The Generalist

Why the Ideal Money Supply is of a FIXED and Arbitrary Quantity and Why Fractional Reserve Banking is Always and Forever Fraud

This post is again inspired by an article from The Freeman, the magazine for the Foundation for Economic Education. In thinking about it now, I imagine that today I would disagree on some level with a great many of the articles published in the Freeman over the years. Some ideas are more distressing than others, though. For example, in a recent letter to the editor, Stephen C. Apolito corrects Howard Baetjer on the definition of inflation. Baetjer responds saying he agrees “with Murray Rothbard’s aversion to government-issued fiat money, largely because I believe that governments and their central bankers cannot possibly know how large the money supply should be” and he thinks that “when people wish to hold more money, banks should create more money. When they wish to hold less, banks should extinguish some.”

Banks should be creating and extinguishing money? In the words of the Freeman itself “It Just Ain’t So!” Whether “free banking” or no, banks shouldn’t be messing with the supply at all. Here’s why.

Why the Ideal Money Supply is of a FIXED and Arbitrary Quantity

First, let’s think about what money actually is. Money is NOT the “most sought after good”, although it usually develops from that. Yes, money is a “medium of exchange”, but defining money so generally doesn’t tell you anything about what serves as the ideal. In addition to its function facilitating exchange (or as part of it) money serves also as a “data storage” device and it facilitates calculation by keeping track of who owes what in terms of goods. In that sense, it is essentially an IOU.

I think some confusion over this concept stems from the fact that money usually develops spontaneously from a commodity, usually the most “sought after good”. But, money does not have to be a commodity. It can be sticks with carved notches (the tally sticks of Medieval England for example), numbers in a ledger, or blips in a computer.*

Now in real life, it’s nearly impossible to separate any legitimate money from a commodity. (You’ll see why I use the term legitimate in a minute). The reason is that any attempt to do so leaves open the ability to rig the tally. For this reason, the commodity chosen to be money is usually something rare and difficult to obtain more of. A good money generally has to have other properties, too, like being easily divisible, and every divided piece must be identical to the others. (This property is known as fungibility.) This is the reason that elements like gold and silver make such terrific money. The quantity of gold or silver in circulation at any given time is pretty much fixed because it is so difficult to mine and because it is a commodity which is used up to some degree (although gold and silver, as elements can always be reclaimed from waste, it is often expensive to do so.) Now of course, gold and silver are actual commodities and so the amount in circulation at any given time can and should shrink and grow. But it is for this reason that the concept money gets confused with the concept commodity in people’s minds. Money as a concept (Aristotle might have said money qua money) ought to be fixed in quantity. The quantity itself is irrelevant because money as a concept can be infinitely divided. It doesn’t matter how many goods there are, the money can be divided to accommodate any price. (Aren’t numbers beautiful?)

Just to make this really clear, let’s take a look at how it would work. Let’s say there are only 5 “blips” to go around and there are, at the start of our make believe society, exactly 5 baskets of goods. (In real life you could never divide all the goods and services in the world this way. No matter. Your brain just needs to simplify it in order to understand it. We can apply it to the real world later.)

money_01500

Now we can see that each basket is worth 1 blip. What happens if the amount of goods increases to 10 baskets?

money_02500

Now each basket is worth 1/2 a blip.

But what happens if our society is really productive. Suppose we end up with 10,000 baskets of goods! (Now that IS productive.)

money_05500

How much is each basket worth now? We just divide 5 by 10,000 (can you DO that? Yes!) and we get each basket is worth 0.0005 blips!

Obviously with real commodity money this could get difficult. But conceptually, it’s doable and money is a concept. Even with a physical commodity money, chances are we would never need to adjust the amount of money in circulation because the arbitrary figure would be large enough to start with.

Now, why don’t I take into account the number of people in the society? The number of people in a society is not relevant to the money supply because money represents goods, not people. As long as any particular person is productive and produces goods, he ought to end up with some money, but it’s his goods (or services) which are traded for it.

Why is the ideal money supply fixed in quantity? Because modern money, unlike commodity money, is essentially a tally system. Money represents the portion of the supply of goods and services in an economy that you have a claim to. There is never any guarantee that you will get any particular amount of goods and services; the money represents a percentage of the goods and services available. If there is a hurricane that wipes out a portion of the supply of goods and services, you will suffer just like everyone else. When the supply of money changes, however, your proportion of the supply of goods and services changes.

Again, the truth is more complicated, but let’s looks at it simplified.

Suppose you have 2 electronic blips. The supply of money is 10 electronic blips. The amount of goods and services in our little world is 10 baskets. You therefore have a claim to 2 of them. That gives you 20% of the supply.

money_03a500

But, what happens if the money supply increases? You still have 2 electronic blips, but now the supply of money is 20 electronic blips. The amount of goods and services in our little world is 10 baskets. You now have a claim to 1 of them or only 10% of the supply.

money_03b500

Where did your other 10% go? It went into the pockets of the holders of the new money. And what did they do to earn it? Nothing.

It gets worse, however. In the above example, the pie remained the same. In a healthy economy, though, the pie does not remain the same. It grows. This allows those who keep the tally to skim quite nicely. If you only look at the “price” you are getting, you will never realize what is happening to you. Let’s look at it.

money_04500

As you can see, although the “price” you pay and the number of baskets you get has remained the same, you still lost out. This is the effect of a growing money supply. And it gets worse still, because a growing (or shrinking) money supply means that calculating a profit or loss from a business becomes impossible. As this continues or worsens, business activity falls and the pie shrinks!

Why “Fractional Reserve Banking” is Always and Forever Fraud.

Now before we go on, it is necessary to understand how banks work. This is a complicated subject and I am going to take some liberties again in order to simplify it for you. First, why do we need banks?

Banks, as a concept (again Aristotle, and some other writers you may encounter might say banks qua banks), facilitate the use of money for productive enterprise. They do this by borrowing one individual’s money and lending it to another individual. For the service, banks (qua banks) take a portion of the interest the borrower pays (and sometimes some other fees). Interest, despite what you might have heard elsewhere is the necessary cost of borrowing. When you lend someone else your money you don’t have it anymore. You cannot spend it until the other person pays you back. That time is worth something and you should be compensated for it. That’s what interest does. Also included in interest payments are other factors, like what the risk is that the other person won’t be able to pay you back and in situations where the money supply is not fixed, how much inflation you can expect before the person pays you back.

This service performed by banks might not seem like much, but it is really the cornerstone of a modern economy. Think of it this way. If you decided to simply save your money in a mattress, the entrepreneur down the block who is planning to introduce an entirely new technology that will enhance your life experience 10 fold may never get the chance to introduce that technology. By lending to others we ourselves are ultimately rewarded. For this reason, banks (qua banks) are essential.

Because money and lending are so essential to a proper economy, bankers, if they are not ethical, are in a position to attain extreme power over others. They do this by obfuscating and confusing people into believing that the supply of money needs to “expand” and “contract” according to demand. This would be the case if the money were commodity based, like gold and silver. In that case the supply would expand and contract naturally based on the cost of mining and bankers would have no hand in it. Today, there is no commodity money. Today we are using a tally system with the quantity of the blips, or pieces of paper, expanding and contracting according to the whim of the banker. (It is important to note that your neighborhood banker is likely completely unaware of this. He is simply doing a job. In the US the “banker” would be the Federal Reserve, but there is likely a world system with bankers who control the Federal Reserve, too. For this reason, I don’t recommend confronting your neighborhood banker with what you learn here unless of course your goal is to help him understand.)

So, how does an ideal banking system work?

In an ideal banking system, if you lend someone your money, you cannot spend it until they pay it back. If you did, that would be kind of like having your cake and eating it, too, wouldn’t it? The modern CD or Certificate of Deposit account is closest to the ideal banking system. When you open a CD you are agreeing to lend your money to the bank for a specified length of time. For the use of your money the bank pays you a fee – the interest rate. During that specified length of time you do not have the use of your money. The bank might let you take it anyway if you need it sooner, but only after a delay and a penalty. The reason they do this is because they have promised that money to someone else as a loan and now they will have to ask that person to pay back the loan sooner. If you were the borrower in this case, you wouldn’t like that very much. (The reality is of course more complex than this – the bank might not need to ask for the money back, but they might have to turn down another loan to someone else because of it.)

Today, savings accounts, checking accounts, and other types of deposits can be “loaned out” even though technically you haven’t loaned the bank any money and you can supposedly claim it at will.

Now, how does “fractional reserve” banking work?

In the old days of the gold standard, paper money represented gold stored in a vault. It was simply easier to carry around a paper claim check than it was to carry around gold, which is heavy and hard to secure. For this reason people usually traded the claim checks and only rarely presented them to the banker to get their gold back. Nevertheless, the amount of claim checks in circulation was directly related to the amount of gold in a banker’s vault, therefore the supply of claim tickets would shrink and grow as people deposited more or redeemed claims. This wasn’t a problem because the gold was still the money and the paper just a substitute. As time went on, however, the claim checks became more and more standard and the people’s trust in them grew. At some point a banker realized that he could make a profit by “loaning out” the gold in his vault. He didn’t really have to remove any of the gold from the vault though; he could just print more claim tickets. In this case, each ticket is supposed to represent the same weight in gold, but in fact, it does not.

money_07500

This is fraud.**

This is also the beginning of “fractional reserve banking.” The phrase “fractional reserve” is a banker’s euphemism. There is no reserve. The “fraction” is simply the amount of gold that the banker doesn’t print double tickets for. For example suppose the banker wants to keep a 10% “fractional reserve.” This just means that 10% of his claim tickets can be redeemed for gold before he goes bust. It also means that 90% of his claim tickets are fakes.

Now in modern times there is no gold at all. The “reserve” today is simply a percentage of the wealth that is deposited with the banks. I say “wealth” because that is the only way I can describe money which represents a real portion of the supply of goods and services as compared to money which represents nothing. In fact it is not so easy to divide like this. Unlike the gold claim tickets where the lucky few who managed to redeem their claim tickets before the banker went bust actually got the amount printed on the ticket, today there is no “amount” of anything on the ticket and it is the luck of the draw whether or not a person manages to get the full claim – in fact this may not even be calculable.

Now of course the above represents a very simplified explanation of how our modern banking systems work and how they should work. But I think it serves as a good starting point for understanding why no one – not even the government – ought to be messing with the amount of money out there. This concept is going to become more and more important for people to understand as we come to rely less and less on an actual object in our daily exchanges. Cash even in the form of paper is probably on its way out. Even today, the bulk of exchange is handled by computerized blips that have no physical representation outside of cyberspace. While convenient, this modern tally system is (and has been) an extremely dangerous state of affairs – something I think a lot of average people are starting to notice these days. I hope this article (and my previous articles The Basics: Money, Inflation and Deflation and The Basics: Banking, Inflation and Deflation) will help demystify the process somewhat.

Notes:

*I’ve gotten some questions regarding my use of the term “commodity” in this article. If you are using the term “commodity” to include any item that a person might want, money would certainly be a commodity. But, I think it’s important when defining terms not only to be clear but to have the terms be useful. I do not think it is particularly useful to define “commodity” in a way that does not differentiate money from the things it is used to buy – therefore money to me is not a commodity.

**Also known as counterfeiting. I don’t like this term, however, because some people will mistake counterfeiting as printing money against the wishes of the government. The government has no business printing money, either.

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4 Comments

  1. Stephen C. Apolito

    26 Sep 2009 - 10:45 am

    Greetings:

    Thanks for mentioning my response to Baetier’s article in the Freeman. Isn’t it amazing how little economists know about money? Maybe I should refine that: They seem to know much about “make-believe” money, but little about real money. I got to thinking recently that if the President’s stimulus package was such a good idea, why not less us all in on the action by allowing each of us the legal right to print money in our basement? We could certainly do as well as the government in inflating the money supply, jacking up prices, and sowing the seeds for the next economic boom-bust cycle!

  2. Lisa

    1 Oct 2009 - 3:02 pm

    Hi Stephen,

    In fact, it was your letter that inspired my article. I didn’t see Baetjer’s original article until much later. It’s painful to see that kind of stuff in the Freeman, I think poor Ludwig von Mises is rolling in his grave.

    I made a similar analogy to printing money in the basement when trying to explain inflation and credit expansion to a high level CPA. He simply could not understand how these things were remotely similar since the mortgage money is “backed” by the house. That the money to buy the house did not exist prior was completely incomprehensible to him. Another CPA working as a VP at an international corporation laughed (albeit nervously) and told me that I didn’t know what I was talking about when I suggested the market had the potential to fall 90% because of credit contraction after an orgy of inflation. He told me that the market has “natural” ups and downs and that he was “trained” in economics and he should know. Well… he should

    I feel sorry for them. I think to myself, if these are the guys who deal with money every day, what about the average person who comes out of years of college lucky to be able to balance a check book? In fact, they might be better off. They don’t have years of falsehoods to overcome.

    Again, your letter served as the inspiration for what I think turned out to be a reasonably good article. Thanks for that!

  3. Gene Callahan

    2 Sep 2013 - 5:46 pm

    “by keeping track of who owes what in terms of goods. In that sense, it is essentially an IOU”

    Everything in this piece about money is wrong. Money does not “represent” goods: it IS a good. It is not an IOU: it is a good. You exchange it for other goods, and how many of them you will get is up to the seller. If you were “owed” those goods, you would be entitled to a fixed quantity of them. Prices could never fluctuate.

    Read some Mises.

  4. Lisa

    23 Jan 2016 - 12:05 pm

    Gene,
    You should have read the post instead of reading only a few lines. I think you would disagree only with my style – not the content.

    You are right in that I should not have used the term IOU because it is not strictly correct. Perhaps a “claim on wealth” would be a better way to put it. Nevertheless, the concept of money needs to be contrasted with the concept of a commodity. While a commodity can be used as money, there is a conceptual difference. If one doesn’t make that distinction then you can read all the Mises you want. You won’t understand it.

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