A Black Hole In Economics: Money Creation And Its Consequences, Session Four
Good Money Creation: The Capitalist Money Factory
Welcome to Session Four of my course on money creation and its consequences. Due to the holiday season, I won’t publish next Friday. So, the next course installment will be on Friday, January 5.
The subject of this lesson is “good” money creation, by which I mean money creation that enables productive, non-inflationary economic growth. The theme is that sound money production springs from free market-based decisions by bankers and borrowers guided by the profit motive. Today, I aim to demonstrate that even an imperfect but mostly free banking system can produce sound money, that is, money that is widely accepted and holds its value over time.
As usual, a manuscript with detailed notes and references is attached for those who would prefer to read the content or examine my sources, all of which are fully documented.
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HardmoneyJim
December 22, 2023
With respect to the acceptable limits of credit in a sound banking system, some rather long winded thoughts on a hypothetical fair gold-backed, banking system.
I consider that for any money to be sound it must necessarily be linked to productive activity, that it in fact equates to deferred spending, an IOU on the market system or as Ayn Rand brilliantly put it, frozen effort. If such were the case, every dollar held and not yet spent could legitimately be used by another for investment purposes. Yet the true owners of those funds would, for a myriad of reasons, baulk at gambling with their nest eggs.
With the current system as i understand it, bank deposits are technically repayable on demand. Bankers in turn, knowing seldom will all depositors want all their money back at the same time, gamble and lend out as much as they dare. But what if we were to inject honesty into the system?
As individual we all have varying time horizons for our unspent dollars. someone with a weeks worth of reserve wouldn't likely have need for a bank, whereas the the guy with 25 years of reserve spending most definitely would appreciate having a safe place to put that 4000 oz. of gold.
The above thinking was derived from an argument about Ayn Rand and marginal lending and my reading of Hernado DeSoto's book, "The Mystery of Capitol." I'm guessing you are familiar with his book, but he brings up the point of how difficult it is, in the developing world, to leverage real assets into collateral for bank loans. He writes about regulatory impediments and inability to attract micro loan as the factors that continue to impoverish the third world.
As an aside, he has a very informative look at the way legal issues were dealt with in the American gold rush, essentially discussing how common law works.
Back to the hard, gold as currency era. You make the point that when a loan is repaid the paper certificate is erased, but I wonder if that is the case . If for example, the bank did have a leger that separated available and on loan gold holding with limits placed on minimum reserve holding I could see that happening if loan certificates were name dedicated and not transferable. If the bank gold was held in a common pool I wonder if those paid loans would just wind up being added to the banks balance sheet as diluted the value of money.
That's my short take on early money but the point I want to make is that I see that it's logically valid to lend out all assets not needed for immediate use. If there were no artificial spending methods outside of productive exchanges there still would be a truly phenomenal quantity of investment capitol. The idea that the money would be 'owned' by people that worked for it would be a great incentive to look for high quality loans, as opposed to government boondoggle loans a market system would reject.
The marvel of our modern money system would take a volume to describe but while etransfers and micro credit card transactions are highly valued by me, I hold little confidence in the trustworthiness of giving up on physical money, the Canadian government seizure of Trucker Protester's bank accounts without warning or warrant being my wakeup call as to the fragility of security when an all powerful government agency pits itself against a private citizen.
And a final point, it is well know and has often been implement in times of war, adding counterfeit paper to a country's money supply is destabilizing to that country. I still wonder how we ever got to the place where no one seems to recognize that doing so to your own country is tantamount to committing suicide.
Merry Christmas Jim.
A couple of comments: In one part of today's talk, you state:
'Finally the behavior of depositors can limit credit creation in the banks. Depositors will move
out of banks where they perceive excessive risk. Banks are constrained by the need to maintain
a prudent level of cash reserves. Loss of deposits means loss of reserves, which restricts the
banks ability to expand its loan book further. To attract new deposits (and thus cash reserves)
the bank will likely have to offer higher interest rates to depositors'
I think that there are a couple of issues with that paragraph but let me start off with its 'phrasing' -- or more specifically, 'what you didn't say'. In particular, you might want to be a bit more explicit and reference the bank's leverage ratio and balance sheet as to why there is the 'perception of excessive risk'. And while depositors may perceive 'excessive risk' in the nature of the bank's loans themselves (e.g. too much speculative lending versus productive lending as you describe), most likely, the perception of 'excess' will come from the balance sheet and leverage ratio of total liabilities to equity. A bank with a 5:1 leverage ratio is more resilient than one with a 9:1 ratio .... or Bear Sterns (and its 33:1 leverage ratio). Bringing up the capital ratio of the bank more clearly identifies the main 'signal' depositors would likely use to perceive this risk.
But there is another reason for bringing up 'the nature of the bank's balance sheet' as well -- whole sale bank money (or other bank lending to the another bank). If the bank's only source of liabilities is deposits, then everything you say in this chapter is both 'correct' and 'clear and easy to understand' -- but it is not a good description of an actual bank (even small local ones) since about the late 1970's. Wholesale money is a 'thing' and it changes the process you describe for 'disciplining' bad bank behavior (or at least I think it does -- help me here if I am wrong).
Without wholesale money, individual depositors would, presumably one at a time, start to 'peel away' from the bank as soon as the risky bank's most risk adverse depositor gets concerned about the bank's lending (practices or leverage ratio). This peeling away would occur first with the most 'risk averse' depositor and than progress to the next most risk adverse, etc. At some point, this loss of depositors gets significant and the trend itself becomes a 'signal' for other depositors, further accelerating deposit loss. At some point along the way, the bank 'gets the signal' and 'corrects' is risky behavior (or it fails, which is a catastrophe for its remaining depositors and a 'warning' sign for other banks and depositors in the industry).
With wholesale money, the total level of the banks liabilities (and assets) may be unaffected or minimally affected by small to moderate deposit loss from this 'informed' and 'risk adverse' depositors group. Unless the bank is near its reserve constraints (and it is unlikely that it is reserve constrained since the 1950's on), this small to moderate loss of deposits doesn't affect its lending since the inflow of wholesale money enables the bank to continue on doing what it was doing. So, the bank's behavior is largely unaffected.
The more important piece however is what happens to remaining depositors in the bank. These remaining depositors won't see the balance sheet of the bank decrease due to deposit flight (if they look closely at the balance sheet, they will see the nature of the bank's liabilities changing, but that is a much less obvious and powerful signal). Therefore -- wouldn't the signaling mechanism of deposit flight to other depositors become delayed or interrupted? Could this delay / interruption become so pronounced that the 'self-correcting' process you hope to see not take place?
I have a couple of extra comments but let me break them up to make it easier for you to address them (if you wish to address them).