No Free Lunch: Economics for a Fallen World: Third Edition, Revised

Chapter Eleven: Money, Money, Money! 257 So why would anyone willingly change from a commodity standard to a fiat money? A detailed answer is beyond the scope of this text, but some history is helpful to understand both our current monetary system as well as some of the problems we have today with the boom/bust business cycle. In the beginning of the chapter we outlined that money would be the most marketable commodity, usually chosen to be gold. Gold has the marvelous attribute of high value for a given weight, and similarly, it is very heavy (dense) for a given size. So, historically, it would not necessarily be convenient to carry around, both from the physical weight of the metal as well as at risk from theft. To overcome these problems, goldsmiths would offer secure storage of gold for a small fee. A goldsmith had to have a secure storage facility for his own gold; he could make additional room available to customers for a fee. The goldsmith would give the depositor a receipt for the gold that he held on deposit for a customer. So if you were a customer and wanted to buy something, you could go down to the goldsmith and exchange your receipt for physical gold, and then take the gold and make your purchase. Often the recipient of that gold would then take it back to the same goldsmith for secure storage and get his own receipt in exchange. It didn’t take long for everyone to realize this is a lot of work for nothing, and soon the receipts for warehouse gold would be traded directly, avoiding the need for the physical gold to ever leave the vault. Then, a “funny” thing happened. The goldsmith realized he had all this gold just sitting idly. Seems like a complete waste to just…sit there. “Maybe I can loan out a small part of it at interest, since the likelihood of everyone wanting all their money back at the same time is extremely low,” thinks the goldsmith. So he loans it out. Pretty soon other goldsmiths do the same, and they begin to compete for the gold so they can loan it out at interest. Competition for the gold leads to the elimination of storage fees as goldsmiths offer better deals to depositors to store their money with them. Depending on the prevailing interest rates that gold loans made, the depositors might even earn a little interest. For example, if the goldsmith could loan the money out at 6% interest, he might be able to pay 2% interest in addition to eliminating storage fees. The 4% “spread” would pay for his workers and the cost of security, etc., in addition to his profit. 1 This seems like a marvelous win-win for everybody. Depositors’ fees go away and the goldsmiths make money. What could be the problem? Well, there is only one slight problem. Money gives us command over resources, and when money is being used both as a store of value (for the depositor) and as a means of exchange (by the borrower), we have two people using the same money. This is the origin of fractional reserve banking, where a bank only keeps a fraction of its total deposits on reserve and loans out the rest. We’ll expand on this later, but for now we just need to understand there are two people using the same money. Both of them think they “own” a particular amount of gold, while it is of course impossible for both of them to get it at the same time. So prior to the goldsmith loaning out the gold (by issuing additional receipts for the same gold—the original counterfeiting), we had a fixed amount of gold in a society for Fiat money: a money that has no inherent use or value other than its monetary function, which is declared by “fiat,” or the order of the sovereign.