What might a maximally-empowering monetary system look like?
Before I tell you that, I will begin with a brief description of the monetary
system in the Anglosphere countries.
The Current System
At the center is an institution known, quite fittingly, as
the ‘central bank’. The central bank possesses the power to legally create
additional units of their corresponding national currency (either physically or
digitally). Besides allowing them to control the country’s money supply, this
power also allows them to act as the ‘lender of last resort’ to commercial
banks. When a commercial bank is in danger of going bankrupt, the central bank
can just whip up some new currency and lend it out to them, thereby helping the
commercial bank to weather the storm.
Because indeed, without the central bank, commercial banks
would be in constant danger of sudden insolvency. This is due to a practice
that they engage in known as ‘fractional reserve banking’. When you deposit
money into a checking or savings account at your bank, you would be forgiven
for believing that the bank is simply holding your money in safekeeping for you
(as the word ‘deposit’ would seem to imply). But you would be mistaken in that
belief. Actually, the bank is only required to hold about 10% of the money that
you deposit in reserve; the rest they can, and often do, loan out to other
people and businesses at interest. Although this practice is highly profitable
to the bank, it is also very risky. If, for whatever reason, the depositors’
confidence in the bank is shaken (perhaps due to the revelation of some high
profile bad loans that the bank made), many will rush to the bank to try and
withdraw their money before the bank goes under. This rash of withdrawals will
quickly deplete the bank’s reserves and, because the rest of the money is tied
up in loans, will render the bank insolvent (unable to fulfill its contractual
obligations to its clients). Such an event is known as a ‘bank run’, and
happened quite regularly before the advent of modern central banking in the
early 20th century.
The inflationary nature
of the current system
Central banks acting as ‘lenders of last resort’ have indeed
been effective at preventing bank runs. Unfortunately, this blessing comes with
a steep price tag: inflation. Inflation occurs when the quantity of money in a
society is increased. Inflation leads to the reduction of the purchasing-power
of each monetary unit, unless counterbalanced by a sufficiently-increased
demand to hold money reserves or by a sufficiently-increased quantity of goods/services
on the market. Central banks’ directly increasing the supply of money
(printing/digitally-creating money) is one obvious source of inflation, but the
practice of fractional reserve banking is another, more subtle, one.
It works as follows: a man deposits $100 into his checking
account. Assuming a reserve requirement of 10%, the bank holds $10 of this in
reserve, and loans out the rest ($90). Now, the first guy has $100 in his
checking account, and the recipient of the loan has $90. Where there was once
$100, there is now $190! But it doesn’t end there: those $90 will soon end up
in bank accounts, and the process repeats. The depositors have $90 in their
accounts, $9 is held in reserve, $81 is loaned out. Now there is $271! This
process repeats until the money supply has been multiplied to about ten times
the ‘monetary base’ (the part of the money supply directly controlled by the
central bank).
Some may object to this analysis by arguing that the first
man, after the bank has done its magic, doesn’t really have $100. Rather, he
has some kind of financial instrument worth $100, while the bank has $10 in
cash and $90 worth of loan assets. Technically, this is correct; strictly
speaking, ‘cold hard cash’ and ‘money in the bank’ are two separate economic
goods. However, the demand for these two goods is highly interrelated. Most
people, unless they wish to engage in large illegal transactions, don’t have a marked
preference for cash over money in the bank. Why would they? Bank money can be
used as payment at most commercial establishments (using a debit card), at the
same rate as cash, and if, for whatever reason, cash is required, bank money can
be converted into it at virtually no expense. As such, both goods fit into the
category of good, ‘generally accepted medium of exchange and means of final
payment’. Most people will have a certain demand for this category of good,
while the specific array of goods in this category that they choose to hold is
mostly dictated by convenience. Evidence of this virtual interchangeability of
cash and bank money can be found in the fact that their values, since the
advent of modern central banking, have never deviated by a non-negligible
amount from one another. And therefore, when discussing the monetary system
overall, it is sound to classify both cash and bank money as the good ‘money’,
and to consider it using a unitary supply and demand analysis.
All of this is to say that central banks, and the fractional
reserve banks which they enable, are jointly responsible for virtually all of
the inflation that occurs in modern monetary systems. Inflation, in turn, has two
significant effects on the respective individual power levels of people in a
society. We shall discuss them in turn.
Inflation’s
redistributive effect
Firstly, inflation has a redistributive effect. Inflation
benefits those who are economically closer to the source of the newly-created
money, at the expense of those who are further away. This can be seen most
clearly in the case of a criminal counterfeiter. Imagine the counterfeiter
creates a bunch of perfect cash replicas, and spends them at his favorite local
establishments. While the biggest beneficiary of the new money is the
counterfeiter himself, these establishments also benefit via a direct increase
in demand for their offerings. The establishment owners will then use the extra
money to either consume or invest, thus benefitting those towards which this
extra monetary demand is directed. The process continues until the new money
has flowed through most of the economy.
The problem is that, as the new money flows through the economy,
it causes a tendency for prices to rise as a result of the increased monetary
demand going around. This is not a problem for those who got a piece of the new
money early, but for the economically-distant parties, it means that their
buying prices will have increased before benefitting from any of the increased
demand themselves, thus leaving them worse off.
A similar process occurs as a result of inflation
orchestrated by the central bank and their fractional reserve bank cronies. In
this case, one of the biggest beneficiaries of the new money will be the
society’s government, due to the large quantity of government bonds that
central banks tend to purchase with fresh money. Other big winners include:
commercial lending banks, well-connected investment banks (such as Goldman
Sachs), government employees and contractors, owners of real estate and stock
market assets, and the many businesses who cater to these groups. On the other hand, some of those most harmed
include: anyone on a fixed income, workers for whom negotiating a raise is
difficult, people who are economically/geographically far-removed from the
centers of finance and government, and people with substantial money holdings.
Looking at these lists, it would appear that, in general,
richer people are more likely to benefit from this kind of inflation, while
poorer people are more likely to be harmed. Thus, this kind of inflation tends
to affect a redistribution of resources from poor to rich. Since, in the
previous post, we concluded that, taken in isolation, a redistribution from
rich to poor is a net positive for aggregate individual power levels, the
reverse of this, which is the result of central bank inflation, must be
considered a net negative.
In addition, as we also discussed in the previous post, when
power is redistributed from individuals to government (or any large institution
for that matter, although the problem is the most serious with the government),
‘leakage’ and ‘friction’ cause significant amounts of it to be lost. Since the
kind of inflation that we are discussing has this effect, this must also be
considered a negative.
Business cycle effect
Little known fact: central bank/fractional reserve bank
inflation is the primary cause of the dreaded business cycle that plagues most
modern economies. Here’s how. This kind of inflation is also known as credit
expansion, because the new money generally begins its journey through the
economy in the credit markets. Traditionally, central banks have favored
government bond purchases as a conduit for expansion of the money supply.
These bonds are purchased on the secondary market, usually from large
investment banks, rather than from the government’s treasury directly. This
increased demand for government bonds operates to reduce the interest rate (or
yield) on such bonds. It also operates to reduce the interest rate/yield in the
credit markets generally. The non-central-bank capital that was tied up in the government bonds that
the central bank purchases, is now freed up and redirected, usually towards
increasing the demand for some other kind of investment, which then operates to
reduce the interest rate/yield on that investment,
and so on. Eventually, most of the new money will gradually leak out of the
credit markets and enter the wider economy, but generally not before exerting a
powerful downwards pressure on interest rates. This is why central banks use
bond purchases as a tool when they want to lower the market’s interest rates:
it works.
So, credit expansion results in inflationarily increasing demand
in the credit markets, before increasing demand in the rest of the economy. The
result is a lowered interest rate; the same thing that would occur if people,
in a non-inflationary environment, decided to direct more of their monetary
demand towards the credit/investment market, and less towards the consumer
market. However, with credit expansion, there is no necessity that people
actually reduce their consumption demand. In fact, there is reason to believe
that credit expansion inflation causes people in general to increase their consumption demand. This
results from the lower interest rates making saving/investment less lucrative,
the inflation making cash holding more costly, and the illusion of prosperity
that inflation creates among those who are less aware of the rising prices that
it causes.
Thus, we get a situation where both investment demand and consumption demand seem to be
increasing. But how is this possible? Either resources are consumed in the
present, or they are saved and then
invested in an attempt to improve the effectiveness of future productive
endeavors. It can’t be both. And indeed, it is not. What happens as a result of
the credit expansion is a redirection of the resources destined for investment.
The lower interest rates draw investment resources towards longer-term
investments (such as R&D or expensive facilities/equipment that are only
expected to pay off over a long period of time). At the same time, the
increased monetary demand for consumer goods draws investment resources towards
businesses/assets that are close to the final consumer (such as retail stores,
restaurants, consumer tech companies, residential real estate, etc…)
So, this is where the resources are being redirected to, but where are they being redirected from? The all-important middle. The
economy becomes schizophrenic; not knowing whether it is supposed to become
more long-term oriented or more short-term oriented. Investment in the
intermediate steps necessary to eventually turn a long-term investment into a
series of goods ready for consumption is relatively neglected. A scramble for
these, now underproduced, intermediate goods results in a bidding up of their
prices. Those undertaking to bring long-term investments to fruition begin to
worry that they may not have enough money to carry it through. They attempt to
borrow more, which the central banks often, initially, enable via yet more
credit expansion, at an increased rate to accommodate all the extra demand.
Eventually though, the party must come to an end. In order to
avert a hyperinflation (one of the biggest disasters that could possibly befall
a capitalist economy), the central bank must eventually halt or slow down the
credit expansion. When it does, the credit markets tighten up and interest rate
rise, thereby dooming many of the long-term investments undertaken during the
expansionary period to unprofitability or loss. The expansionary boom turns to
contractionary bust, and a period of recession/depression ensues.
During this period, businesses go bankrupt, jobs are lost,
people’s houses are foreclosed. This period lasts until the economy has had a
chance to adjust to the reality of the situation, after years of being misled
by the false signals of the boom. Or, until the central bank foolishly decides to
embark on another credit expansion, which often seems to help the situation in
the short-term, but really is just setting the economy up for an even bigger
crash down the road (for instance, in the US, credit expansion to ‘combat’ the
2000 burst of the tech bubble set the stage for the far worse 2008 financial
crisis).
So, central bank inflation causes the business cycle, but is
the business cycle positive or negative for power levels? It is almost
certainly negative. The economic instability makes it more difficult for people
to plan for the future, as the business cycle, which is entirely outside their
control, could throw their economic lives into disarray at any moment. It could
cause them to suddenly lose their jobs, or to suddenly lose a great deal of
their savings. The latter is particularly cruel, because it is inflation that
pushes people away from cash and safer investments and towards riskier
investments, which in a significant inflation, are the only kind that allow
their savings to grow in terms of purchasing power. Then, the inflation-caused
business cycle proceeds to put these riskier investments in grave danger. It is
almost as if the policy of central bank inflation were designed to make people feel more powerless over their economic futures.
And as such, I must vociferously oppose it.
A better way
As we’ve shown, the current monetary/banking system is quite
disempowering, and therefore, is not to be recommended. A better alternative to
it would meet the following criteria: 1. It would eliminate or severely limit
inflation. 2. It would ensure that people’s deposits weren’t constantly
threatened by bank runs and bank insolvency.
3. The transition from the current system to it wouldn’t cause too much
turmoil.
Luckily, there exists an alternate system, and a transition
plan to get to it, that meets these criteria. It would work as follows: first, the central bank whips up enough new
cash to bring all of the banks’ reserve fractions on their customers’ checking
and savings accounts to 100%. The banks are given this money in exchange for
title to the loans that they had made with the checking and savings account
funds that they had not held in reserve. The banks must henceforth remain on
100% reserve for these accounts.
Second, the government transfers all liability for its debt
to the central bank, to be paid off as much as possible with the portfolio of
loans just acquired from the private banks.
Finally, the government just needs to prohibit the central
bank from creating any more new money. The result of all this will be a stable
currency, rock solid banks, an end to credit expansion and their corresponding
business cycles, and a debt-free government.
Objection: credit
shortage
One objection which could be made to this system is that, by
forcing banks to be on 100% reserves for their checking/savings accounts, the
amount of credit available to the market will be significantly curtailed.
Whereas before, banks could lend out 90% of the money in these accounts, now
they must hold all of it as unproductive cash. This could cause problems for
businesses and individuals who rely on bank loans.
This objection assumes that withdrawal-on-demand accounts
(checking/savings) will remain as popular in a 100% reserve system, as they are
in the current fractional reserve system. I believe this assumption to be
inaccurate. On 100% reserves, banks would have to start charging customers for
the service of holding their money for them (rather than recouping their costs
by loaning out 90% of the money at interest).
This will likely prompt bank customers to look for alternate places to
put their money. Low-risk, but interest-bearing, financial instruments such as
Certificates of Deposit (CDs) would likely become more popular. Money in CDs
cannot be withdrawn-on-demand; depositors must wait until the maturity date of
the investment before being able to withdraw their money.
With these, it is clear that the depositor doesn’t have ownership of the money
until the investment has matured. The inflationary duplication inherent in
withdrawal-on-demand fractional reserve accounts is avoided with these
instruments, while still allowing the bank to loan out the money on the
depositors’ behalf at interest.
So basically, all that will change is that the reality of the
situation will become more apparent to bank customers. In the 100% reserve
system, bank customers will explicitly decide how much of their money they wish
the banks to hold and to be available on-demand, and how much of it they wish
the banks to lend out for them, with the knowledge that the money will not be
available to them while it is tied up in loans. It will give individuals much more
power and control over their economic affairs than either the old fractional
reserve system, when bank runs were commonplace, or the modern central banking
system, where constant, power-sapping inflation is the norm. This, I think, is
well-worth giving up a little bit of credit availability for.
Objection: no more government
debt
Another objection that will likely be raised has to do with
the way the government’s debt is handled in my plan. Because there is no
guarantee that the assets acquired from the commercial banks in exchange for
bringing them up to 100% reserves will be enough to pay off the entire national
debt. Certainly not in the United States, where there are (as of January 2017)
about $9 trillion in savings accounts,
$1.9 trillion in checking accounts.
Take 90% of this as the approximate value of the assets to be acquired, and we
reach about $9.8 trillion, less than half the total US national debt of $19.9
trillion.
So, government debt holders will most likely have to take a
significant haircut. They will not be very happy about this, and the government’s
credit rating will take a severe hit as a result. Perhaps the government will
never be able to borrow at non-prohibitive interest rates ever again. But to
this, I say: good! There is no good reason why governments should be
perpetually in debt. It costs a fortune
in interest payments every year, sucks up savings that could have been more
productively invested in the private economy, and encourages the ballooning of
government by allowing politicians (in the short-term anyway) to engage in
politically popular spending without politically unpopular tax increases.
Ah, but what if the government actually needs to make a real
investment (such as an expensive piece of infrastructure)? Then wouldn’t it
make sense for them to finance this with debt, like private companies do? It
would; but there’s actually no need for governments to be building
infrastructure. Private companies would do a better job of it anyway. This is
something we will explore in a future post.
