Fiat

Inevitability

In Lyn Alden’s Broken Money (read this), she makes the case that our fiat money system was inevitable due to technical advances. And while something just feels off about fiat, it is hard for me to say exactly what’s the cause. Lyn has a theory. Telecommunications allowed transactions to fly around the world at the speed of light, while settlements were still tied to the speed of matter (e.g. ships, horses, and later on cars). Why does this matter? Well, to answer that I have to unfortunately wrap my head around a few financial instruments and jargon. Things I generally find very boring, but have to give them credit, probably have a larger impact on the world than I can even imagine.

jargon

My understanding of the financial instruments is poor. So here are some common, need-to-know things which help someone get a feel for the system.

• Loan // A financial arrangement where a lender directly provides funds to a borrower. Generally, the borrower pays interest on the loan amount in order to convince the lender that this is a good idea. As long as the borrower doesn’t disappear, the loan is an asset for the lender. It is slowly making them money for taking on the risk.
• Bond // A special type of loan with a lot more standardized structure. The borrower (aka issuer in this case) is usually a large entity like a corporation or government. The structure increases the tradeability of bonds compared to an anything goes loan. It also makes bonds from the same issuer more comparable. These characteristics usually convince the blond lenders (aka investors) to lend at lower interests rates since there is less risk.
• Treasury // A special type of bond where the issuer (borrower) is the US Treasury department.
• Security // A very general term which encompasses a wide range of financial instruments that represent ownership, debt, or rights to ownership. Tradability is often a characteristic of securities, but what is considered a security is kind of a jurisdiction question (lame!). But bonds, treasuries, and stock is usually a security.
• Financial Instrument // A monetary contract between parties that can be created, traded, modified, and settled.
• Bearer Asset // Type of financial instrument or property where ownership is determined solely by possession rather than through registration in a database or ledger.
• Arbitrage // The practice of purchasing and selling identical assets in different markets to profit from price discrepancies. Listening to the signals. Spatial arbitrage is easy to visualize (e.g. gold in New York vs. London). Temporal arbitrage is a little tricky, it exploits price differences across time. This is often seen in interest rates. A depositor does not value present liquidity, willing to temporarily part with it for a low interest rate. A borrower values present liquidity, willing to pay a higher interest rates for it now. An intermediary can arbitrage the two can capture the difference.

banks

Why are banks here? What value do they offer?

If some money like gold exists in a culture, banks usually naturally arise and offer two features for ease of use. The first is double entry bookkeeping. If two merchants trade often, they could keep passing gold back and forth between themselves. But this could get risky and tiresome depending on the amount of gold. But if they both store their gold at the same bank, they could just ask the banker to keep track of the transactions between their accounts in a ledger, gold doesn’t have to move at all. The second is banknotes, including versions which are bearer assets. Theses are light, easy to track paper notes, but they could represent a large chunk of gold assuming all parties trust the bank. The combination of these features makes it much easier and safer to make transactions if you trust your bank. But they are also the beginning of the slippery slope to fiat.

In the beginning, a bank accepts gold
deposits from its customers. It just
holds it for them for a small charge.
The gold is a an asset for the bank,
and the customer accounts are
liabilities, since they can show up
and ask for their gold whenever they
want. Liabilities == assets, always.

+------------------------------------+
|              LIABILITIES           |
|                                    |
|  BANKNOTES      []             0   |
|  DEPOSITS       [//////////] 100   |
|                                    |
+------------------------------------+
|                ASSETS              |
|                                    |
|  GOLD RESERVES  [//////////] 100   |
|  LOANS          []             0   |
|                                    |
+------------------------------------+

The bank notices that the customer
gold almost always just sits there. The
bank offers a deal to the customers,
no more charge for holding it, but part
of their gold will be loaned out. It is
still "theirs", but they might not be
able to withdraw all of it at a certain
point.

The loan is an asset for the bank. It
is a financial instrument which they
will earn a bit of money on. While the
gold still probably sits in their safe,
it has been "given" to the borrower in
the form of a banknote. Liabilities
still matches assets since both have
been expanded by the same amount.

The weird part here is that technically
all the banknotes and deposites (120)
can pull from the reserves (100). The
consumer doesn't want a loan from the
bank even if that is technically valuable.

The bank is lazily performing temporal
arbitrage, but it is quite possible that
consumers are fine with this risk too
as long as they get something out of
it (e.g. free accounts).

But you can see the *fractional* reserve
emerge, there is only 100 actual things
of gold for 120 claims. A bank could
offer a strict version of arbitrage by
requiring deposits to be held for a
certain amount of time, and match that
to loans. But we haven't seen that as
much in practice.

+------------------------------------+
|              LIABILITIES           |
|                                    |
|  BANKNOTES      [//]          20   |
|  DEPOSITS       [////////]   100   |
|                                    |
+------------------------------------+
|                ASSETS              |
|                                    |
|  GOLD RESERVES  [////////]   100   |
|  LOANS          [//]          20   |
|                                    |
+------------------------------------+

Fractional reserve banking in ascii art.

leverage

Things get a little more complex when multiple banks get involved. What happens if bank Alpha issues some banknotes for loans, and that borrower turns around and stores the banknotes in bank Beta? Bank Beta could play it safe and settle the notes immediately by exchanging them for gold at bank Alpha. But what if it really trusts Alpha and doesn’t want to deal with the physical burden of settlement? It could just add the banknotes to its assets. And then…well, if it considers the Alpha notes “as good as gold” it treats them as reserves. And it could make a loan with them! The strange thing here now, there are Alpha banknotes and Beta banknotes which both track to the same piece of gold. The gold is more leveraged. Which is all fine and good until some bad loans are made and things start to retract. A highly leveraged asset can fall back way further than what many would anticipate.

As mentioned above, Lyn points out that telecommunications made it extremely easy to perform transactions, while the cost of settlements remained the same. There is more incentive to keep leveraging than to ensure an asset isn’t over-leveraged through a settlement. And as more banks enter the picture, no one actually wants to deal with all sorts of different banknotes. It can actually start to look a bit like a barter system again. So things tend to centralization, an upside down tree, where bank reserves are banknotes just from some sort of central bank. They act as clearinghouses for the leaf banks, providing efficient standardizations. The clearinghouses can also provide a sort of backstop presence to the banks it supports. However, the more layers of fractional reserves in the system means it is more leveraged, more fragile to any disturbances which cause consumers to exchange their banknotes.

CHARLIE BANK (BASE BANK):
+-------------------------------------+
|              LIABILITIES            |
|                                     |
|  BANKNOTES      [//////////]  $10M  |
|                                     |
+-------------------------------------+
|                ASSETS               |
|                                     |
|  GOLD RESERVES  [///]          $3M  |
|  LOANS          [///////]      $7M  |
|                                     |
+-------------------------------------+

BETA BANK (MID-TIER):
+-------------------------------------+
|              LIABILITIES            |
|                                     |
|  BANKNOTES      [////////]     $8M  |
|                                     |
+-------------------------------------+
|                ASSETS               |
|                                     |
|  CHARLIE NOTES  [////]         $4M  |
|  LOANS          [////]         $4M  |
|                                     |
+-------------------------------------+

ALPHA BANK (TOP-TIER):
+-------------------------------------+
|              LIABILITIES            |
|                                     |
|  BANKNOTES      [//////]       $6M  |
|                                     |
+-------------------------------------+
|                ASSETS               |
|                                     |
|  BETA NOTES     [///]          $3M  |
|  LOANS          [///]          $3M  |
|                                     |
+-------------------------------------+

Getting a little more real with a tree of banks.

In the above example, there is only 3M gold in the system, it is leveraged by 24M banknotes. Of those 24M banknotes, 17M are in circulation. But only 17.6% of those can actually be redeemed. The more leverage means that percentage goes down and the size of a knockout punch for the system goes down with it. The system is trying to be efficient, but carries some risk of extreme inefficiency if things lock up. But at this point, I wouldn’t describe this as a moral failing of any sort. It is up to the banks to make responsible decisions and they will carry the burden of messing it up.

entropy

If a large enough failure occurs, it appears natural for a government to step in and just say “hey…don’t do that”. Instead of going through the short-term painful process of letting things fail and rebuild, the government becomes the backstop which never fails (TM). If push comes to shove, the government can create more of its own banknotes and declare that they are valuable. They are no longer tied to the natural scarcity of something like gold. This keeps the system going in the short term, but certainly feels too good to be true.

When the government bails out the system, they don’t let it flush away its passed bad decisions. Instead the public pays for them to keep going! Bit of a double-wammy. At this point, I believe this is a moral failing. Wealth is extracted from the masses and given to a select few. The bailout distorts real-world signals and encourages banks to keep it rolling and double down. There is no risk, the public will pay for a failure while the bank still captures any gains. Even if a banker has a soul and finds this wrong, if they don’t take advantage of it their competitor will. Ideally, this system is anti-fragile. It should quickly react and send signals, flow with the ever changing entropy of the world. Break down a bit here, build up a bit there. But the government influence starts to point all the entropy in one direction. When the system does start to push back, it pushes back hard. The government needs to push back harder! A cycle is created which feels like can only end in absolute collapse.

What is even worse, a government might have entered the backstop role just for that reason, but it doesn’t take long for them to realize they can now pay for things without having to tax. They can just implicitly pull wealth by printing more banknotes. A power that no modern government has resisted.

hope

But what if we found a new technology which allowed settlement speed to match transactions once again? How far can this all be unwound?