The true nature of money has, through the centuries, been an inexhaustible source of puzzlement. This has abated somewhat in the Greenspan era when currency management sort of limped along by being conducted according to business as usual. Post Greenspan, the avalanche of crises triggered by the subprime debacle should have come as a wake-up call that business as usual is a recipe for disaster. But you wouldn’t guess so from The Economist’s Special Report on International Banking (May 17, 2008), which foresees return to “normal” after a “salutary dose of reality”. This underlines what many readers have noticed, namely that The Economist is not what its title suggests, but rather is The Voice of the Industry.
One of the ways in which The Economist affirms its orthodoxy is to state or suggest that only cranks entertain ideas like the gold standard or social credit. The Web is more rewarding in this respect. For example, the Wikipedia article (version of 080530) on the gold standard tells that Alan Greenspan, this pillar of orthodoxy, was once a proponent of its return.
Though the gold standard is a lousy system, it has the advantage of being a fruitful starting point in the search for something better. Business as usual does not have this property. The problem with the gold standard is that the money supply is rigidly equated to the amount of gold that circulates as coins or serves as back-up to paper certificates. In the 16th century, when the gold of the New World was imported into Europe, this gave rise to a large amount of inflation. In the 1930s the US economy required a larger supply of money than was available under the then reigning gold standard, thus aggravating the depression.
These problems suggested a monetary system in which economists determine the money supply needed by the state of the economy and in which governments have various means at their disposal to ensure that the actual money supply closely approximates this ideal. Both economists and governments like this idea: they are flattered by the power it ascribes to them.
This may have worked for a while, but since asset-backed securities, credit derivatives, and hedge funds neither governments, nor anybody else, has any idea what the money supply is. So there we are: equating the money supply to a gold reserve at a fixed price doesn’t work. Alternative ways of controlling the money supply, such as the M1 and M2 of yore don’t work. Isn’t there anything else?
There is a lot one can do nowadays with digital authentication techniques. It is time to investigate whether it is possible to implement digitally a collection of monetary certificates that is the equivalent of the Federal Reserve’s gold supply in the days of the gold standard. These digital techniques have been used for message authentication and digital signatures. It is worth investigating whether they can be used to create a digital one million dollar version of the hundred-dollar bill signed by the Secretary of the Treasury.
As a reminder of the main idea of the gold standard, I have written an account of an idealized society that had the gold standard, but administered in a way that never has been realized in history. In history, there was no mechanism of regulating the supply of gold that served as back-up of the money in circulation. With a digital equivalent of gold, this is possible,with the advantages illustrated by the story of Gaius the Goldbug.
A thought experiment
Long ago and far away lived Gaius the Goldbug, who headed a kingdom with a remarkable system of money and banking that was not only a great improvement on what came before, but also on the arrangements since then. Indeed, I draw your attention to Gaius’s system because it is so much superior to money and banking in the early twenty-first century, even with our computers and professional economists. Wisdom accumulates, but so does folly.
Though Gaius’s success was mainly due to his good sense, it is also because he and his subjects were ignorant of certain facts. For example, they did not know the microbial origin of communicable diseases. Also, they had no idea where their gold came from. They knew how it had been used for payment, that gold coins can be converted to jewelry, to fancy dinnerware, and back to coins, that it can be adulterated and purified, but due to an accident of geography and an imperfect knowledge of the past, they did not know that gold occurs in nature. As a result they entertained the most fanciful notions about the origin of this substance.
Early in his reign, Gaius decreed it illegal for his subjects to own gold in any form. He supported his decree with certain draconian measures, of which I will spare you the details. As a result, his subjects were considerably relieved that the Royal Treasury was willing to receive gold, for which paper certificates were issued. These notes, payable to bearer, were decreed to be legal tender for all debts, public and private.
Gaius continued a strenuous policy to acquire gold wherever he could get hold of it. It was helped by the fact that his kingdom greatly increased in wealth compared to the neighbouring realms. Thus it was only a matter of time that Gaius had in his treasury what was thought to be the world’s supply of gold. Hence “Gaius the Goldbug”.
What makes Gaius so remarkable is what he did with the power so acquired. He was extremely scrupulous in the issue of gold certificates: for every one in circulation there was indeed the stipulated quantity of gold in the treasury. Although the notion of public accountability was far from his mind, Gaius was very much concerned that the public have confidence in the paper money they were forced to use. Anyone who wanted could surrender gold certificates for the corresponding amount of bullion. One could even have it assayed by an expert of one’s choice. Of course, one had to leave it at the treasury, as that was the only place where gold was allowed to be. There was an eccentric rich nobleman who elected to keep most of his fortune this way. It was set apart in a neat pile, roped off with thick red velvet cords. The really rich, of course, were not noble, but bourgeois, and did not go in for such foolishness.
Money came in several categories. Paper notes in circulation were gold certificates. These came in various denominations, all small multiples of the florin. But many transactions involved amounts less than a florin. For these, base metal coins were used that were denominated in fractions of a florin. There were also gold certificates in very large denominations, which could only be held by banks.
Which brings us to banks. Then as now, only a small proportion of all financial transactions involved notes payable to bearer, or the coins derived therefrom. Most payments were made by transfers between bank accounts. If someone got a bank loan, it was usually made available as a balance on the borrower’s account. Superficially, Gaius’s system of money and banking looked much like that of the mid twentieth century, before credit cards.
There were however important differences that can best be illustrated by the following episode in a bank manager’s working day in the time of Gaius.
Into his office comes a gentleman accompanied by four servants, all armed to the teeth. One is carrying a box. According to the habit acquired during many years on the job, the manager assays his visitor. Clearly a person of substance, and not a town dweller. He might have been a nobleman, but for his retinue. These country yokels can only come from a farm.
Manager: Good morning, sir. What can I do for you?
Farmer: Good morning to you, sir. I have come to inquire about the rate of interest that would accrue to my savings if I were to deposit them at your esteemed establishment.
Manager: I see that you have a term deposit in mind. How much were you planning to place and what term were you contemplating?
Farmer: Pray, what is the difference between a term deposit and just a deposit?
Manager: A term deposit is really not a deposit at all. It means that you lend me the funds you wish to place for the agreed term, at the end of which I pay you back plus the agreed interest. A proper deposit is just that: I accept the funds from you for safe keeping. You can reclaim it any time you want. In this case you are not paid interest. On the contrary, you owe me a fee for the safe keeping.
Farmer: Indeed I have a term deposit in mind. I was planning to place what I brought in this box: one million florins.
Manager: One million florins? Surely, you must be joking … Can I have a look? Jeepers creepers! You may well be right: this could be a million, though counting it would take some time. The reason I asked you how much you planned to place is that at the moment I cannot accept a term deposit of more than a thousand. That would be for three years at a rate of zero point six percent per annum. I will be very happy to keep the remaining nine hundred and ninety nine thousand, or whatever it turns out to be, for the usual safe-keeping fee.
Farmer: Surely you are joking? You will not let me earn interest on ninety-nine percent of my money? And you’ll charge me for safekeeping the rest? What kind of a bank is this?
Manager: A small correction, if you allow me, sir. I was proposing to accept ninety-nine point nine percent of your money for noninterest-bearing deposit. As to what kind of bank we are, I know for a fact that there are several banks in town that do not accept any term deposits at the moment. I will be happy to refer you to one other where you may be able to place another small portion of your considerable fortune.
You see, the difficulty of placing term deposits is not so much due to a shortcoming of our establishment as to economic conditions in general. After all, a term deposit means that I borrow money from you, which I can only do when I have suitable applicants for loans. Of late I had to reject most of these. If they default on me, then I will have to repay you out of our own capital. Hence every term deposit is a risk for us. In recent months, with very little growth in the economy, there seem to have been few opportunities for investment. But all this may well change before long. Such things tend to go in cycles.
A term deposit really means that I become the middleman between you as a lender and a suitable borrower. I get paid for the risk by charging a higher interest from the borrower than I pay you. And of course I need to get paid for the work we do, for the rent of our building, and so on.
Of course you can try to do without a middleman and advertise the availability of your funds to suitable borrowers, or answer matching advertisements. I would advise against this course of action, though. It is too risky without a lot of experience in this business.
Farmer: So I was right after all!
Farmer: You see, it is all because of my wife. She keeps nagging and nagging. Always complaining about keeping my money under the bed and “not letting it work for me”, whatever that means. Always nagging about my working instead of putting my money in a bank and living off the interest, wanting me to take vacation forever. Thank you for this most informative discussion. I’ll be happy to go home and make more money by working my beautiful farm. Goodbye, sir.
Manager: Wait, wait! You mean you will be carrying one million florins into the countryside and keep them at home? Allow yourself peace of mind and avail yourself of our excellent deposit or safekeeping facilities.
Farmer: And pay you instead of getting paid? If you think that’s peace of mind, then you don’t know my wife, sir. Good bye!
Thus, under Gaius, a bank cannot fail by a “run” on it: all money that can be withdrawn at any given time is a noninterest-bearing deposit that is sitting right there at that time. The only difference between a deposit withdrawable on demand and paper sitting in a deposit box is that the former is less expensive to keep: the bank can replace a large number of paper notes in small denominations by one in one of the huge denominations that only banks keep. But any time the King’s inspectors make a swoop on a bank, it is verified whether all on-demand deposits are covered by gold certificates owned by the bank.
Alas, even under Gaius banks could fail, though not by depositors simultaneously withdrawing their money. When a term deposit comes due, the borrower of that money has had to pay it back before that time. It may happen that the borrower defaults. In that case, the bank has to pay the term depositor from its capital. When a bank has made too many bad loans, it will fail by going bankrupt, just like any other enterprise where liabilities outweigh assets by too large a margin. The term depositors become creditors in the bankruptcy case.
So far I have only discussed the role of a bank as place of safe keeping and as a middleman between borrowers and lenders (under Gaius, savers are lenders). It may be that there is more demand for capital than is available from savers. To understand what happens in such a situation, we must realize that only a small part of the gold in the treasury serves as backing for certificates. This we call the active gold. Even if the rest of the gold, which we call frozen gold, were to disappear, it would still be the case that the entire money supply, cash, bank balances, everything, is fully covered by gold in the treasury. That means that the money supply can readily be increased by issuing certificates for gold so far frozen.
Disastrous experiences in neighbouring realms have taught Gaius that an excessive money supply results in inflation. On the other hand, a shortage results in a recession. Only when Gaius is satisfied of a bona fide lack of credit will he unfreeze gold. As he does not believe to have a privileged insight in these matters, he leaves the decision as much as possible to market forces. That is, he auctions the new certificates as loans from the treasury to qualified borrowers. These include all the chartered banks (otherwise they wouldn’t be chartered), as well as investment banks and blue chip companies. Though Gaius is acutely aware of the value of start up companies, these need not apply. To judge the soundness of their investment proposals is such a difficult matter that only the venture capital departments of the banks can be relied on to do this.
The new certificates being auctioned are loans from the treasury for a fixed term. The banks bid on the interest rate, which is fixed for the term. The banks with the better prospective borrowers can afford to bid higher than the others. It is interesting to note the mechanism which causes the banks to exercise caution in this regard. The treasury only charters private banks, that is, banks whose capital is owned entirely by the partners. Making too many bad loans results the bank’s bankruptcy and thereby in the loss by the partners of their personal fortune. Needless to say, this is a rare occurrence.
The auctions are in fact an ongoing affair. Remember, the certificates being auctioned are fixed term loans. So, even when the money supply is fixed and the percentage of treasury paper in it is fixed as well, loans by the treasury to banks keep coming due. In a steady state economy they have to be replaced by newly auctioned loans. For this reason the auctions occur on a weekly basis with the interest rates being bid on them as constant information about the state of the economy. When the interest rate goes too high, more gold is unfrozen. When there is little new investment, there are few bids in the auction. At such times there are no takers of new treasury certificates even at zero interest.
This is a difficult point for Gaius. He feels it’s wrong to lend out money for free, so he terminates the auction at one half percent per annum without being able to give a good reason for this particular figure. In such situations the money supply shrinks, as previous loans from the treasury keep coming due, but new ones are issued at a lower rate; gold changes from active to frozen status.
Here are the rules by which Gaius works. If the interest rates bid at the auctions for treasury paper go high, unfreeze gold to satisfy the demand for money. Experience taught that either employment is already high, or will go higher soon after. When there is little or no demand for a prolonged period of time this usually goes together with low employment. The money supply mechanism seems powerless to remedy this. It has the desired effect on the economy in only one direction; like a rope that can be pulled but not pushed.
In such recessions Gaius used to be at a loss for what to do. His brains trust came up with ideas such as placing treasury certificates of suitably small denomination in bottles, burying these and then auctioning licenses to go and hunt for the bottles to new companies hopefully using previously unemployed workers for this purpose.
In time it was found better to rely on the army. This organization had always, boom or recession, been responsible for taking in the unemployables. In addition, the army had standing orders to offer employment at wages considerably below the going rate. As all army operations, this was paid out of the treasury.
But in recession times the army jobs, though poorly paid, become attractive. To help the army cope with the great influx of new workers, the treasury issues certificates directly to the army at zero interest interest. In this way the money supply is increased. It is the army’s task to have ready a number of worthwhile undertakings that can wait for a slump in commercial activities, like the building of roads and sea walls.
Observers from the distant future will of course wonder how Gaius finances government operations in general. The answer is simple: in the first instance by revenues from taxes and from interest paid by banks on the loan of treasury certificates. When the money supply needs to be enlarged, some government operations are financed by treasury certificates that would normally have been borrowed by banks but which they find themselves unable to bid upon due to recession. Care is taken that such funds are never used for salaries of permanently employed civil servants, but only for the substandard wages paid to unemployed temporarily inducted into the army.
I conclude this thought experiment by reporting the prevailing opinion of Gaius’s contemporaries, who were aware of the unusual nature of Gaius’s policies. Observers could not help noticing the great and increasing discrepancy in general prosperity between Gaius’s kingdom and that of the neighbouring realms. The former enjoyed a golden age where the booms and recessions were but small ripples on a high and increasing level of prosperity. The latter lurched from crisis to crisis, racked by revolutions and experiments with widely varying politico-economic systems. The puzzling thing was that many of the leaders of these short-lived revolutions were men of admirable, even inspiring character, who were deeply moved by the wretched state of their fellow citizens. Gaius on the contrary was perceived as a man without a soul. He seemed completely obsessed by the details of turning his economy into an ever better machine. Never was there any indication of his being moved by the plight of the few economically disadvantaged among his subjects. Never did he respond to calls to help a neighbouring nation in the throes of civil war. Only in a few cases did he help by agreeing to add to his territory a choice morsel of a hapless and helpless adjacent state.
Yet there can be no doubt that he facilitated a society with a general level of happiness unrivaled before or since.