A Thought Experiment on Money
Let’s imagine a small mountain kingdom with only ten very scarce and thus highly valued seashells in circulation. These few shells are certainly valuable in terms of scarcity, but there aren’t enough of them to act as a means of exchange.
One solution to this innate problem of scarcity—money has to be scarce enough to retain value but not so scarce that there isn’t enough of it in circulation to grease trade—is for the kingdom to issue 100 slips of paper for each shell, each slip of paper representing 1/100th of the shell’s value. Now there is enough money in circulation to facilitate trade and each slip retains a store of value equal to 1/100th of a shell. The slips are paper money, i.e. currency.
This system works well, but the rulers of the kingdom aspire to consume goods and services in excess of what their share of the shell-backed money can buy in the open market. The kingdom’s leaders print another 100 slips of paper without acquiring a shell to back the new slips with intrinsic value. Nobody seems to notice, and so the leaders print another 100 slips. Note that the kingdom didn’t produce more goods and services; its leaders simply produced more money.
Eventually this excess of paper slips reduces the value of each slip in circulation. What once cost 10 slips now costs 20 slips. This reduction in the purchasing power of money is called inflation, as the price of goods inflates as the money supply is increased while the production of goods and services remains unchanged.
Let’s assume the kingdom’s leaders avoid the temptation to expand their consumption by printing money rather than first increasing the production of goods and services.
As the kingdom expands its production of goods and services and its population, the original 1,000 slips of paper are no longer enough to facilitate trade: lacking money, people revert to the clumsy alternative of bartering goods and services or issuing letters of credit. The purchasing power of the existing money might well increase due to the imbalance between the demand for money (high) and the supply (limited); what once cost 10 slips now costs only five slips.
The value of each slip has now detached from the underlying value of the shell. It’s not the scarcity of the shell that is creating the paper’s value—it’s the scarcity of paper money itself which is creating the paper money’s store of value.
The kingdom can respond to this shortage by issuing more slips of paper. If the kingdom only issues a sum of money that is equal to the increase in goods and services produced, demand will remain high (as trade in the expanded supply of goods and services expands) and the value of the money will remain stable as well.
This detachment of the value of the paper money from the underlying value of the scarce shells worries some in the kingdom, and they propose that the kingdom borrow ten shells from others and pay them interest for the loan of the shells. In effect, money is being loaned into existence: the kingdom borrows ten shells and issues 1,000 new slips of paper that is fully backed by the new shells. But the kingdom has to pay interest on the loan.
One advisor has an insight: rather than actually borrow the shells, why not just borrow the money into existence by selling the kingdom’s promise of paying interest? Why bother with the shells when the only transaction that’s needed is payment of interest on the newly created money?
And so the kingdom sells ten promises to pay interest—what we call a bond—and the buyers receive interest, just as if they’d loaned the kingdom a valuable shell.
The new money isn’t backed by shells at all; it’s backed by the interest paid on the bonds. The kingdom sells off the original ten shells and issues ten more bonds. Now the kingdom’s money is not backed by any intrinsic store of value; it is backed entirely by the kingdom’s promise to pay interest on the bonds.
If the kingdom is prudent and only issues enough money to match an increase in the production and exchange of goods and services, the demand for money will remain in line with the supply, and the money will retain its value.
On the face of it, the kingdom’s money has no intrinsic value at all; but if we follow the example closely, we see that the money is both a store of value and a means of exchange, and its value (when priced in shells, goods or services) fluctuates with supply and demand.
The kingdom’s slips of paper fulfill all the requirements of money.
When the kingdom loaned the money into existence, the money retained its value as long as the kingdom only issued new money to match the demand for money from the expansion of production and exchange. In other words, the supply of money rose in tandem with the expansion of the real economy’s production of goods and services.
The fact that the kingdom had to pay interest on newly issued money created a cost to issuing new money that eventually limited how much new money could be created. Creating too much money would not only reduce its purchasing power, but the treasury of the kingdom would be drained by the interest paid on new bonds.
This raises a very interesting point: when the kingdom created new money only to match the expanding production of real-world goods and services, it didn’t matter that the new money was not backed by either shells or bonds; demand for the money alone maintained purchasing power. There was no need to back the newly issued money with scarce shells or interest-bearing bonds.
Economist Paul Samuelson observed that “money is a social contrivance.” In other words, money exists to serve a social function—to facilitate exchange and the real-world production of goods and services to the benefit of all participants in the economy. If the supply of money is connected to the demand generated by the production and trade of goods and services, it needs no backing nor does it need to be backed by interest-bearing bonds.
Let’s now turn to the way money is issued in the present: by central banks.
Money Issued by the Central Bank Benefits the Few at the Expense of the Many
Let’s imagine that we have a $1 billion line of credit with our central bank at an interest rate of .25%--one-quarter of 1%. We don’t need to post any collateral, and the central bank has given us whispered assurances that should we lose the money in risky gambles, the losses will be made good by the taxpayers. This is called moral hazard: the risks have been disconnected from the consequences.
If we make a profit with the borrowed money, it’s ours to keep. If we lose the borrowed money, the taxpayers will foot the bill.
It’s difficult to imagine a better deal: near-zero interest rate, no collateral, and no risk of having to suffer the consequences of losing the borrowed money.
But our advantages are even better than this already astonishing deal: with the magic of fractional reserve banking, we get to create $19 billion of new money with our $1 billion of borrowed central bank money.
Our options to make low-risk profits are nearly limitless. Anything we earn beyond the annual interest of $2.5 million is ours to keep. We could invest the $1 billion in Treasury bonds yielding 2%. That would yield us an annual gain of $17.5 million for doing absolutely nothing beyond clicking a few keys to buy $1 billion Treasury bonds.
If we are willing to take on higher risk, we could buy stocks that pay dividends of 3% or more annually. If the stocks rose in value, then we’d also earn capital gains. An annual gain of $30 million or more is easily possible in the relatively low-risk investment.
If we wanted even higher yields, we could seek out bonds in other countries that are paying 6%. If those currencies are strengthening versus the U.S. dollar, then this foreign-exchange gain could boost our total gain to 10% annually—a cool $100 million, out of which we only have to pay the central bank a modest $2.5 million in interest.
Or we could set up a bank that issues auto loans and credit cards with the $1 billion. Thanks to fractional reserve lending, our $1 billion in cash (never mind it was borrowed from the central bank—to the rest of the world, it’s cash) can leverage $19 billion in high-interest consumer loans. If the average interest paid on our loan portfolio is 10%, we are earning $1.9 billion in gross revenues. If operating the bank costs $900 million, we net a cool $1 billion annually from the $1 billion line of credit: 100% annual return.
This is precisely how the banking system works, and it illustrates how central banks enable private banks to accrue vast profits. Those closest to the central bank money-spigot are given an opportunity to leverage up astounding profits.
In theory, central banks claim the noble task of providing credit to the private banking sector to facilitate increased production of goods and services, but in reality central banks benefit the few with access to their credit at the expense of the many. The few can generate immense profits without producing any goods and services.
Imagine if we each had a relatively tiny $1 million line of credit at .25% interest from a central bank that we could use to issue loans of $19 million. Let’s say we issued $19 million in home loans with an annual interest rate of 4%. The gross revenue (before expenses) of our leveraged $1 million is $760,000 annually. Since the accounting of the $19 million in loans is highly automated, our expenses are modest. Let’s assume we net $600,000 per year after annual expenses of $160,000. Recall that the interest due on the $1 million line of credit is a paltry $2,500 annually.
Median income for workers in the U.S. is around $30,000 annually. Thus a modest $1 million line of credit at .25% interest from the central bank enables us to net 20 years of a typical worker’s earnings every single year.
But central banks don’t offer this largesse to individuals or communities; these profoundly profitable privileges are only available to private banks.
Today's Money Regimes Are Doomed To Failure
I hope you now understand that the current system of issuing money and credit intrinsically benefits the few at the expense of the many. This vast privilege and the equally vast inequality that is the only possible output of the system cannot be reformed away; it is intrinsic to centrally issued money and private banking.
The problem isn’t fiat money—currency that isn’t backed by scarce commodities; it’s centrally issued money that is distributed to the few at the expense of the many. This centrally created money is issued not to facilitate the production of goods and services and the demand that naturally arises from the expansion of the real economy, but to serve the state and its cronies.
Centrally issued money centralizes wealth and generates systemic inequality. This is equally true of all centrally issued currencies. But the inequity that is intrinsic to this system is politically, socially and financially destabilizing, and so this system is unsustainable.
In Part II: The Future Of Money, we consider what the landscape will look like once the current system of central bank-issued credit-money implodes. Which new form(s) of money are most likely to rise from the ashes?
Click here to read Part 2 of this report (free executive summary, enrollment required for full access)
This is a companion discussion topic for the original entry at https://peakprosperity.com/the-fatal-flaw-of-centrally-issued-money/