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

Chapter Eleven: Money, Money, Money! 258 the overall support of commerce to include all the functions of money (including store of value). Imagine that the goldsmiths loaned out all the gold; that is, printed counterfeit gold receipts for all the gold in their safes. We now would have twice the claims on real resources than we had before, but the amount of goods and services stays the same. So prices would begin to be bid up as consumers would use the receipts to exchange for goods and services. Businesses would respond to the increased demand by moving up their supply curves and charging more, as seen in Figure 11.2 . Business would be booming and suppliers would be happy, but consumers would be unhappy with rising prices. So the first problem we see is an increase in prices. The other aspect of this problem will illustrate the bigger issue. When the goldsmith issues additional warehouse receipts, he is committing a fraud. He is legally obligating himself to surrender real gold on demand to the parties that hold the receipt. This he obviously cannot do—at least to all parties. He is counting on his fraud not being discovered, since seldomdo all parties decide to redeem their warehouse receipts at once. But when they do, he will surely be found out. Nervous depositors may even precipitate the crisis with a bank run, where all depositors demand their money back at once. Does this ever happen? Have you ever watched It’s a Wonderful Life ? Watch this short scene: The Bank Run Now as much as we love the movie’s hero, George Bailey, he doesn’t really seem to understand the fraud he has committed. The reason he has a problem is precisely because he has promised two people the use of the same money; a promise that cannot be kept. Like most sins in life, it doesn’t particularly matter that “everyone (all bankers) does (do) it.” It’s still fraud. Is it possible to have fractional reserve banking without fraud? Perhaps, but then your money in the bank would be “savings” and not a “demand deposit.” This problem is identical to that of the goldsmith, the earlier version of the modern fractional reserve banker. And this is not limited to black and white movies, as if we’ve solved the problem. We still have fractional reserve banking and therefore we still have financial crises and bank runs. The latest example was during the Northern Rock bank panic in England in 2007. P ($) All Goods/Services Q (#) Q 1 Q 2 P 1 S D 2 D 1 P 2 Figure 11.2, Increase Warehouse Receipts for Gold. We can imagine that an increase in total warehouse receipts in an economy would operate similarly to a shift in demand curve for all goods/services due to an increase in income. In this setting, prices would rise while quantities would increase.