the 300 Goldnotes from the farmer and, in exchange, gives him a certificate that says, “This entitles the farmer to 300 Goldnotes in 5 years and 1 Goldnote monthly in interest until then.” Yep, it’s a bond, which has always just been a fancy name for the piece of paper that someone gets when they lend money to someone.

The entrepreneur got to borrow 7,000 Goldnotes to build his factory, and no inflation or usurpation of wealth happened!

Having only 7,000 Goldnotes to lend (instead of 23,000) means much less investment in potential wealth-generating innovations. Those other entrepreneurs who would have borrowed money will just have to wait until society has more to lend. Or, they could find outside funding from another society, which would work just as well.

Which version of reality is better?

On the one hand, with fractional reserve banking, you’ve got a lot more investment earlier on, but it comes with several major costs, including people losing 70% of their cash wealth without having any way to stop it (while the banker gains a bunch of wealth by taking all the interest from loaning all that money!), dramatic price shifts and the economic inefficiencies they induce (the linked post explains why prices are so important in an economy, but this series will also directly address the specifics of this situation in upcoming posts), the booms and busts and bank failures that monetary expansions and contractions cause, and the significant risk that the society’s money will continue all the way down the evolutionary path to fiat money with all its issues.

And, on the other hand, you’ve got less investment earlier on, but there are no major costs to it.

Over the next few weeks, I’ll delve more into the downsides of fractional reserve banking, which will help us better quantify them so we can weigh them against the upsides.

But before I end this post, I’d like to introduce two new terms: exploitative loans and assentive loans.

An exploitative loan happens when someone is lending wealth that isn’t theirs and that they don’t have approval to lend out. For example, the banker, who is storing other people’s wealth, is exploiting those owners of the wealth by lending out their wealth (without their consent) and earning interest on it.

An assentive loan happens when someone is lending wealth with the assent of the owner of the money (usually because the owner of the wealth is directly making the loan). Like the counterfactual I described above.

Assentive loans don’t induce any inflation, and the owner of the wealth gets the benefits of the loan.

Exploitative loans induce inflation (because the banker carries them out by printing extra Goldnotes), and the banker is the one who gets all of the benefits of the loan.

As a final sidenote, have you noticed that I introduce a lot of new terms in this series? It’s because people need clearly defined and precise terms to encapsulate ideas. Once an idea has been well understood and encapsulated into a term, that term acts as a base upon which new ideas can be built. In this way, you can construct a huge edifice of clear and thorough understanding about a topic that was previously incomprehensible. So that’s what we’re systematically doing here. And, if I achieve that purpose well, the impact that this knowledge will have on your opinions about modern governments’ fiscal policy are hard to overstate.

Part 13 here.

I introduced so many new things in Part 10 that it will take several posts to process them before progressing Avaria’s monetary system further.

First, I said that this new gas-powered vehicle business venture will be very beneficial to society if it works. Why?

Remember how I said way back in Part 1 that all of society’s wealth originally is gleaned from the land (mixed with labor)? And remember how we are quantifying wealth in units that I’ve been calling Wealth Units (WUs)? Well, what happens to those WUs after they’ve been gleaned is they get distributed throughout society as people provide goods/services for each other and get compensated.

So the WUs are spreading around from person to person, but do those WUs ever get consumed/lost from society? Or do they just keep circulating around and around forever?

We discussed this already when we talked about the blacksmith painting his house black. That paint is slowly going to wear off over the next several years, and then he’s going to have to paint his house again. So if the materials used to make the paint cost 4 WUs, those 4 WUs are now lost from society. But that’s better than not painting his house and the whole thing rotting, which might lead to a loss of 10,000 WUs from society.

Or think of the farmer feeding his family with part of his harvest. Every bit of food that is eaten is WUs that are lost from society.

Maintaining a human society costs WUs every day. All things are depreciating, so they are all dissolving away WUs each day. And if there are lifestyle changes (for example, that people decide they want to live in larger houses that now depreciate more WUs per year than their previous smaller houses), the daily cost of maintaining that society increases. And as long as the society can afford it, this is not a problem.

But it’s wonderful when there are innovations that decrease the daily cost of maintaining a society . . . innovations like gas-powered cars and tractors that can decrease the cost of travel and farm work. If the farmer and his farmhands used to spend an accumulated 800 hours of labor per year harvesting grain, but then the farmer buys a tractor that cuts the harvesting time down to 200 total hours, he has just saved 600 hours of labor. And assuming at least some of that extra time is put into working to glean more wealth from the land (say, he expands the number of acres he farms the next season), this innovation has now increased the overall wealth entering society. By the way, I’m assuming here that the depreciation of the tractor is lower than the additional WUs it enabled the farmer to glean.

So, like I explained in Part 4, the inventions that make a society wealthier do so by lowering the cost of maintaining their standard of living. And any invention that does that for the wealth-gleaners and frees up more of their time so they can glean more wealth per year is especially helpful for increasing society’s wealth.

I haven’t added in the extra layer of complexity of considering trade with other societies, but it shouldn’t be too difficult to see that if Avaria starts actively trading with other societies, this will increase its wealth even more as Avarians start to specialize in things that they are particularly good at making and then achieve even greater efficiency gains through economies of scale while also receiving goods from other societies doing the same (assuming travel costs don’t outweigh the lower wealth prices they’re getting from imports).

An important point about how trade increases wealth is this: When two people or two societies make a willing trade, it’s not like one is getting wealth and the other is getting goods. Both are trading things that they see as approximately equivalent value, which means that there is not automatically a net flow of wealth in one direction or the other. The exception to that is the profit that the business owner is receiving. For example, if the blacksmith starts exporting his excellent cook pots to another society, and he’s charging 10 gold coins per pot, with 1 of those being his profit, then when he gives up a pot that cost 9 gold coins to make (including the materials and his time) and gets 10 gold coins in return, there has been a net transfer of 1 gold coin to Avaria. And if the WU:gold coin exchange rate is 5:1, that means Avaria has netted positive 5 Wealth Units as a result of the trade. Of course, businesses based in the other societies are also receiving profits, so it all may be a wash. It really just depends on where the business owners live, because that’s where the profits from the business are getting sent to.

Ultimately, this is how we progressed from hunter-gatherer and agrarian societies to our modern-day societies filled with more wealth (and spending more WUs per day) than humans even a couple hundred years ago would ever have imagined. It happened one invention at a time–the loom, the printing press, electricity, the lightbulb, the internet, etc.

So that was the first thing I wanted to spell out a little more clearly.

And the second thing, related to all of that, is this: Inventions often require capital to develop and disseminate them. Without enough investment into these ideas, nothing happens with them, and the wealth of a society doesn’t progress.

So that’s why I said the banker’s loan to the entrepreneur provided a great service to society. Each of his loans have a chance of paying off bigtime to society.

And my final point of this post is to point out the difference between money and wealth in a new context by asking, What pays for things–money or wealth? I hope it’s obvious by now that money doesn’t pay for things; wealth pays for things. Money is just the medium we use to store that wealth. I hope this makes it clear why I emphasized that so much early on–that money has two purposes, and the second one that many people forget is that it is a store of wealth.

So, when you pay for something by giving money, you’re doing that because the money is storing wealth. And people need to be compensated for their work (and the goods and services they’re providing) with wealth because wealth is the only thing that can be traded for other forms of wealth, such as food and clothing and shelter.

For example, if you live in Avaria and are hungry, you can go to the general store and exchange some wealth (stored in the form of a gold coin) for another form of wealth–food. Contrast that with if you brought in some Monopoly money to the general store and tried to buy food with it. Why would the store owner refuse? It’s not because it’s the wrong kind of money; it’s because that money is storing no wealth. (Clearly Avaria is not in Canada because Monopoly money is basically is what we use there.)

I’m explaining this last point specifically and thoroughly because it’s another insight that modern monetary theorists don’t understand–they think that money is what buys things, so they think printing more of it will be able to buy everything everyone in society needs. I hope I’ve thoroughly debunked that misunderstanding by now.

That’s all for this post. In Part 12, we’ll talk about the downsides of the banker giving all of those loans.

I wrote in Part 9 about the characteristics of optimal money and showed that Goldnotes actually do a little better than gold coins.

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

First, let me add a new term. The general term for intrinsically valuable stuff being used as money is specie (not to be confused with species).

Ok, now let’s get back to Avaria to see what happens next.

Peppercorn Bank has become a very successful business. After the banker introduced Goldnotes, everyone in society started storing their excess gold coins in Peppercorn Bank because Goldnotes came to be preferable to having to carry around gold coins. So the banker was earning a lot more in monthly storage fees.

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

He, being a banker, was tracking pretty closely the day-to-day changes in how many gold coins he actually had sitting in his vault. He found over the next few years that he was usually storing around 10,000 gold coins, but it could go as low as 8,000 depending on the time of year and other factors. And he is sure it has never gone below 7,000 ever since society shifted to primarily using Goldnotes.

So he gets an idea. He says to himself, “Self*, what if I lend out those extra 7,000 coins that are just sitting there doing nothing?”

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

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

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

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

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

In fact, something surprising happens over the next few months after he gave the entrepreneur those 7,000 Goldnotes. He now has 17,000 Goldnotes in circulation, and he finds that he still never has specie requests that total more than 30% of that (just like before), which means the maximum he ever has to redeem is 5,100 gold coins. But he still has 10,000 gold coins in the vault, remember? So he still has 4,900 excess gold coins in the vault just languishing because they will never need to be redeemed!

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

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

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

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

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

The banker is very happy. He ends up having about 33,000 Goldnotes out in circulation, and 23,000 of those are ones that he lent out, so he is earning interest on 23,000 Goldnotes every month! And he no longer has an unnecessarily high number of gold coins just sitting in his vault.

The banker just invented what is called fractional reserve banking.

Is fractional reserve banking bad?

We’ll see–I’ll be analyzing the effects of it over the next several posts to definitively answer that question.

Here’s another question you should already know the answer to: Are new Wealth Units being created when he prints extra Goldnotes? Of course not. But, interestingly, Avaria feels like it’s booming because it’s suddenly flooded with money, and prices have not adjusted accordingly. So this apparent huge increase in wealth in Avaria is an illusion, as we’ll come to understand clearly, but the Avarians don’t know that.

There is a lot to process with this change, which we’ll do in the coming weeks, but my final point this week is that we just transitioned to yet another type of money!

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

* Shout-out to my first econ teacher, Prof. Kearl, who would talk that way in class

In Part 8, our gold prospector became a banker. And then he precipitated a shift from commodity money to receipt money by inventing Goldnotes.

I think this is a good place to finally give my official list of of all the characteristics of optimal money, which will be useful moving forward as we track the evolution of Avaria’s money. Here is my list:

1. Intrinsically valuable (scarce): This requires two things. Whatever is used as money needs to have some use independent of its use as money, and the more uses the better so that a replacement for one of its uses doesn’t significantly alter its overall demand. But that alone isn’t enough. If something is freely available without exerting any labor to procure it, it won’t necessarily cost anything even if it does have an important use. Oxygen at sea level, for instance. So the second requirement is that labor needs to be exerted to procure it, which now puts a price on getting it. The importance of this becomes clear when I get to the second characteristic . . .
2. Value is stable over time: This requires supply and demand to be fairly stable over time. Or, if one rises or falls, market forces will temper its degree of change and will also cause the other to rise or fall with it (as explained already in Part 6). The more industrial (non-monetary) uses for this commodity, the more its price will be dependent on many more things than just its monetary use, which will help keep its value stable when different countries shift to (or away from) using it as money. Also, if it has many different industrial uses, that means if one industrial use goes away due to innovation, that will not alter its demand (and, thus, price) quite so much. Choosing something whose supply and demand is less susceptible to economic shifts (i.e., choosing something that isn’t strongly a “luxury good” or an “inferior good”) can also help its value remain stable during times where stability in the value of money is most important, although this is less important in a society that has commodity money because the economy will not be subject to severe booms and busts like economies based on other monetary systems. (This point will be explained later in this series.) But even without so many booms and busts, if the commodity is firmly in the luxury good category, for example, then its value will drop significantly in a recession (thus messing with the WU:money exchange rate and making the money price of things unstable and unreliable), which makes a recession even worse.
3. Durable (and nonperishable): The importance of this one is obvious. We don’t want our money to suddenly become worthless if it goes bad or dies, nor do we want the edges of it to easily wear away through common use.
4. Homogenous (easy to determine the quality/worth of it): If metal is being used, this is easier to determine the purity and weight (and, therefore, the value) than, say, a cow, or a share in a new business.
5. Can be precisely measured: This is similar to the last one, and these days there isn’t as much of a challenge in measuring things, although back in the day this would have been an important consideration, especially if the type of money being used had a very high value-to-weight ratio, because that would require especially precise measurement instruments.
6. Easily divisible into the right amount for payment, and dividing it doesn’t alter its value: A live milk cow cannot be easily split into smaller values. Something like corn, on the other hand, meets this criterion perfectly. Or metal that can be melted and divided into different sizes, although that’s not as easy to divide as corn.
7. Not too heavy (portable): People would rather not be burdened by having to carry really heavy money.
8. Value-to-size ratio is in the sweet spot: If buying something takes a whole wagonload of money, that’s inconvenient, even if the money isn’t very heavy. On the other end of the spectrum, if you’re using diamonds for money, even losing a tiny diamond is a significant loss.
9. Impossible to counterfeit: We don’t want any loopholes that significantly alter the number of Wealth Units required to procure more of the thing we’re using as money. I suspect no good contender for being used as money is truly impossible to counterfeit, but this is a list of the optimal characteristics, and the goal is to get as close to as many of these as possible.
10. Aggregate quantity not easily manipulated by anyone: If there are only a few sources of the the commodity we’re using as money, then gaining control over those sources is much easier for a single person or a small group of people. This would then give the owner(s) of the sources of money the ability to manipulate the money supply in ways that benefit themselves and their investments. So the commodity being used as money needs to be able to be sourced from many places that cannot easily be monopolized.

Obviously nothing will meet all those criteria perfectly, but it gives us a standard against which we can evaluate any form of money.

Why don’t we do that right now and see how well gold coins and Goldnotes do?

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

Gold coins: Looking through the list, gold coins do a great job overall. They’re a little heavy maybe, but at least they’re fairly small (without being too small), and different-sized coins can be minted quite easily to suit different values. I said our blacksmith figured out how to counterfeit gold coins, but that was admittedly not super believable, and in modern times it would be very difficult to counterfeit gold coins and get away with it for long. Gold is unfortunately squarely in the luxury good category, so that’s another downside, although the degree to which this is important goes down as a higher percentage of the total gold supply is dedicated to its monetary use compared to its other uses (I will explore this idea further in future posts).

Goldnotes: Your first impression may be to think that it doesn’t meet the first criterion, but remember what I said in Part 8–Goldnotes are directly backed by something that is equal to their stated value, and they can reliably be exchanged immediately for that thing, so the fact that they’re made of paper is actually not relevant. In fact, Goldnotes actually do better as a form of money than gold coins, for several reasons. They’re lighter and easier to stack and carry. Their value is also more easily determinable, which I’ll explain briefly. Historically, when societies were using both precious metals and receipt money for money, the receipt money would often trade at a slight premium compared to the equivalent amount of precious metals because the value of the receipt money was more reliable than a metal coin. Why was the value of a metal coin less certain? There were a lot of reasons–counterfeit, coin clipping, etc. But when any coin was deposited into a bank, before the receipt money was given in return, an expert appraiser would check each coin to determine its exact value. So the receipt money circulating was basically like a guaranteed-face-value coin, which made it worth more than the sometimes questionable coins that were also circulating. Our blacksmith never would have gotten away with his counterfeiting had there been a sophisticated bank around performing this service! Overall, because Goldnotes are lighter and more reliable in their value than gold coins, I’m going to declare this shift from gold coins to Goldnotes an upgrade to a better currency! Thanks, banker.

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

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

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

We’ll be evolving Avaria’s money in a big way in Part 10 because I will be introducing “fractional reserve banking,” which is where things really start to get crazy.

Up to this point, I’ve explained a lot of foundational principles. The importance of those will become clear quickly as we watch Avaria’s monetary system evolve into a more modern system.

Let’s say a gold prospector visits the region and finds a new gold deposit in the mountain right next to Avaria. He establishes a mining operation there and moves to Avaria himself. He wants to safely store all this gold he’s mining so it doesn’t get stolen before he can sell it, so he has the blacksmith build him a huge safe.

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

Suddenly everyone in town is a little more hesitant about storing their hard-earned wealth in their house. And most Avarians have gold coins stored in their houses because they have been industrious enough to have accumulated some extra wealth.

And that’s when they strike upon a genius idea. They remember that the prospector has a large and secure safe in his house, so they make a proposal: “How about you store our extra gold coins in your safe for us? We know you have plenty of excess capacity in there, so it should be easy for you to do. In return, we’ll pay you a small storage fee each month.”

This is a no-brainer for the prospector, et voila! Avaria has a bank, and the prospector has become a banker. And since he loves spices so much, he names it Peppercorn Bank.

Each time a person brings some gold coins to store, he carefully counts them out and makes two copies of a piece of paper. He gives one to the depositor and keeps the other in the safe with the person’s pile of coins. The papers say how many total gold coins that person stored in Peppercorn Bank. And each time they visit him to put more money in the bank (or take some out), they just need to bring the most recent paper so he can update it. In this way, both the customer and the banker know exactly how many gold coins are supposed to be in that customer’s pile, and they could ask to go in and see them any time.

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

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

The banker also thinks that if a lot of people start using those papers for transactions, more people will want to do the same because of how convenient they are, so more people will end up converting their gold coins to paper by storing their money in Peppercorn Bank too, which will allow the banker to earn even more money off of storage fees!

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

After printing all the Goldnotes he needs, the banker visits every depositor, shares with them his new Goldnotes idea, and trades them for their deposit papers, making sure to give each depositor the appropriate number of Goldnotes to represent the number of gold coins they have already saved in his bank.

And from that point on, he always gives Goldnotes in exchange for gold coins stored in his bank. He cautions everyone not to lose any Goldnotes because there will be no way to prove that the Goldnote was stolen. But he does say that if a Goldnote is getting old and worn, they can bring it to him and he’ll exchange it for a nice fresh one.

Pretty soon, the townspeople are making exchanges both with gold coins and Goldnotes, but more and more they are transacting with Goldnotes due to the additional convenience of them being so much lighter and less bulky. But, any time they want some gold coins for any reason, they simply present the Goldnotes to the banker and he exchanges them for gold coins.

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

Is it ok that these Goldnotes are, themselves, nearly worthless?

Yes, because 100% of these Goldnotes are always able to be traded for gold coins immediately, so you can consider them to be fully interchangeable with gold coins, only they are more convenient.

Here’s the principle: Receipt money is equivalent to commodity money as long as 100% of the receipt money is backed by the commodity and the receipt money is always immediately exchangeable for the commodity itself.

In Part 9, I’ll explain a few additional principles related to all of this. And then, the post after that, I’ll talk about what the banker decides to do when he sees all that gold just “sitting there doing nothing” in his vault. (Dun dun duuuuun.)

In Part 6, I talked about how storing wealth is always risky because any asset used to store it is susceptible to shifts in value, so you could lose some of your wealth simply by the asset losing value. This is the risk of storing wealth, but it’s a risk worth taking in order to have some wealth saved away in case of an emergency.

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

The Cost of a Lifestyle

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

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

Compare that to today. Our modern lifestyles cost way more than 50 WUs per week. Fortunately, innovation has enabled us to generate way more WUs/hour as well, so even those living below the poverty line can afford a lifestyle that is way more lavish than almost everyone who lived even a couple hundred years ago. But still, how much of it is necessary? Do we need to eat so much and spend so much on travel and entertainment and things? I tire of this rat race of working so hard to just barely be able to afford a modern lifestyle.

Another difference, when comparing to our ancient counterparts, is that we have the ability to work extra to store some wealth in case of a time of need. This is all thanks to the invention of money. But so many of us spend so much and work so much that there’s no leftover wealth to save or invest and no leftover time to work to generate more wealth either.

I used to work at a hospital where I would average four 12-hour shifts per week. How many of those 48 hours were generating WUs that simply went to sustaining my lifestyle that week. Maybe I could become more frugal and only need to work three 12-hour shifts per week, and it would be enough to sustain my lifestyle and also invest for retirement. Then I could spend more time doing things that are more important to me, like spending time with my kids. How many shifts/week would facilitate the greatest happiness and fulfillment?

How to Be Immune to Inflation

All right, so those were my thoughts on the number of WUs it takes to sustain a lifestyle and how it has changed over time (plus some philosophical musings), and those ideas will come up again in subsequent posts in this series. Now let’s talk about becoming “inflation proof.”

Remember in Part 6 when I talked about the blacksmith starting to counterfeit gold coins? The effect of that was that the number of WUs stored in the form of gold coins stayed the same, but the total number of gold coins had increased, so each gold coin represented fewer WUs. Yes, I’ve said this same thing in a few different ways now, and that’s because it’s important. Another way I’ve said it is that the WUs got “diluted” over a larger total number of gold coins. I’ve also given a ratio to calculate how many WUs each gold coin is worth:

aggregate-number-of-WUs-attempting-to-be-saved-as-cash:aggregate number-of-gold-coins

Understanding this principle is a prerequisite to understanding inflation, which I’ve also already defined. The important thing to remember is that we perceive inflation by seeing diffusely higher prices, but what’s really happening is the number of WUs represented by a unit of money is decreasing, which means the money price of everything has to increase to still reimburse the seller the appropriate number of Wealth Units.

There are lots of different factors that cause inflation in modern monetary systems, and I haven’t talked about most of them yet, but they all act in the same way: They alter the WU:money ratio. And printing more money is one way to do that.

As a sidenote, I think this is a good place to mention that when a society uses money that has intrinsic worth (i.e., commodity money like gold or corn), it prevents the government from causing inflation (i.e., taking some of your wealth without your consent) by creating more money out of nothing because nobody has the ability to create gold or corn out of nothing!

Now, on to explaining how to become immune to inflation.

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

Let’s say the farmer has 100 WUs worth of grain that he’s stored to sell next year because he’s going to grow a different crop next year. Then, the blacksmith counterfeits a bunch of gold coins and causes 10% inflation in the intervening months. Has the farmer lost any WUs worth of grain? Nope. He still has the same amount of grain, and grain’s wealth price has not changed. So, when he finally goes to sell his grain, he’ll figure out the WU:gold coin ratio and price the grain accordingly. Maybe he would have sold the lot of it for 10 gold coins last season, but this season he will sell the lot of it for 11 gold coins instead. Either way, he is getting paid 100 WUs. This assumes that the price of grain has not changed. For example, if some other farmer had pests eat the majority of his wheat crop, maybe grain has become in short supply, which would allow our farmer to sell it for more than 100 WUs. But, assuming no market changes have altered the wealth price of wheat, he would still sell the lot of it for 100 WUs, just the money price required to get those 100 WUs would have changed.

My point is this: In monetary systems where new money can be printed, cash is susceptible to inflation, but non-cash assets are not susceptible to inflation because their prices simply change to reflect the new WU:money ratio.

So, you want to be “inflation proof”? Store your wealth in non-cash assets and you’ll be fine. Although, be careful which non-cash assets you choose–most are susceptible to depreciation (like a car). The best would be to store your wealth in non-cash assets that appreciate over time (like most investments do, which we discussed in Part 3).

This is the last of the foundation I needed to build to finally start evolving Avaria’s money toward modern money. It all starts with the invention of banks in Part 8, which changes everything.

In Part 5, I wrote about how the Wealth Unit:gold coin ratio adjusts as the market demands depending on how many WUs are needing to be stored in society’s total supply of cash and how many total gold coins are available to facilitate that.

In this post, I’d like to expand on that by discussing more about the factors that determine the value of money.

First, let’s recap from Part 1, where I explained how wealth is acquired.

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

Now let’s look more at the factors that can change the value of that stored wealth.

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

But what happens if the value of the asset you received in return for your labor suddenly goes down? Say, you got paid in corn, but you stored it in your damp cellar and it got moldy? Tough luck. It’s like you didn’t work as much to store as many WUs because those WUs you earned are gone. This is why perishable things are not as handy for storing WUs. And it illustrates the risk of storing wealth. There will always be a risk to storing wealth; all we can do is try to minimize that risk.

For example, a good way to prevent your stored wealth from going bad is by storing it in a non-perishable form. But even non-perishable things are susceptible to their value changing in other ways. Even precious metals can have big swings in value depending on, of course, supply and demand, such as how fruitful the mines are, or how many other things people want to use them for (such as golden calf statues).

The thing with any commodity being used as money is that it has built-in mechanisms to keep its value relatively constant. For example, if a society starts getting really wealthy and is trying to store more and more WUs in the form of gold coins (including starting to build up piles of gold coins in their houses), the demand for gold coins (and, therefore, its value) has increased. In response to this, people will start acting differently.

For example, some people will start buying bronze necklaces instead of gold necklaces because the gold ones are too expensive now (i.e., consumers will find substitutes for gold, thus decreasing gold’s demand).

And gold miners will find ways to mine more gold (i.e., supply of gold will increase), such as by adding a night shift to their mining operation. They didn’t have a night shift running before because the cost of the lights and the higher cost of nighttime labor didn’t make it worth it, but now that the price of gold is so much higher it has become profitable to add that night shift.

The eventual result of all these market responses will be as follows: less gold will be demanded and more gold will be supplied. The combination of those two factors should be obvious–the price will drop. It might still be higher than it was initially, but not to an extreme degree.

My point is that market mechanisms will keep the price of any commodity being used as money relatively stable over time, which is a pretty important aspect of anything that’s going to be used to store wealth. So, to our running list of desirable features for whatever we choose to use as money, we could add “intrinsically valuable commodity,” or, maybe, “the price is subject to market forces.”

Sure, mining innovations may end up decreasing the number of WUs it takes to mine new gold, which might make it cheaper over time, but it’s just as probable that over time more uses will be found for this unique metal (especially as its price drops), so its price will probably stay fairly consistent. Additionally, remember the time period over which those changes in the value of gold are happening–probably over years and decades. A change in value of the commodity we’re using as money becomes less of an issue when it’s slow like that because those changes will only affect the longest-term financial plans and occasional recalibrations can be made in response.

In contrast, any form of money that can have rapid swings in value can totally ruin even the short- and medium-term financial plans of individuals and businesses. Investments–including short-term ones–become riskier, which alters the risk/benefit profile of investments and makes people less willing to invest in the innovations needed to generate more wealth for society (discussed in Part 3). So what I’m saying here is that investment will increase when the value of money is more stable. Remember this when we get to future forms of money in Avaria that have rapid swings in value. Anything that induces swings in the value of money will stifle investment.

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

But I hope my point is clear: No matter what you use as money, it’s always going to be susceptible to some degree to shifts in value (meaning the WU:money exchange rate will always be subject to change), so the best we can hope for is something that meets the other criteria for an optimal money (i.e., nonperishable, easily carried, easily divided into different amounts, etc.) and that its value will shift minimally and slowly. And having it be subject to market forces is a major boon to keeping a thing’s value more stable.

Now, let’s consider an example of changes in the WU:money exchange rate that is particularly relevant to our modern day. For the sake of simplicity, I’ll first describe a scenario using Avaria, and then I’ll talk about its application to modern day after that.

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

The total number of Wealth Units that people are storing in the form of gold coins hasn’t changed, but suddenly gold coins are much more plentiful. According to the calculation I introduced in Part 5 (True value of a gold coin = Aggregate-number-of-WUs-attempting-to-be-saved-as-cash / Aggregate-number-of-gold-coins), this will make the value of gold coins drop rapidly. In other words, each gold coin will now represent fewer Wealth Units. If someone has stored 1,000 WUs in the form of 100 gold coins (because the previous exchange rate was 10 WUs:1 gold coin), maybe now the exchange rate is only 5 WUs:1 gold coin, so their 100 gold coins are only worth 500 WUs now. Their purchasing power has been cut in half.

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

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

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

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

In most countries today, we use paper money, which has negligible intrinsic worth. The government (or, the government’s central bank, which is called the Federal Reserve in the United States) can print as much of it as it likes. Each time they print* more money (like for a COVID-19 stimulus), the Wealth Unit:US Dollar ratio drops. Maybe in 2020 the ratio was something like 0.07:1, but now it’s dropped to 0.065:1. It’s a small change when I write it like that, but let’s think about this for a minute.

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

This is an important point. No new labor units were created! Printing money is not a way to make a society rich because money printing doesn’t generate more Wealth Units. It just dilutes the wealth already stored in the form of cash. Many politicians in the past–including the ones in charge of monetary policy–have misunderstood this! Even modern Ph.D. economists who advocate for this idea of “modern monetary theory” don’t understand this difference between money and wealth and, because of that, advocate printing money whenever the government wants to add a new program.

So if someone worked hard and earned 1,400 WUs and chose to store them in the form of $20,000 (when the exchange rate was 0.07:1), now how many WUs do they have after the government printed a bunch of new money and changed the exchange rate to 0.065:1? They still have $20,000, but it’s now worth only 1,300 WUs. This is a decrease of 7% of their cash-stored wealth, and if the government is doing that every year, it will be slowly but surely taking away this person’s cash-wealth savings without them even realizing how it’s happening! In fact, for every person who owns USD in any form, the U.S. government is taking away a percentage of their wealth every year that the government prints more money and induces inflation. In fact, since the Federal Reserve was established in 1913, about 97% of cash-stored wealth has been taken through inflation. That’s crazy!

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

This is a good place to clarify what I believe is the most clear and useful definition of the term inflation. Inflation is a decrease in the Wealth Unit:money exchange rate through diluting the aggregate wealth stored in money over a larger total amount of money. Any other definition of inflation, including the ambiguous definition, “inflation is when a lot of prices rise in an economy,” are less useful because they fail to make explicit the difference between a rise in prices as a result of the diminution of the value of money as opposed to a general increase in the Wealth Unit costs of things (such as when global supply chains are disrupted from a pandemic).

One last interesting point. The government, when it prints this new money, is the first one to spend it. The act of spending this new money is what introduces it into circulation. And prices will only adjust after the new money has entered circulation. So, not only does the government have all this newly created money that it can spend (using wealth taken without permission from the people who own the already-existing US dollars), but also it gets to spend that money at pre-inflation prices!

Ok, this was a longer post than the others in this series, but I wanted to get to this stopping place. I have much more to say about the theory of money–we haven’t even invented banks yet!–so this series will be continuing for quite a while, and each additional post will build the foundation of knowledge needed for modern monetary systems to make sense, which is the pre-requisite to knowing which proposed monetary policies will be helpful and which will be detrimental.

*I’m speaking metaphorically. Generally these new dollars are not printed; they’re created in a computer at the Federal Reserve bank by simply changing the listed value of an account. But the effect is the same, so I prefer to use the term “printing money” because I think it conveys the idea more clearly.