Some Pysics Insights

Gold and the Money Multiplier

A short and (hopefully) mildly entertaining essay.

Banks accept deposits, and sometimes pay interest on those deposits. Taken all by itself, that's not a good path to making a profit. What they do to earn money is they lend out the money they accept as deposits, and charge interest on those loans. This is a simple fact, and has been true pretty much as long as there have been banks -- certainly banks were operating this way long, long before there was a Federal Reserve Board.

However, this very simple scheme has unexpected consequences, and these consequences depend in no way on whether a country is on the gold standard.

Bankers, it is generally agreed, have little sense and cannot anticipate economic difficulties nor their consequences. So, in an effort to assure that banks have a little cushion against unexpected withdrawals, the government (any government, not just the U.S. government) typically requires that banks retain a fraction of their deposits, and not lend out absolutely everything down to and including the pictures on the office walls. For the rest of this essay we'll assume that banks are limited to lending out no more than 90% of their primary deposits.

Now, here is a little parable about the gold standard.

Consider a country named Smallworld.  Smallworld is on the gold standard, with a vengeance: the only form of money is gold coins. One might think, therefore, that in Smallworld the money supply would be fixed.

Joe's Money:

In the beginning, the only person in Smallworld with any money at all is a deep-rock miner named Joe Fed.  Joe has $100, in the form of gold coins, which he received as pay for digging stuff out of the ground.  Joe has, quite literally, all the money in the world.

So, in the beginning, the money supply of Smallworld is $100.

Joe doesn't need to buy anything just now so he goes down the street to Smallbank and deposits his $100.  Now, the bank has $100 in cash, but they have a liability of $100 as well, which is the record of Joe's deposit.  Their net worth is, consequently, $0.

The money supply, which includes bank deposits, is still $100; all of Joe's money is in the bank.

Fannie's Money:

Fannie wants to buy a house, but she has no money. She decides to settle for a tent (it's cheaper) and she goes to Smallbank to make a loan.  She borrows $90.  The banker hands her .... $90 in gold coins (that's the only kind of money there is).

She buys a tent from Omar the Tentmaker, puts it on the back of her camel, and heads off to look for a place to pitch it.

Omar now has $90.  He has no immediate need for the money so he goes down to Smallbank and deposits it.

Smallbank now has $190 in deposits, all in the form of gold coins.  $90 is currently out on loan, but that doesn't affect the total of size of the primary deposits in the bank.  The money supply, which includes bank deposits, is now $190.

Let's look at the money supply in detail:

Joe Fed $100
Omar the Tentmaker $  90
Total money $190

Freddie's Money:

Freddie already has a house (actually, it's a cave), but he needs someplace for his dog Henry to sleep, and since all the money in the world is currently in Smallbank, he must borrow to buy it. He borrows $81, which is all that Smallbank can lend him while staying within their reserve requirement. From there he goes to visit Omar, and buys a pup tent. He puts it in a dog cart and Henry pulls the cart back to Freddie's cave.

Omar doesn't need to buy anything just now so he deposits the $81 -- in gold coins -- in Smallbank. Now let's look at the primary bank deposits at Smallbank:

Joe Fed $100
Omar the Tentmaker $171
Total money $271

The money supply now consists of $271, all in gold coins.

Sallie's Money:

Sallie wants a television for her dorm room. She has no money (Joe and Omar have it all, of course) so she goes to the bank to borrow some. The bank can lend her $72 while staying within their reserve requirement (actually they could lend her $72.90 but Smallworld has no pennies -- gold pennies being almost too small to see and impossible to keep track of). She takes her $72, and buys a television from the well known French firm "Lafayette" for $50, and two cases of Coca-Cola for $22 from Big Coke Company. She gives Lafayette and Big Coke gold coins in payment, of course.

Lafayette gives one $5 coin to Pawn1, the clerk who sold the T.V., and puts the remaining coins, totaling $45, into their business account at Smallbank. Big Coke pays $12, in the form of a $10 piece and two $1 coins, to Fargo, the stage coach driver who delivered the soda, and deposits the rest in Smallbank. Fargo and Pawn1 also deposit their money in Smallbank for safe keeping until they next go grocery shopping.

Deposits now total:

Joe Fed $100
Omar the Tentmaker $171
Pawn1 $    5
Lafayette $  12
Big Coke $  12
Total money $343

The money supply now consists of $343, all in gold coins.

The TRICK is that most of those coins now belong to multiple people.

DISASTER strikes Smallworld

For years one of Joe Fed's responsibilities has been purchasing mining equipment. A big item is overalls for the miners, and he's been buying them from Omar the Tentmaker (who makes clothing as well as tents). Now it's come to light that Omar has been giving kickbacks to Joe.

Joe and Omar both decide to leave town. Rather than carry cash, they use their bank deposits as security to obtain letters of credit (which have existed for a long time, and are basically an IOU by a bank), and they run for the border. Once over the border into Otherworld, they deposit their letters of credit in Otherbank. Otherbank sends the letters of credit back to Smallbank for redemption.

Everything is fine for about two weeks, which is how long it takes the camels carrying the letters of credit to get to Smallbank.

The letters of credit constitute a demand for $271 in cash, and Smallbank only has $100 of cash on hand (plus a bunch of "non-cash assets" in the form of loans they've made). They can't make good on the letters until they can raise more cash. Either they need to raise more cash right away or they need to cut a deal with Otherbank, perhaps involving transfer of a package of some cash and some loans ("non-cash assets").

The camel drivers go down to the local bar to talk it over while the bank presidents (there are 12 of them) try to figure out how to solve this problem. A local reporter hears the camel drivers talking, and the very next morning, the local paper, Smalltalk, has a screamer headline:

As soon as they see the headline in Smalltalk, everyone in town runs down to Smallbank to get their money out. Now, a situation which was bad has become worse: Smallbank needs to pay out $343 immediately, but they still only have $100 of cash on hand.

They do the only thing they can think of: They chase everybody out, lock the doors, and call in all their loans in an effort to raise cash.

Sallie, Freddie, and Fannie find themselves with demands for money they don't have. Sallie, who is a poor student and doesn't care anyway, immediately files for bankruptcy. Freddie runs to Fannie for help, and they pool their resources, which is useless because they don't have any. They try asking Henry for advice but his only contribution to the discussion is an occasional "Woof!".

Pawn1 and Fargo find out that they can't buy groceries, because their assets are frozen due to the collapse of Smallbank. Worse, they've lost their jobs, because Lafayette and Big Coke are laying off workers because they can't pay them because of the banking system collapse.

Finally, the $100 -- which is all that's left of the money supply -- is given over to a passel of lawyers who try to figure out who's to blame for the mess.

And as far as I know they're still arguing over it.

Page created on 03/22/2018 from a bit of email which was sent to a defunct discussion group a large number of years ago