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Tuesday, June 10, 2008

The Compound Interest Paradox Revisited - A List of Monetary Systems

Table of Contents

The Federal Reserve
Free Market Banking
A List of Monetary Systems
Edward Flaherty is a Troll

There are a whole bunch of possible monetary systems that can be tried. In this post, I list all the monetary systems I can think of.

Fiat Monetary Systems

Debt-Based Fiat Money

This is the current system, used in the USA and the rest of the world. This is how the Federal Reserve operated from 1971-present.

With debt-based fiat money, most of the wealth confiscated when new money is printed accrues to the financial industry.

The fact that the entire world is using an unsound monetary system seems like too much of a coincidence to me. If countries were truly independent, then some country would experiment with a fair monetary system and taxation system. That country would experience tremendous economic growth. Of course, the Supreme Leader of Humanity will never allow that to happen.

Credit-Based Fiat Money

Instead of borrowing money from a central bank, government can directly spend fiat money into circulation. Under such a system, the wealth confiscated when new money is printed accrues to the government, instead of to the financial industry.

When you ask "Why doesn't Congress just print money to pay off the national debt?", the answer is that's not the way the US monetary system works. Fiat debt-based money with negative real interest rates provides a massive government subsidy to the financial industry, paid by everyone else as inflation.

Credit-based fiat money was used in the colonies before the US revolution. It was called "colonial scrip". There was no gold in the colonies, so they had no choice but to use paper money. Benjamin Franklin went to Parliament and told them how wonderful credit-based fiat money was. When the British central bank found out that their monetary monopoly was threatened, Parliament outlawed the colonial scrip and sent troops to enforce their decree. Some people say this was the true cause of the US revolution. Later, massive counterfeiting discredited paper money. The US Constitution specified that the new country was on a gold and silver standard.

President Lincoln issued "Greenbacks" to fund the US Civil War. His only alternative was to borrow gold from the bankers at an usurious 20%+ interest rate. By issuing Greenbacks, President Lincoln was able to fund the Civil War and avoid being in huge debt to the bankers. By passing a "legal tender" law, the Greenbacks were treated as equivalent to gold. Some people say this is the true reason that President Lincoln was assassinated.

In Germany, Hitler's government issued credit-based fiat money before WWII. Some people say that is the reason Germany went from being economically crippled to an economic powerhouse in a few years. Hitler's government was responsible when it issued paper money, and the system worked. Some people say that WWII was not a war of fascism vs. democracy. It was really a war of fiat debt-based money against fiat credit-based money.

Fiat credit-based money works if the government is responsible when it issues money. The Federal Reserve is not a check against Federal deficit spending. All Congress needs to do is ask and it gets a loan. Most of the benefits of printing new money accrue to the financial industry. Congress only takes a small slice of this pie.

However, fiat credit-based money does not satisfy a true free market advocate. What right does the issuing authority have to claim seignorage income. With *ANY* form of fiat money, people current holding money have no way to prevent their purchasing power from being diluted, as new money is printed.

Corrupt Gold Standard Monetary Systems

Many economists falsely say "History has discredited a gold standard." That is not true. It was government interference that caused the gold standard to fail.

Warehouse Receipt Banking

The earliest form of banking was warehouse receipt banking. The goldsmith issued paper receipts for gold held in his vault. People began trading these paper receipts as if they were money. The goldsmith observed that he had a lot of gold sitting in his vault. People didn't all simultaneously demand to redeem their paper gold for physical gold.

The goldsmith then got into the business of loaning gold at interest, and crediting depositors with interest. At that time, there was no sense of accounting standards. This led to what I call "Totally Fraudulent Fractional Reserve Banking".

All of the corrupt gold standard monetary systems provide people with the illusion of warehouse receipt banking while something really nasty is happening behind the scenes.

Totally Fraudulent Fractional Reserve Banking

The banker/goldsmith realized that depositors didn't simultaneously demand all their gold. The banker was able to issue more paper promises for gold than gold he had in his vault. By trial and error, the banker realized that he could get away with issuing 10x as much loans as deposits.

Suppose the banker had 1000 ounces of gold on deposit. He issued loans and paper promises for 10,000 ounces of gold. If the banker was crediting depositors with 4% and issuing loans at 5%, his spread was not 1% as his customers believed. He was paying 4% for each ounce deposited, but collecting 50% for 10 ounces lent out. This is a spread of 46%!

At that time, there was no sense of accounting standards. People didn't realize they were being screwed over.

After making 46% returns for even a few decades, the banker became economically powerful. He became powerful enough to choose the official rulers. With enormous political power, this corrupt banking practice was declared legal and the government declared a "banking holiday" if the banker got into trouble. By organizing as a cartel, the bankers controlled most of the world's resources. By organizing branches in multiple countries, the bankers were more powerful than any single government. A Supreme Leader of Humanity emerged.

Totally Fraudulent Fractional Reserve Banking is how the Federal Reserve operated from 1913-1933. The Federal Reserve was allowed to print more Federal Reserve Notes than the amount of physical gold in the US Treasury. Americans could still redeem their Federal Reserve Notes for gold. As long as all the Americans didn't simultaneously redeem all the Federal Reserve notes for gold, the scam went undiscovered.

In 1933, there was a run on the dollar as people realized that too many Federal Reserve Notes had been printed. President Roosevelt responded by defaulting on the dollar and declaring it illegal for people to own gold.

Gold Standard With Debt-Based Money

The USA was nominally still on a gold standard from 1913-1933. However, the Federal Reserve used the same "monetizing the debt" scam that it uses today. The US dollar was still debt-based money. The Federal Reserve only issued new Federal Reserve Notes when someone took out a loan.

Partially Redeemable Gold Standard With Debt-Based Money

From 1933-1971, foreign central banks were still able to redeem their dollars for physical gold. Private gold ownership was also outlawed in many foreign countries, so this perk only applied to central banks.

This still acted somewhat as a check on inflation, because the US government didn't like shipping gold to foreign countries. However, the US dollar was not redeemable into gold for the average person. It was a gold standard in name only.

It was still possible to buy gold jewelry. Some people tried to arbitrage this. They bought pure gold jewelry for a slight premium to the "official" price of gold.

Fully Backed Gold Standard with Regulated Fractional Reserve Banking and a Handful of People Control Most of the Gold

This is the system used in the USA from 1789-1913.

When the USA was created, it adopted a gold standard and a "free coinage" provision. "Free coinage" meant that anyone could take gold bullion to the US Treasury and have it converted into official money.

The problem is that there were no gold mines in the new country. The European Central banks had almost a complete monopoly on the world's gold supply. The new country handed the keys to its monetary system to the European central banks.

The USA achieved political independence with the Revolutionary war. However, monetary independence was not achieved. The USA was on a gold standard, and the European banks had a practical monopoly of the world's gold supply.

The European banks invested in banks in the USA. Their oligopoly meant that they could charge whatever price they chose as interest. This enabled them to operate the Compound Interest Paradox.

Regulation of banking limited the ability of non-cartel banks to interfere with the cartel's operations.

Even though the USA was on a gold standard, the only way someone could acquire gold was borrowing it from a bank. Gold came with debt-strings the same as Federal Reserve Notes. Only gold was recognized as valid for paying debts and taxes. Government violence created an artificially high demand for gold. This played into the hands of the bankers, who had a near monopoly of gold.

The important point is that a gold standard COMBINED with regulation of banking is what failed. Regulation of an industry drives up prices in that industry. This allowed banks to charge interest over the free market level, allowing the Compound Interest Paradox to take hold.

Gold Standard with Regulated Fractional Reserve Banking

The monetary system in the USA from 1789-1913 can also be described as "regulated fractional reserve banking". Unlike totally fraudulent banking, described above, there's another dishonest model for fractional reserve banking.

Suppose a bank receives 1000 ounces of gold in demand deposits, crediting an interest rate of 4%. It issues 900 ounces worth of loans, at a charge of 5%. In this case, the bank pays 4%*1000 and collects 5%*900, for a profit margin of 0.5%.

This is not as dishonest as Totally Fraudulent Banking, where the bank made a profit margin of 46%. However, there still is a problem. The bank has effectively increased the money supply by 900 ounces of gold. The bank has 1000 ounces of "demand deposits" but only 100 ounces of gold on hand. The bank is technically insolvent at any given instant.

If a newspaper published a rumor "This bank is insolvent!", then it REALLY would be insolvent as all its customers demanded their deposits immediately. The banking cartel can bankrupt any non-cartel bank at will, merely by publishing a rumor of its insolvency; this rumor becomes a self-fulfilling prophecy.

The cartel member banks, if subjected to a run, are able to lobby the government for a "banking holiday" and a bailout.

Also, with "limited liability" incorporation, the bank's owners and management are protected from personal liability in the event of a run. This encourages dishonest behavior by a bank. Limited liability laws place a nearly insolvent bank in an unethical position. The nearly insolvent bank is better off taking risks with its depositor's money, hoping for a favorable outcome on its wager. After all, in bankruptcy, it doesn't matter if you're bankrupt with debt of -$1 or -$20B; the owners and management are protected. "Limited liability" laws give the bank's owners a put option to cheat creditors in bankruptcy court. Without limited liability laws, the management and owners of an nearly insolvent bank would start selling assets and returning deposits; in a truly free market, they would be personally liable for unpaid debts in bankruptcy.

"Limited liability" laws, regulation of banking, and "banking holidays" encourage dishonest behavior by bank management. The serious problems with banking didn't start until after the Supreme Court declared that corporations had the same rights as people.

Before the Supreme Court ruled that corporations had the same rights as people, personal responsibility limited dishonest behavior by banks. A bank's owners were risking their personal assets in the event of a bankruptcy. This meant that the owners were responsible with depositor's money.

The banking industry started being heavily regulated after the US Civil War. In the late 19th century, the Supreme Court allowed corporations to have the right of property ownership and the right to make and enforce contracts. "Limited liability" incorporation, combined with regulation of banking, practically destroyed the free market in the USA. Even though the USA formally abandoned its gold standard in 1913 with the creation of the Federal Reserve, previous laws and regulations allowed banks to create economic chaos.

Gold and Silver Standard with Regulated Exchange Rate Between Gold and Silver

The US briefly experimented with a bimetallic standard. Both gold and silver were declared as money. The problem is that the exchange rate between gold and silver was fixed by the government, instead of being allowed to float and be set by the market. Silver was overvalued and gold was undervalued. This caused people to spend silver and hoard gold.

Also, politically connected insiders profited from the adoption and abandonment of the bimetallic standard. Politically connected insiders bought a lot of silver before the bimetallic standard was adopted. Those same insiders sold off all their silver before the bimetallic standard was dropped. Plus, when the bimetallic standard was adopted, there was a boom as the money supply increased. There was a bust as the bimetallic standard was dropped and the money supply decreased.

A bimetallic standard works, PROVIDED the exchange rate among metals is not fixed by the government. The exchange rate must be allowed to float.

Stateless Monetary Systems

The Importance of Metal as Money

Without a centralized state, money MUST be backed with tangible goods. Metal coins are what the free market selected as money, before government became powerful enough to tamper with money.

There are several reasons why metal coins make good money. Metal coins are fungible, i.e. every .999 fine one ounce silver coin is equivalent to every other .999 fine one ounce silver coin. Metal is useful for producing other goods; the metal coin can be melted and used for its industrial value. Metal coins are easy to count; if you trust the mint, it's very easy to quickly count a stack of coins and determine the value.

Consider other goods that have been used as money. For example, using tobacco as money doesn't work, because not all tobacco is of equal quality. What happens if you are using tobacco that is of a better or worse quality than people are expecting? Goods other than metal coins suffer this defect.

In a stateless society, it is likely that several different metals would be used as money. Gold would be used for large purchases. Silver, copper, and cheaper metals would be used for small purchases. Rather than dealing in fractions of an ounce, paper credits could be used to handle change. Alternatively, small laminated metal slivers could be used for change.

A contract would always specify the metal to be used as payment. However, other metals could be substituted based on the free market exchange rate.

Austrian Economics

Austrian Economics says that banks who offer their customers "demand deposits" should be required to offer a warehouse service. They will charge their customers for safeguarding their deposits. They will not credit interest.

If a customer places a time deposit, then the bank is allowed to loan out the money. The bank must balance its loan portfolio so that its loan repayment schedule equals its demands to depositors. If the bank's loans are sound, they could always be sold, if necessary.

The incentive for customers to make time deposits instead of warehouse deposits is that they receive interest. If the bank is sound, the customers should always be able to sell their deposits for the face amount, plus accrued interest, minus a transaction fee.

However, Austrian Economists say that this banking model should be enforced via government violence. Austrian Economics is not a true theory of economics, because Austrian Economists still say "There should be a government."

Austrian Economists hold out the unrealistic fantasy that the current economic and political system can be reformed. A complete collapse is MUCH MORE likely than reform.

Time-Deposit Banking

In a free market, customers would never deposit their gold in a "fractional reserve bank". A fractional reserve bank is technically insolvent at any given instant. A fractional reserve bank tells its customers they have "demand deposits", while loans are all for a term. If all customers simultaneously withdraw all their gold, the bank will be unable to meet its obligations.

In a true free market, someone operating a fractional reserve bank is guilty of fraud. Free market competition guarantees that nobody will ever deposit money in a fractional reserve bank. A fractional reserve bank can't exist without government violence protecting them from the negative consequences of their fraud. Regulation of banking prevents sounder banking models from emerging.

Free market competition would also mean that banks would be required to disclose their books to depositors. Most people wouldn't bother reading the statements. Accounting associations would certify the banks' balance sheet.

One type of sound bank is a warehouse receipt bank. A warehouse receipt bank does not credit depositors with interest. A warehouse receipt bank will charge its customers a storage fee. A trusted third party will audit the warehouse receipt bank, so people know it isn't secretly practicing fractional reserve banking.

Another type of sound bank is a time-deposit bank. A time-deposit bank will accept term deposits from customers, and credit them with interest. A time-deposit bank will make loans. The spread between the interest credited to depositors and collected on loans is the bank's profits. There is no Compound Interest Paradox in this banking model, because free market competition will keep the bank's profits at a reasonable level.

If a bank is sound, a customer holding a time-deposit should always be able to sell it for the face amount, plus accrued interest, minus a small transaction fee. The customer with a time-deposit should be able to trade it almost exactly as if he had actual physical gold. Time-deposit banking *DOES* expand the money supply to match the needs of trade. Time-deposit banking LEGITIMATELY expands the money supply. Provided all the loans are sound and backed by tangible assets, time-deposit banking is not exploitable. All paper promises for gold are convertible to gold at maturity, guaranteeing the integrity of the system.

If a customer has a time-deposit and finds that he could no longer sell it for parity, then he would know there was a problem with his bank.

Suppose a bank issued too many loans, inflating the money supply. People would get suspicious, and they would start demanding physical gold instead of this banks' paper. The bank would be unable to attract deposits. Either the interest rate credited to depositors would rise, or the bank would be unable to issue more loans.

Suppose a bank stopped issuing loans, deflating the money supply. Competing banks would start issuing more loans to make up the difference. Competing banks would offer greater interest payments, attracting deposits.

In a *FREE* market, it's impossible for banks to collude and create boom/bust cycles. First, there would be way too many banks for collusion to be possible. Second, competing banks could profit off banks attempting to manipulate the money supply.

The Real Bills Doctrine

Before the Federal Reserve was created, there was a financial instrument known as a "Bill of Exchange". Consider a small farmer. The farmer needs to raise money in the Spring, to plant his crop. The farmer will sell his crop in the Fall. If the farmer doesn't have enough cash, he would like to write a loan backed by his crop. The mechanism for doing this was called a "Bill of Exchange".

Suppose the farmer needed to borrow 1000 ounces of gold. Assuming the crop will be harvested and sold at the end of September. he would write a "Bill of Exchange" saying "I promise to pay 1000 ounces of gold on October 1". Suppose interest rates were 4%/year. On April 1, the farmer could sell this Bill of Exchange for 980 ounces of gold. This money would be invested in his crop. The "Bill of Exchange" would be backed by the farmer's harvest. If the farmer were concerned about a drought and a bad harvest, he could buy insurance.

This "Bill of Exchange" could be sold and traded as if it were money. Suppose that B bought the Bill of Exchange for 980 ounces of gold on April 1. Suppose that B needs gold on July 1. B could sell the Bill of Exchange to C for 990 ounces of gold. In the same way you "endorse a check", B would sign the Bill of Exchange indicating he had sold it to C. A Bill of Exchange might acquire several signatures before maturity.

At each step, the value of the Bill of Exchange is the maturity value, discounted by the interest rate. This is where the term "Discount Rate" arises. The "Discount Rate" used to mean the rate at which a Bill of Exchange was discounted.

The "Real Bills Doctrine" says that a Bill of Exchange is *NOT* inflationary, because it is backed by tangible goods. Mainstream economists say "History has discredited the Real Bills Doctrine".

The "Bills of Exchange" system worked spectacularly well until 1913, when the Federal Reserve was created. The Federal Reserve provided government-subsidized negative real interest rates. At this point, someone wishing to borrow money should borrow through the Federal Reserve. It was no longer practical to write a Bill of Exchange and borrow from a fellow businessman. The Federal Reserve's negative real interest rate policy meant that the best way to borrow was from a bank.

Another important point about the "Bills of Exchange" system is that individual reputations were important. If you defaulted on a Bill of Exchange, everyone else would know. You would never be able to borrow money again. You would only buy a Bill of Exchange if you knew and trusted the issuer.

In the present, it isn't practical for someone to make a gold-denominated loan. With inflation rates if 15%-30% or more, why would anyone borrow gold? They would be better off borrowing from the Federal Reserve via a mortgage, receiving the Federal Reserve subsidy.

The Social Credit Monetary System, stateless

My description of the Social Credit Monetary System is a way to organize a stateless monetary system. A monetary system does not need a centralized issuing authority in order to be stable.

If you credit all nonzero balances with interest, the Social Credit Monetary System is logically equivalent to the "Bills of Exchange" system.

Don't confuse a LETS network or other centralized monetary system with my description of the Social Credit Monetary System. The "Social Credit Party" has nothing to do with what I consider to be "Real Social Credit".

When an agorist economy first gets started, people will just use physical gold or silver as money. I don't think these other systems will become used until the underground economy starts to become sophisticated. Currently, if you're going to borrow money, it's cheaper to borrow from the Federal Reserve using subsidized negative real interest rates. It doesn't make sense to borrow a gold-denominated loan, priced at the true inflation rate of 15%-30%, when you can borrow from the Federal Reserve at 6% via a mortgage.

Time-deposit banking, a bill of exchange, or the social credit monetary system with interest credited/charged on nonzero balances are *ALL* logically equivalent. In a *REALLY* free market, banking is an honest business.

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