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Bitcoin: One of the Greatest Economic Experiments of All Time

Whether you love or hate Bitcoin and cryptocurrencies you have to admit that it is one of the greatest economic experiments of all time.[1]  It is very rare in economics to have a well-defined and controlled experiment.  I learned about this experiment in a decentralized private currency with a limited supply by 2012.  At the time it was not clear if this experiment would ever really get off the ground.  Bitcoin was valued at about $13, with a market capitalization around $15 million.  In addition, it was difficult to buy and sell Bitcoins.  Despite this I had conversations with people about the questions Bitcoin posed, particularly about the nature of money.  There had been other cryptocurrencies before Bitcoin and when they got traction governments shut them down.

Now it is clear that Bitcoin, cryptocurrencies, and the underlying technology (decentralized, trustless, blockchains) are here to stay.  A single Bitcoin is valued at over $6,300.00 and the total market capitalization of cryptocurrencies is around $181 billion.  This is small compared to the FOREX market, but too large to ignore, which means the economic experiments will be played out.  Here are just some of the questions posed by this experiment.

 

1) What is money?

Bitcoin and most cryptocurrencies do not actually have a physical or even computer coin or token.  They are in fact just ledgers where the “coin” is the unit of value.  The ledgers show who paid whom what and a positive account shows that you have provided value and are owed (or at least hope to) obtain value from the community in the future.  If Bitcoin is successful it will show that money is not a thing, it is really just an accounting system that is it is just information.

It will also show that money is technology.  Andreas Antonopoulos points out that the last real upgrade to that technology was the credit card, introduced by Dinner’s Club in 1950.

2) Does Money Have Inherent Value?

Or stated another way does money need to have an inherent value?  Bitcoin does not have inherent value and in fact nothing has inherent value.  For something to have value means it has to have value to someone.  Value cannot be separated from the valuer.  The only things that even come close to having inherent value to humans are food, water, and air.  If Bitcoin succeeds it should settle the question of inherent value.

3) Do We Need Legal Tender Laws for Money to Work?

Most people seem to assume that money must be backed by a government or it will not work.  Legal tender laws are laws that state you must accept the legal tender as settlement for any debts public or private.  Of course, there are many examples in history where people used gold and silver as money that was not endorsed or backed by any government.  The United States did not have any legal tender laws from the Constitution until the Civil War.  If Bitcoin succeeds then it will be clear that money can be private, i.e., not backed by a government and legal tender laws.  If you want to know more about legal tender laws in the U.S. see Money and Banking.

4) Is a Low Rate of Inflation Good for the Economy?

The Federal Reserve and most central banks argue that a little inflation is good for the economy.  We are warned that without inflation we might fall into deflation, which caused the Great Depression.  In the United States the target inflation rate is 2% per year, which means the purchasing power of a dollar today would be ¼ of what it will be in 70 years later.  Even Milton Friedman argued that the money supply should grow at the same rate as the economy.  According to Friedman this would keep the value of the dollar stable.  This means if the economy grows at 3% per year then according to Friedman the money supply would grow at 3% per year.  One question Friedman does not answer is who benefits from this growth in the money supply?  The answer is the Federal Reserve and the U.S. government, essentially get 3% of the value of the economy in this example for doing nothing.  Also note that the U.S. was in a deflationary period in the 1880s and 1890s and it was a time of extraordinary economic and technological growth.

Bitcoin has an inflation rate (supply increase) that is used to pay the miners during the start-up years.  Presently the supply increase is about 4% per year.  In order to convert this into an inflation rate the way the term is commonly used in the United States, we would have to subtract out the growth rate of the economy.  The expected growth rate of the U.S. economy this year is 2.7%.  Thus the inflation rate for Bitcoin is 1.3%, which is less than the Federal Reserve’s target rate.  Also Bitcoin’s inflation rate slows down overtime and the total number of Bitcoins that can ever be produced is 21 million.

If Bitcoin succeeds, we will see whether a little inflation is good for the economy.  We will also see if private citizens prefer to hold a devaluing currency or value increasing currency.

5) Do We Need Central Banks?

Central Banks are a fairly recent phenomenon.  The United States did not have a central bank until the creation of the Federal Reserve in 1913.  The U.S. did have national banks, but these were not central banks.  A central bank has control over the currency of a nation and through convoluted processes creates and destroys money to “manage” the economy and to fund the government.  For more see How Central Banks Create Inflation.  The record of the Federal Reserve of “managing” the economy is very checkered including the Great Depression, the inflation and high unemployment of the 1970s, and losing 95% to 97% of the purchasing power of the dollar during its existence.

If Bitcoin succeeds, it will end the power of or at least significantly diminish the power of central banks.  We will then see if a central bank is necessary to create prosperity and smooth out the ups and downs of the economy.

6) Do We Need Securities Regulations – the SEC in the U.S.?

Securities like stocks and bonds were mainly regulated by common law fraud and contract law until the 1920s in the United States.  The justification for securities regulations have always been to protect investors.  There have been a number of studies on point and not one of them has shown that investors have done better because of securities laws and some have shown they do worse.

Bitcoin’s technology has the potential to create stocks, bonds and other securities.  However, it is not as clear that these can escape the regulatory rules in the way that Bitcoin can.  Already we have seen crypto-assets created that bypass both Venture Capitalists, Wall Street, and securities regulations.  Before the creation of the SEC in the United States in the 1930s this was quite common.

If Bitcoin’s technology can escape securities regulations, we will see if securities regulations help investors or if they just entrench large Wall Street banks.

7) Is a Financial Sector that Takes Up 20% of the GDP Good for the Economy?

Cash is almost dead in most modern economies, which means we pay for goods and services with credit or debit cards.  This “convenience” costs at least 3% of the transaction price assuming the bill is paid immediately.  It also puts the banks and government in between almost every transaction.  Securities regulations and banking regulations are so complicated that people are forced to use financial intermediararies for almost any financial transaction.  In 1947 the financial sector was only 10% of the United States GDP.  Finance does not create wealth, it just greases the wheels of transactions.  For instance, money is just a way for one person to sell their “time” and buy goods.

Bitcoin and Bitcoin’s underlying technology if they succeed may significantly shrink the financial sector.  For instance, by allowing everyone to be their own bank or credit card company or loan originator the fees to the financial sector will be severely undercut.  If Bitcoin succeeds we will see if the large financial sector was creating wealth or consuming it.

8) Do We Need Income Taxes?

Bitcoin has the potential to severely undermine income taxes and capital controls.  Do people think they get value for their income taxes?  Are income taxes a method of raising revenue or a system for punishing the politically un-connected or unpopular?

9) Can Bitcoin Decentralize the Internet?

The Internet was built on a series of decentralized technologies.  Because of the inefficiencies of our financial sector, the only way to monetize the Internet was with centralized systems like Google, eBay, Youtube, Amazon, etc.  Efficient micropayments that can be implemented using Bitcoin technology have been postulated as a way to decentralize the Internet and return it to its origins.  Only time will tell.

10) Do We Need the NSA to Protect Us?

The technology behind Bitcoin has the potential to store and transfer information that is not trackable and cannot be hacked.  These systems are just being developed.  If they are successful, we will find out if the NSA was just a boondoggle or if it was truly protecting us, not the government.

 

 

[1] Unless you are an Austrian Economist and then you do not think experiments and therefore observation are relevant to economics, which means you are not doing science.

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October 31, 2017 Posted by | -Economics, -History | , , , , | Leave a comment

Money and Banking (Intellectual Capitalism Part 3)

There are a lot of misconceptions about money and banking.  Often people either think these are the root of all our problems or the solution to all our problems.  Both seem to believe that once money enters the equation in economics magic happens.  This paper will focus on how money and banking work in a free market and then examine the distortions caused by government manipulation of money and banking.

 

Money

If you examine an economics book on money it will tell you money is a medium of transaction, a store of value, and a unit of account.  Some economist say that money being a medium of exchange is the real function (definition) and the other two functions follow from money’s primary purpose.  I agree and therefore in this paper the definition of money is a medium of exchange.

All sorts of things have served as money including sea shells, tobacco leaves, grain, large immovable stones, tea leaves, cigarettes, silver, gold, paper, and computer bits (entries).  Why money is a useful invention is usually explained by way of an example.  Suppose that you raise cows for a living and you wanted to buy a loaf of bread.  If you tried to trade your cow to the butcher, you would want several hundred loaves of bread in return.  Most of the bread would spoil before you can eat it, so you only want two loaves of bread now.  On top of this, the baker wants chickens not a cow.  Under a bartering system these transaction will not occur, however with the addition of money you can sell your cow to the butcher and he will give you money.  You can then use the money to buy two loaves of bread, which the baker can use the money to buy chickens.

It is likely that money originally grew out of an IOU (I Owe yoU) system.  For instance, in the example above it is possible that once the rancher and the baker agree that the cow is worth 300 loaves of bread, then the baker would give the rancher two loaves of bread and an IOU for 298 loaves of bread.  The rancher intends to present the IOU to the baker every week for his two loaves of bread.  At which time the baker will give him two loaves of bread and an amended (new) IOU.

Unfortunately, the rancher gets sick and needs a doctor.  The doctor agrees to accept the baker’s IOU in payment for his services.  Now the baker’s IOU has acted as medium of exchange, which means it is money.

Money is just a generally accept IOU.  In other words many people will accept it as a general IOU that they can “redeem” from most people.  In the example above the doctor would have to worry that the baker might not make good on his IOU.  Now some people will argue that only paper fiat money is a generalized IOU.  However, even gold is functioning as a generalized IOU.  It is commodity money and as a result may have value in the market separate from its use as an IOU, but the person accepting it as money does not need it as a commodity.  He is planning on trading it with other people for goods and services.  On a deserted island (with no hope of rescue) you could have a ton of gold, but it would useless and you would not be better off with it than without it.  This also shows that wealth is not the same thing as having money.

One of the advantages of this point of view on money as an IOU is that it makes it clear that money is not wealth, even gold. The Spanish Kings and Queens found out this point when they brought back tons, literally, of gold and silver but still ended up going bankrupt.  The gold was not wealth and they spent their gold on things that did not create wealth.  Wealth is the things and knowledge that solve the objective problems of life (inventions).  I added the knowledge part because if you give an aboriginal person living in the Brazilian rain forest a super-computer, or an MRI machine, or even a bulldozer they are not wealthier because they do not know how to use these things (inventions) or even trade them.  Wealth is also about the objective problems of life, the most fundamental ones being air, water, and food.  These are still problems for many people in the third world.  Even in wealthy first world countries people have real objective problems, such as health problems, safety, etc.  It might not be as obvious why cruise control or smart phones solve objective problems, however if you think about it both do.

The idea that money is not wealth is important because it immediately makes the fallacy of Mercantilism apparent, which Adam Smith spent 100s of pages on.  In addition, it makes it clear that we cannot become wealthier by manipulating the money supply.  The only way to become wealthier on a per capita basis is to create new things that are more efficient at solving the objective problems of life or solve new objective problems of life, in other words create new inventions.

People often argue about the differences between money, currency, real money, commodity money, debt money, paper money, and fiat money.  Currency is generally defined as something that is specifically designed to function as money, such as coins.  Commodity money is when the money is a commodity such as silver, gold, grain, or is backed by a commodity.  Now real money can mean several different things, however I am talking about people who argue that only gold (silver) is real money.  By this they seem to mean that gold is a commodity money and all other currencies are to be measured against gold.  All commodity moneys have the advantage that they are more difficult for the government to devalue, however bitcoin also has this feature.  The other point is that gold has a long tradition as a widely recognized money.  This is true but does nothing to enlighten what money is or what its function is.

Fiat money is money that is not backed by a commodity.  Usually it is paper money although more and more it is just electronic entries in a computer and often it is legal tender, which will discuss in more detail shortly.  Paper money is self-explanatory.  Debt money can have several meanings, but usually means the money “created” when a person (entity) takes out a loan.  Many people argue that debt money is evil or somehow costs us interest just to have money.  Since all money is essentially an IOU, all money is created by a debt, i.e., a claim to future goods and services.

 

Proto Banking

Banking and money have been closely linked at least since the Agricultural Revolution about 11,000 year ago.  The Agricultural Revolution was a series of inventions that provided man with access to a huge increase in the number of calories per acre.  As a result, the human population expanded enormously and the territory of humans also expanded.  These excess calories were converted into population increases until the number of calories collected/created by the human population were roughly equivalent to the number necessary to support that population.

The grains that were the major source of these extra calories had to be stored, because the grains ripened all at once.  While the grain was stored, it needed to be protected from water and vermin.  If the grain ran out before the next harvest, people starved to death.  Efficient, effective storage of grains reduced the chances of running out grain before the next harvest.  A centralized grain storage (grain silos) was more effective than econgrowth.smallindividual storage of grains.  When a farmer deposited their grain they received a receipt (clay tablet) for the grain.  Eventually people started to use these receipts to pay for other goods (services).  For instance, if you wanted to buy a chicken instead of going to the grain silo and taking out enough grain to pay for the chicken, you just handed over some of these clay tablets to the owner of the chicken.  In other words these receipts became money.

In ancient Mesopotamia, as long ago as 5000 B.C.E., clay tablets were used to represent beer or grain.[1]  These clay tablets functioned as money.  Gold also started functioning as money about the same time, but was probably only used for large or long distance payments and therefore was not used by average people.[2]  These clay tablets were “created out of thin air” in the vernacular of today.  After a harvest there would be a lot of these clay tablets around and we would say the money supply increased.  As people withdrew grain, the grain bank would redeem these receipts.  We do not know if the “bank” destroyed these clay tablets, which would have been the logical thing to do or if they stored them for the next harvest.  Either way the money supply would shrink until the next harvest.  In fact the number of clay tablets (in circulation) would have shrunk to almost to zero just before the next harvest.  We know this is the case because of evolution.  Population expands until it takes up the available food supply, which is known as the Malthusian Trap.  This means the grain would be almost gone by the time the next harvest rolled around.

If you eliminate money (clay tablets) this does not change the economic situation.  Until the Industrial Revolution people lived on the edge of starvation and it was common for families to have to ration their food and even pick who would get food and who would not.  Because the healthy adults were the only way any of them would survive through the next year, the old, the young, and the sick were the first one’s whose food was cut off.  This is a grim reminder that economics is not just a game, but has real world consequences.

If we replaced the clay tablets with coins (e.g., silver, gold), then the money supply would not go up and down.  However, the price of food (and other goods) would go up and down.  After a harvest the price of food would be cheap and just before the harvest food would be very expensive.  The monetary system would not change the underlying economic situation one bit.

This is what we have learned about money in a free market:

1) Money is a medium of exchange

2) Money is a generalized IOU

3) The money supply can vary in a free market without fractional reserve banking.

4) Many things can function as money and only the market should “decide” what is money.

5) Money is not magic and does not allow magic in economics.

Now we are going to introduce some government (non-free market) distortions to money.  Going back to our clay tablets, someone probably realized that it did not make sense to destroy the clay tablets when people withdrew grain, since they would have to make new clay tablets after the harvest.  The “bank” probably started storing them and this of course led to the temptation of stealing the clay tablets.  Also the government probably decreed that taxes had to be paid in these clay tablets, which was the first step to making them legal tender.

We are going to skip forward to Roman times.  The Roman’s used silver coins as their currency.  The main unit of money was the denarius, which was between the size of a modern nickel and dime and equivalent to a day’s worth of wages for a skilled laborer.[3]  As late as 68 C.E. the silver in a denarius was almost 100%, but then it started to decline.  People balked at using this debased money, however the government declared the new, lower silver coins legal tender.  By 265 C.E. the silver content in coins was down to 0.5%.  Not surprising the Roman Empire suffered huge inflation.  The Roman’s minted so many coins that even today you can buy several Roman coins of standard quality for twenty dollars or so.[4]  For clarity later on I am going to call this “simple inflation”.

An important point here is that legal tender laws are always the first step towards inflation.  The only reason for a government to pass a legal tender law is so that they can “print” money.  In other words, the government is undertaking an endeavor that would get any private citizen throw in jail.  With the end of the Roman Empire legal tender laws and banking died out during the Dark Ages.  Coins were mainly used by the rich during this period.

By the 1700s legal tender laws were being seen again in Europe.  France experimented with legal tender laws, allowing The Mississippi Company in the 1710s to have control over its legal tender with disastrous results.  Supposedly, the French swore off paper money and modern banking for years after this.  Some historians have even argued that this backwardness in France’s finance system was part of why they were beaten by the English.  This is a fascinating story, but beyond the scope of this article.

The British followed suit in 1833 making banknotes issued by the Bank of England (a private bank at the time) legal tender.[5]  The United States had no legal tender laws (after the Constitution) until 1862 during the American Civil War.  The North printed $450,000,000 under this law to help finance the war.  Eventually this law was declared unconstitutional in Hepburn v. Griswold, 75 U.S. 603 (1870).  The Court reasoned that the Constitution allowed the federal government to coin money, but not the power to make paper legal tender.  The government argued that since it had the power to carry out war and the issuance of the legal tender was necessary for carrying on the war, then legal tender laws fell under the “necessary and proper’ clause of the Constitution.  The Court rejected this argument and also pointed to the fact that the Constitution prohibited the states from interfering with contracts.  The Constitution did not specifically, prohibit the federal government from interfering with private contracts, but it would be against the spirit of the Constitution to allow the federal government to do so.  In one of the stranger twists in history, Salmon P. Chase helped push the legal tender legislation through as Lincoln’s Secretary of Treasury, then he was appointed Chief Justice of the Supreme Court and lead a 5-3 decision to declare the law unconstitutional.  Unfortunately, this case was quickly overruled by the Knox v. Lee, 79 U.S. 457 (1871) Supreme Court decision.

Multiple competing bank notes were the norm at that time.  According to the Cato Institute, “the government did not entirely monopolize issuance of notes until 1935, but the laws that made the monopoly possible date from the Civil War.”[6]  Today the legal tender law in the US is 35 USC § 5103 which states:

United States coins and currency (including Federal reserve notes and circulating notes of Federal reserve banks and national banks) are legal tender for all debts, public charges, taxes, and dues. Foreign gold or silver coins are not legal tender for debts.

Legal Tender laws are necessary for government counterfeiting[7] to be successful.  Without legal tender laws, people would quit accepting the money printed by the government.  The key point is that legal tenders are necessary to create inflation.  Any further investigation of money will require that we first examine how banks work.

 

Banking

The first banks in Europe after the Dark Ages were goldsmiths.  Because goldsmiths were working with valuable materials they needed vaults.  Wealthy patrons would often give some of their gold or other valuables to the goldsmith to secure in their vault.  The goldsmith would give the patron a receipt for their gold.  Overtime, just like the clay tablets for grain, people started to trade the receipts instead of taking out gold and paying with the gold.

Some of the customers also started asking for loans.  The goldsmiths wanted to reduce their risk if the customer defaulted on the loan, so they asked for collateral.  Originally, they probably asked for jewelry or other things made of silver and gold, since they knew they could liquidate (sell) these items fairly easily.  The goldsmiths could have given the customer gold out of their gold reserve (capital) and they probably did initially.  Most likely many customers then gave the gold back to the goldsmith and took receipts for the gold.  If the goldsmith’s receipts were trusted enough, they could skip this step and just give the customer receipts.  If the customer failed to pay the loan back, the jewelry (collateral) became the property of the goldsmith.

Or the goldsmiths could have given the borrower gold on deposit from other customers, which is the way most people think of banking working.  In that case then the gold the goldsmith had on hand (deposit) was less than the amount of the receipts outstanding for the gold, which is fractional reserve banking (assuming the goldsmith had no gold capital or the loan(s) were greater than the goldsmith’s gold capital).  Fractional reserve banking is defined as:

a banking system in which only a fraction of bank deposits are backed by actual cash on hand and are available for withdrawal.[8]

Most customers probably deposited the borrowed gold with the goldsmith and took receipts.  Again the goldsmiths probably began to skip the step of giving the borrower actual gold (silver) and just gave them receipts for the gold.  At this point it might appear that the goldsmith is “creating money out of thin air”, however the receipts in this case are backed by the collateral, jewelry in this example.  Actually, all the outstanding receipts are now backed by the gold on hand and the collateral the goldsmith has for loans.

At this point the goldsmith risks all the holders of these receipts asking for their gold and the goldsmith does not have enough gold to fulfill all these demands.  However, the goldsmith does have enough capital to fulfill the demands, because the collateral, jewelry and gold on deposit in this example.  It is likely that initially most of these loans were “callable”, meaning that the goldsmith could demand the borrower pay them back in full (gold or receipts) at any time.  If the borrower paid up, then the goldsmith had no problem paying off the receipts.  If the borrower did not pay up, then goldsmith became the owner of the collateral (jewelry) and could sell it to fully back the receipts.[9]

Eventually the goldsmiths realized it was not only jewelry (gold and silver items) that had value and could act as collateral.  For instance, arable farmland was one of the most valuable assets that people could own for most of history since the Agricultural Revolution.  The goldsmith could not put the farmland in his vault, however he could have a legal claim to the land.  That claim stated that if the borrower did not pay back the loan, then the goldsmith owned the farmland.  Of course it takes longer to liquidate farmland than jewelry and farmland might be more subject to market fluctuations.  As a result, the amount the goldsmith would lend against the farmland was lower than for gold and silver items.

At first goldsmiths probably made loans against farmland that someone owned outright.  Eventually, they figured out that they could make loans on farmland that was being purchased, as long as there was a big enough down payment (the equivalent of loaning less than the value of collateral).  What the goldsmith is doing is securitizing assets other than gold.  When the goldsmiths created receipts for gold and silver deposits they were securitizing gold (and silver).  “Securitize is a pooled group of financial assets that together create a new security”[10] or banknote in this case.  This means that goldsmiths receipts (banknotes) are backed by not only gold deposits but the other assets that they hold as collateral.

This is exactly what a company does when it sells bonds (stock).  The bond is backed by the assets (collateral) of the company.  The bonds are usually very liquid and can be sold or traded in exchange for goods and services, i.e., the bonds are money.

These goldsmiths became fractional reserve banks once they started securitizing assets other than gold.  Fractional reserve banking is an important invention and is created (exists) in a free market.  A fractional reserve bank is doing something analogous to what engineers have done with the telephone system.  The backbone that connects two people together on a phone line does not have the capacity to allow everyone to make a call at the same time.  The engineers know that only a certain fraction of people will normally be on their phones at the same time.  By designing a system to handle this level of usage plus a margin, the cost of the telephone system is reduced.  Of course occasionally, like in the time of an emergency, everyone wants to use their phone at the same time and then you receive a message like ‘all circuits are busy, please try your call again later.’  Another example is the time sharing of resources is done by computers.  Before the 1980s this was done by having a number of computer terminals all connected to one large computer that time shared its resource among these terminals.  This is still done within your computer when it runs multiple programs.  The processing power of the microcontroller is time shared among these programs.

Banks know that only a small number of people will want gold at the same time.  Most of the time people will be happy with banknotes or just accounting entries.  However, if people lose confidence in the bank, then they will all want to withdraw gold (cash) at the same time.  This is called a ‘run on the bank’ and is the same thing as everyone trying to make a telephone call at the same time.  Note that this is a cash flow issue and can happen even to a bank that is profitable.  Usually, banks that were clearly profitable could borrow gold from other banks to weather the run.

When a fractional reserve bank (hereinafter bank) initiates a loan against an asset, let’s say a farm, the bank creates a security (banknotes or an entry in a ledger) equal to the amount of the loan.  In this process it “creates money” equal to the loan.  At one time this might have been done by printing a bunch of banknotes, but now it is an electronic entry in the banks accounting system.  An article entitled “Money Creation in the Modern Economy” published by the Bank of England explains “whenever a bank makes a loan, it simultaneously creates a matching deposit in the borrower’s bank account, thereby creating new money.”[11]  This article also points out that “money creation in practice differs from some popular misconceptions — banks do not act simply as intermediaries, lending out deposits that savers place with them, and nor do they ‘multiply up’ central bank money to create new loans and deposits.”[12]  According to the article, “Money in the Modern Economy: an Introduction”, there are three main sources of money in modern economies, currency, bank deposits (loans by commercial banks) and central bank reserves.[13]  This article also points out that most money in the economy is created by banks initiating loans.  [14]

Some people call this debt money and argue it is bad for the economy.[15]  They imply that this system of money creation requires we pay interest to have money.  First, it is important to point out that this sort of money creation happens in a free market.  Second, the only one paying interest is the person who took out the loan.  In a free market there would also be other forms of money, such as gold, silver, bitcoin etc.

When loans are paid back money is destroyed, just like the case of the clay tablets being destroyed (taken out of circulation) when people turned them in for their grain.  The bank no longer has access to the collateral (e.g., farmland, jewelry, etc.).  As a result, the banknotes (electronic entries) are destroyed.  Note that money is also destroyed if the borrower defaults on the loan.

In a free market (for this discussion most importantly means no legal tender laws and no central bank) banks’ ability to ‘create money’ is limited by the value of the assets used as collateral.[16]  The bank is not creating money, it is securitizing assets and the banks’ ability to create money is then limited to the assets that can be securitized.

If the banks create too many loans that cannot be paid back, then they will tighten their lending standards.  This will result in fewer loans and less money being created.  When the economy is growing banks will fund more loans and create more money.  However, the amount of money in the economy will be proportional to the assets that can be collateralized in the economy.

As a result, in a free market fractional reserve banks do cause variations in the money supply, but do not cause inflation or deflation.  Note that the United States had fractional reserve banks from before the revolution and the United States did not have any periods of inflation.  The banks were constrained in how much money they could create.  Now prices did vary widely sometimes, particularly in times of war.  However it is necessary to separate out the fluctuation in prices due to changes in supply and demand from those due to changes in the quantity of money.  During a war (crop failure) there is an increase in the demand for goods and services, particularly food.  Men are off fighting instead of planting their fields and the war itself often destroys the crops on large tracks of land.  This increase in the price of food will mean that farmland that is not threatened by the war will be more valuable.  As a result, it is likely banks will be willing to lend more money against these farms.  This will result in some increase in the money supply.  However, when the war ends the prices of the farm goods will fall and so will the value of the farmland, which will reduce the number of loans outstanding, reducing the amount of money in the economy.  Averaged out over time money grows at the same rate as the economy and prices are roughly stable.[17]

 

This is what we have learned about banking in a free market:

1) Fractional reserve banking exist in and our an invention of a free market.

2) Fractional reserve banks do create and destroy money, however the amount of money created is proportional to the assets in an economy.  

3) Fractional reserve banks do not cause inflation.

 

(I wanted to include a discussion of central banks, however this article is already too long.  So I will post on central banks and their effects in another article)

[1] Peter Dockrill, This 5,000-year-old artefact shows ancient workers were paid in beer, http://www.sciencealert.com/this-5-000-year-old-clay-tablet-shows-ancient-mesopotamians-were-paid-for-work-in-beer; and

Rachelle Samson, History of money: From clay tablets to legal tenders

History of money: From clay tablets to legal tenders, http://www.versiondaily.com/the-history-of-money-from-clay-tablets-to-legal-tenders/.

[2] Wikipedia, History of money, https://en.wikipedia.org/wiki/History_of_money, accessed 11 November 2016.

[3] Jeff Desjardins, Currency and the Collapse of the Roman Empire, http://money.visualcapitalist.com/currency-and-the-collapse-of-the-roman-empire/, accessed 11 November 2016.

[4] coins  https://www.amazon.com/Lot-10-Uncleaned-Ancient-Bronze/dp/B001BMWATA?SubscriptionId=AKIAIKBZ7IH7LXTW3ARA&&linkCode=xm2&camp=2025&creative=165953&creativeASIN=B001BMWATA&tag=wwwbookcompar-20&ascsubtag=5820b98a48308f0454a513ac

[5] A. Andreades, History of the Bank of England 1640 to 1903, http://socserv2.socsci.mcmaster.ca/econ/ugcm/3ll3/andreades/HistoryBankEngland.pdf,

[6] Schuel, Kurt, Cato Journal, Vol. 20, No. 3 (Winter 2001) p 454.

[7] Counterfeiting in an economic sense is any currency that is not backed by productive or creative effort that someone willing exchanged their creative effort for.  Gold is clearly not counterfeit money, since it requires productive effort to mine gold.  Buy paper money presents a problem.  It takes productive effort to make and print paper, but no one would trade twenty dollars of their effort for someone who printed a twenty dollar bill.  Economic counterfeiting is really a fraud where someone believes the other person has provided value that they did not provide and purposely withheld this fact from the other party.

[8] Fractional Reserve Banking Definition | Investopedia http://www.investopedia.com/terms/f/fractionalreservebanking.asp#ixzz4QUDQvzpR, accessed November 19, 2016.

[9] The collateral is usually worth more than the loan to deal with market fluctuations.  This is why people used to say that a bank would only loan you money if you were already rich.

[10] Securitize Definition | Investopedia http://www.investopedia.com/terms/s/securitize.asp#ixzz4QVLtJy4H, accessed on November 19, 2016.

[11] Michael McLeay, Amar Radia and Ryland Thomas, Money creation in the modern Economy, http://www.bankofengland.co.uk/publications/Documents/quarterlybulletin/2014/qb14q102.pdf, accessed November 19, 2016.

[12] Michael McLeay, Amar Radia and Ryland Thomas, Money creation in the modern Economy, http://www.bankofengland.co.uk/publications/Documents/quarterlybulletin/2014/qb14q102.pdf, accessed November 19, 2016.

[13] Michael McLeay, Amar Radia and Ryland Thomas, Money in the modern economy: an introduction, http://www.bankofengland.co.uk/publications/Documents/quarterlybulletin/2014/qb14q101.pdf, accessed November 19, 2016.

[14] Michael McLeay, Amar Radia and Ryland Thomas, Money in the modern economy: an introduction, http://www.bankofengland.co.uk/publications/Documents/quarterlybulletin/2014/qb14q101.pdf, accessed November 19, 2016.

[15] Debt-Based Money vs. Sovereign Money, http://positivemoney.org/our-proposals/debt-based-money-vs-sovereign-money-infographic/, accessed November 19, 2016.

[16] Credit cards and personal loans may seem to violate this, but a person’s willingness to work is an asset.

[17] JOSH ZUMBRUN, A Brief History of U.S. Inflation Since 1775,  http://blogs.wsj.com/economics/2015/12/14/a-brief-history-of-u-s-inflation-since-1775/, accessed 12/3/2016.

January 2, 2017 Posted by | -Economics, -History, Intellectual Capitalism | , , , | 5 Comments

Is Money an Abstract Concept?

In H&R Block Tax Services v. Jackson Hewitt Tax Services Inc., the court stated that “although tangible in some forms, money is simply a representation of a legal obligation or abstract concept.”  A similar sort of attitude seems to be involved in the Bilski case.  Both cases involve patents where money is used a unit of measure, and this seems to cause all sorts of confusion to the courts.

Is money just a legal obligation as the court states?  The court is incorrect that money is a legal obligation.  Money exists separate from a functioning legal system.  Money is a medium of exchange that measures the total amount of goods and services that can be traded for a certain amount of money.  The court seems to be confused by the legal tender rules, but money existed long before any legal tender laws ever existed.  Continue reading

November 19, 2009 Posted by | -Law, -Philosophy, Patents, Uncategorized | , , , , | 1 Comment