Sunday, November 18, 2007

Here is a short primer on money.

The first "bankers" were goldsmiths. Why? Presumably because they had the vaults and the security to protect their own gold. Customers started asking them to hold their gold for them. The goldsmith would issue a note indicating that the customer had a certain amount of gold in the goldsmith's vault.

Well, customers soon realized that instead of needing to return to claim their gold when they wished to purchase something from a merchant, that merchant would simply accept the note. The merchant, after all, could present that note at the goldsmith and claim the gold.

Pretty soon, few people were claiming the gold --which they would have to carry around and perhaps risk losing. They just passed notes among themselves. There is nothing wrong with this system. Everyone is performing admirably and honorably.

Ten notes in circulation indicates ten pieces of gold in the vault. Ten units of money are in circulation, ten are out of circulation. The money supply is equal to ten units of money. (In this example, there are ten notes in circulation and zero coins in circulation.) Should someone redeem a note, that note is retired (taken out of circulation) and a piece of gold is taken out of the vault and given to the customer (put into circulation.) The money supply is still equal to ten units of money, comprised of nine notes and one coin. The money supply is stable. The value of the note is stable.

But of course there is always someone looking to steal.

The goldsmiths noticed that no one would find out if they issued the occasional extra note and then lent it to someone. "Hey: How about making me a low-cost loan? It won't cost you much since all you have to do is print up another note. It's not like you had to go dig up the gold or anything... Who's gonna know that I didn't deposit a coin with you?" So the goldsmith would put one additional note, one additional unit of money, into circulation.

So let's erase the blackboard and go back to the beginning and say that the money supply is ten units of money: Ten notes in circulation that represent ten coins out of circulation. Now the goldsmith issues one additional note, one additional unit of money. The money supply has been expanded by one unit of money. There are eleven notes in circulation and ten coins out of circulation. The money supply has been inflated. Who benefited? The banker (who makes interest for doing nothing) and the immediate borrower (who gets to borrow money at an interest rate that is lower than what it would cost him to borrow real money from a private person.)

Both parties receive real economic value from this act. But energy cannot be created or destroyed. Where did the energy come from? That energy comes from the legitimate notes, whose legitimacy this fake note has appropriated.

This additional note, unbacked by anything, travels among the other notes, pretending to be worth something. And no one can really tell since the goldsmith is not going to permit anyone to take an inventory of his vault. Would the value of the notes in circulation fall? Not immediately.

Now let's pretend that we're talking about the money supply of a town. Cootersville. There are a hundred people in this town. They all do business with one bank. The First National Bank of Cootersville. All the townspeople have deposited their gold coins in this bank and gotten notes. (Who wants to carry around all those heavy coins?) The money supply is equal to one million units of money.

The bank president realizes that people rarely redeem the notes for gold. He's got a buddy, a building contractor. He builds houses. He wants to borrow money from someone to build a housing complex, but people in the town are asking ten percent on their money. So the contractor asks his buddy at the bank if he could, you know, issue a few more notes. "Who's gonna know?"

The bank president prints up some more notes and issues them to the builder. The notes are in the amount of 100,000 units of money. They claim to represent 100, 000 pieces of gold. The banker charges an interest rate that is less than the market rate. Why? Because if he charged a rate equal to the market rate, then the builder would have no reason to borrow from the banker; he might as well borrow in the free market of the townspeople, who are charging ten percent on their money. So the banker charges something less: say, eight percent. Ding! Take note of this artificially altered price of credit; we'll come back to it. And note that the money supply has been inflated from one million units of money to 1.1 million units. Imposters now circulate among the real money.

Now the builder has his money. He spends it into circulation by buying building materials, paying workers, etc. The workers and the hardware store suddenly have lots of business. Everyone seems to have more money. And they do: they are the recipients of this new 100,000 units of money.

Now let's say I'm a farmer and I've got some cows to sell. I put an advertisement in the paper saying that I will have a livestock auction on Saturday. Ten people show up to bid on the cows. Typically, a cow will sell for about a hundred units of money. But now Jim Bob (who had always wanted a cow but could not afford one) has shown up at the auction. He's a drywall guy and has been doing some work for the builder. He now has money. Jimmy Joe (who typically comes to the auctions and buys cows sometimes because he is a dairy farmer) is now bidding against Jim Bob. Jim Bob has the money to buy a cow now. But Jimmy Joe, the dairy farmer, still needs that cow. So Jimmy Joe is forced to raise his bid by some amount.

That cow I just sold to Jimmie Joe cost him more than the cow I sold to Jimmie Joe last week. This is price inflation. It is a direct result of monetary inflation.

The elderly widow down the street --whose entire savings amount to ten thousand units of money-- must now pay more to buy the chickens from me because Jim Bob Drywall Guy also wants to buy chickens with his newfound "wealth." The value of the widow's money has decreased.

The "energy content" of the builder's fake money came from the widow's money. And from the dairy farmer's money. It was a transference of wealth from the widow and the dairy farmer and to the builder. (And also to the banker, as he is making some money by way of his interest.)

This fractional reserve banking scheme cooked up by the bank president is a theft of wealth from existing holders of money. The fruits of this theft are divided between the banker and those to whom he lends the fake money. This scheme of thievery always requires two conspirators: the banker and the initial borrower. (Who is likely the banker's buddy.)

Now. Back to that altered interest rate. To recap: The townspeople would charge ten percent on their money. Ten percent is the cost of credit in Cootersville. If the banker chooses to issue additional notes to the builder, he must charge a lesser rate than the prevailing rate, else why would the builder borrow money from the banker when he could just get it from the townspeople? The banker wants to lend this money. So he will charge less than the prevailing rate. That is, he will charge less than the market has decided that the price of credit is worth.

The banker has lowered the price of credit.

Let's say I'm an inventor. I invent everything from retrotemporal communications devices to battery-powered tie racks to nuclear-powered mouse traps.

The old style, spring-loaded mouse trap seems to work just fine. And it costs ninety-nine cents. I would never borrow money at ten percent to build a factory to manufacture nuclear-powered mouse traps. Why would anyone do such a thing when someone can buy a spring-loaded mouse trap for ninety-nine cents?

But let's say I've got my heart set on this cockamamie idea of a world improved by nuclear-powered mouse traps. In my financial calculus, a credit price of ten percent makes the idea unworkable. But what if the price of credit were only eight percent? Or five percent? Or one percent? In my financial calculus, my bright idea of building a factory to manufacture nuclear-powered mouse traps suddenly seems viable.

So I borrow the money from the banker at an artificially reduced price of five percent. And away I go and build my factory and buy stuff from the local uranium miner (who has to hire more people and dig up uranium and buy packaging material so that he can ship it to me and he prints up his special stationery so that he can bill me.) The uranium miner has created an entire business around providing me with uranium for my nuclear-powered mouse traps.

So opening day comes! ...And no one seems interested in a nuclear-powered mouse trap. So the economic energy that was stolen from the dairy farmer and the widow has been put to use in building a nuclear-powered mouse trap factory and in expanding the uranium miner's operation. I'm not selling mouse traps and the miner isn't selling any more uranium than he was before. So now the economy of Cootersville has an idle nuclear-powered mouse trap factory and lots of fancy stationery that aren't being used. This is an economic distortion. Such a thing would not have occurred if the credit were purchased at the prevailing rate.

An artificially low price of credit makes all sorts of cockamamie ideas seem economically viable. And we wind up with WebVan and ...And we're out a cure for cancer or an expanded cotton-growing operation or whatever else the credit might have been wisely applied to.

Fractional reserve banking has two effects, both of which are deleterious to an economy: It steals economic value from the dairy farmer and the widow, and it encourages unwise investment.

Fractional reserve banking is theft, plain and simple. It is the single worst thing that ever happened to Cootersville.

...But there is no shortage of sophists to argue in favor of it. Because they are very well paid. Fractional reserve banking is a VERY lucrative business.