Money. The villagers are tired of bartering. The dairy farmer wants to buy corn, even when he does not have milk to trade, and the corn farmer wants to buy meat, even when the butcher does not want corn. So they decide that special gray stones that they can collect from a nearby riverbed will represent an abstract unit of value, called money. They reason that if everyone uses stones to represent value, then people can transact when they would like, rather than when both parties are willing and able to barter. The villagers have abstracted value.
Supply. The villagers picked special gray stones to be money because the stones were portable, durable, and most importantly hard to collect. The only way to get them was to walk an hour outside of town and spend all day sifting through the riverbed. Sometimes, a villager would do this and only find one or two special stones. And so like any other job—winemaking, farming, cobbling—the job of collecting stones was self-regulated by the value of the activity. If the villagers collected too many stones, like they did after a flood cut open a new seam of special stones in the riverbed, then the cost of goods would go up and the relative value of stones, and thus collecting them, would go down. Or vice versa. So the villagers decided that anyone could collect stones, just as anyone could forage for berries or dye cloth. More or fewer people would do it as demand changed.
Debt. The rancher has a problem with money. He raises cows, but this takes a long time, much longer than it takes the dairy farmer to gather fresh eggs. He must go long periods of time without earning more stones. So the villagers decide that some people can simply pay for goods later. The two parties just record the details of the trade on a piece of paper and settle up later. The person who owes money is said to have debt, while the person who is owed money is said to have credit. For example, the woman who owns the general store in town is happy to let the rancher buy on credit, since she has known him since they were both children. However, she does not sell on credit to strangers or to people who do not pay their debts.
Interest. While the general store owner is happy for the rancher to buy on credit, the shoemaker is not. He too trusts the rancher, but he wants money now to expand his business. Since the shoemaker would not be paid in stones for a year—it takes a long time to raise a cow—, the shoemaker cannot use that money to buy new tools or hire an assistant in the meantime. Having stones today is better than having stones in a year. So the shoemaker makes a deal with the rancher: the rancher can have boots today but pay for them in a year; however, rather than paying one hundred stones for the new boots, the rancher must pay one hundred and five stones. The extra five stones are for the lost value of not having money sooner. The villagers like this idea and adopt it. Soon, all debt is repaid with excess stones, which the villagers call interest. The villagers have created the time-value of money.
Bank. The rancher still has a problem. He can buy on credit from the general store and from the shoemaker, but most stores in town will not lend to him, since they do not know or trust him. One entrepreneur in the village wonders about this problem. He notices that the rancher needs to buy on credit, but none of the stores he needs to buy from will lend, while the widow across town keeps a hundred stones in a jar in her cupboard, but has no friends who need the money. The entrepreneur has a clever idea. First, he borrows the stones from the widow, and he promises to return them in one year with an interest of three stones. And then he lends these stones to the rancher, on the condition that the rancher pays him five stones of interest in a year. The business plan is to make the spread, two stones, in a year’s time. This works because the entrepreneur knows both the widow and the rancher. Over time, word spreads, and many villagers who want to borrow or lend come to him. The entrepreneur calls his business a bank. The bank is very profitable, and over time, many banks pop up in the village.
Balance. Eventually, the entrepreneur is borrowing and lending from so many people that there is no correspondance of one person’s lent stones to another person’s debt. At the end of the year, when the widow asks for her money back, the entrepreneur goes into his storehouse to fetch some stones he hasn’t yet lent and gives them to her. He does not even know if they are the stones repaid by the rancher or not, but it does not matter. He even starts letting customers ask for their stones back whenever they would like, to encourage more people to deposit stones. However, this creates a problem: the number of stones in the banker’s storehouse tells him very little. If someone lends him five hundred stones, and then he lends four hundred of those, he will have one hundred stones in his storehouse. But this is a very different situation than the one in which someone simply deposits a hundred stones. So the banker begins to track two lists. On one list, he records everything the bank owns or is owed: the stones in the storehouse and the debt owed by borrowers. He calls these his assets. On the other list, he records everything the bank owes to others, namely deposits. He calls these liabilities. When a villager deposits fifty stones, the banker records fifty stones in liabilities and fifty stones in assets. He calls these two lists his balance sheet, since the bank’s assets must equal its liabilities. Counting his stones in his storehouse only tells him what he has now; his balance sheet tells him what he is owed and what he has promised.
Illiquidity. One morning, the teacher walks by his bank and notices a queue. The bank isn’t even open yet. He asks around, and the people in line say that they heard a rumor that this bank had been lending aggressively and even made some bad loans. Those in line didn’t want their stones to go missing, so they were about to pull their money out. The teacher thinks about it, and decides to wait in line too. By the time the bank opens, there is a very large line. The banker panics. He dutifully gives out all the stones that he can, but eventually he runs out of stones in his storehouse, and there is still a line of people demanding their stones. The banker is frustrated. He knows that his balance sheet balances! He is owed many stones from various villagers. But he does not have the stones now. He does everything he can. For example, the winemaker is late to repay a debt, but the banker and the winemaker are friends, so the banker has allowed the debt to persist. Now the banker forces the winemaker to sell her wine early, at a discount, in order to be repaid today. By nightfall, he asks the remaining villagers to come back the next morning. Then he goes to to another banker in town, the owner of a much larger bank with more stones, and he sells them his balance sheet at a discount. For example, one villager owes the banker two hundred stones in one year’s time. The banker is only able to sell this loan for one hundred and fifty stones, because the larger bank knows he is in trouble. And thus, the smaller bank is forced to close, and the bigger bank assumes his assets and his liabilities. The next morning, the larger bank starts giving money to any depositer that wants their money back, but people stop panicking once they realize the larger bank is the backstop. However, because of this panic, wealth in the village is destroyed. The winemaker was forced to sell good wine at a discount, and the small banker was forced to sell his good debt at a discount.
Speculation. The bankers realize that their business model is inherently fragile due to this timing mismatch: villagers can ask for their deposited stones back before the bank earns back its loans plus interest. If all the depositers were to do this at once, the bank would simply run out of stones. So different bankers experiment with different banking models. For example, one banker does not make money by collecting a spread. Rather, she safekeeps peoples money and charges them interest to do so. Another banker only allows people to withdraw their deposited stones at fixed times, giving him time to ensure he has had some of his loans repaid in order to match the outflowing stones. However, the original banker’s business model is the most popular, because people get paid to store their money and can withdraw it as they wish. Most villagers are happy to accept the risk of a bank running out of money in exchange for being paid interest while still being able to withdraw their money at any time. Much like planting corn is a speculative investment—one could pay money for seed and yield no crop—the villagers realize that depositing money at the bank is a kind of speculative investment. But they are happy to take this risk because they expect to get paid interest.
Payment. At first, the banking business model was to collect a spread between the interest banks paid on deposited stones and the interest banks collected on lent stones. However, over time, the banks became trusted intermediaries for day-to-day payments. For example, imagine that the carpenter wants to buy goods from various merchants. He does not want to cart his stones around all day. This is heavy and dangerous. So instead, he goes to the bank, hands over some stones, and the bank gives him a paper note indicating that the bank is good for those stones. The bankers called these banknotes. Various shops in town were originally skeptical of this scheme; they thought that banknotes were not money but only the promise of money. But over time, they liked the system too, because they did not have to keep as many stones in the back rooms of shops. Everyone could transact with banknotes, and simply exchange them for stones when needed.
Settlement. This new payment system worked extremely well, because now villagers can buy things when they need them, rather than when they have stones, and they can buy at nearly every shop in the village using debt or banknotes, because the debtor is a trusted third-party, a bank. However, the banks realized something odd: they often become each other’s creditors without trying. For example, imagine that the architect banks at Athena Bank and the zoologist banks at Zeus Bank. When the architect buys from the zoologist, she gives the zoologist a banknote from Athena. The zoologist then goes to exchange this banknote for stones at Athena Bank. But this is a hassle. Now the zoologist has to walk his stones from Athena to Zeus. The zoologist would rather have Athena just deposit the stones directly at Zeus, but Athena cannot do this, as it would require manipulating Zeus’s balance sheet. So instead, the banks decide that the zoologist can deposit the architect’s banknote directly at the zoologist’s own bank, and then Zeus will collect the debt from Athena. The banks call this scheme gross settlement. However, for a brief moment, Zeus is inadvertently a creditor to Athena, because it creates a deposit for the zoologist before it has the architect’s stones from Athena. Zeus is loaning Athena stones, as an artifact of who pays who in the village. So the banks hire the fastest kids in town to run stones between banks. They settle these incidental, transient debts as fast as possible.
Residual. Gross settlement is appealing because it is simple. Athena Bank knows the architect, and Zeus Bank knows the zoologist. Every banknote is settled immediately after the transaction, by stone runners. Neither bank is touching the other bank’s balance sheet, and the zoologist himself does nothing. His stones stay within the banking system. But the banks have problems with this system. First, it is costly, time-consuming, and dangerous to transport stones constantly. And second, it is terribly inefficient. In one day, Athena might transfer ten thousand stones to Zeus, while Zeus transfers eight thousand stones to Athena. It would be better if they netted, if Athena simply transferred two thousand stones. So the banks agree: at the end of each day, the bankers will convene and settle all debts by netting their transactions. They call this nightly meeting scheme net debt settlement and the net payment the residual. At the end of the day, Athena might transfer only five stones to Zeus, but this residual payment says nothing about the day’s transactions. It could mask hundreds of transactions between its customers.
Deferral. One night, the bank leaders convene to settle their debts, and Poseidon Bank asks a question: rather than settle with Athena Bank tonight, could it possibly settle with Athena tomorrow night and pay one night of interest? The bankers thought about this and decided that it was not only acceptable, it was desirable. The ability to pay one’s debts, which the bankers called solvency, is different from liquidity. When the small bank was forced to sell its balance sheet at a discount, it was solvent but not liquid, and the inflexibility of the system caused real value to be destroyed. Or take the fishmonger, who pays his suppliers with banknotes in the morning before going out to fish but isn’t able to sell his fish to the restaurants until evening. Under immediate gross settlement, his bank account was often dangerously low, but it was always full again by nightfall. Thus, the bankers reason, it would be better if the system had some flexibility. Since Poseidon is good for the money and only owes Athena for incidental reasons due to who paid who today, why not defer settlement another day? So the banks agreed that while eventually settling was critical to the system, banks could borrow from each other for one night at a special interest rate, which they called the overnight rate. Just as villagers could go into debt to each other in order to resolve a timing-mismatch, so banks could go into debt to each other for exactly the same reason.
Acceptance. The villagers begin to wonder: what is money? Stones are obviously money, but so are banknotes and even bank deposits. For example, every time the bookseller sells a book, he is either paid in stones directly or he is paid with a banknote. After a while, the bookseller realizes something: he hasn’t seen a stone in a while. Everyone buys from him using banknotes, and he doesn’t even convert that banknote to stones. He simply deposits the banknote at his bank, and then banks settle the debt later, sometimes days later. The bookseller realizes that once he’s handed a banknote, he considers himself paid. Of course, if he only viewed stones as money, he would not be paid until he converted this banknote into stones. But he goes to bed each night with only a number on a balance sheet to tell him he has money. The villagers begin to wonder if maybe all the things they thought mattered about special gray stones—durability, portability, scarcity—were not the real reason people were willing to accept them as money. Maybe money was just anything that another person would accept as settlement for a debt. If this were true, then a banknotes were also money.
Creation. An extremely profitable businessman came to Zeus Bank for a loan, but the banker has a problem. Her storehouse of stones is nearly empty, and she cannot issue more debt without another villager handing over more stones as deposits. But then she thinks about the bookseller. The bookseller accepts banknotes as payment and buys goods for his family using banknotes as well. He has not asked for his stones in the storehouse in years, and the banker does not even think of herself as storing his particular stones anywhere. She only has a pile of stones in the storehouse, and she can’t remember the last time she worried about running out of them. What she does worry about is the residual payment owed at nightly settlement. Sometimes she is paid a little, sometimes she pays a little, depending on payments across the village. And if she owes more than she expects, she can borrow at the overnight rate. In her mind, the real risk is not a villager asking for their stones. It’s her overnight interest payment growing if she keeps rolling her debts forward. This is the risk that she must and can manage. So she takes out her balance sheet, and simply writes down a new line: a liability in the form of new deposits for the businessman and an asset in the form of this man’s debt to the bank. Her sheet balances. This isn’t an accounting trick in her mind, and she doesn’t even think about it as creating money, because she isn’t creating stones. The liability or deposit is simply a claim for stones against her bank. The profitable businessman can now, if he wants, ask for real, physical, special gray stones, and she could give them to him. But he won’t! He will only ask for banknotes and repay his debt in banknotes. Thus, with a stroke of the pen, the businessman has banknotes to expand his business, and the ingenious banker’s residual payments shift, imperceptibly, day over day, as slightly more money in the village is a claim against the stones in her storehouse.
Squeeze. Every autumn, all the farmers in town withdraw their stones from their banks to pay the the agricultural workers who bring in the harvest. These are typically poor, itinerant workers who do not have bank accounts. They always want to be paid in stones. On a normal night, the banks’ nightly settlement is easy because everyone in the village is paying everyone else, and so the residual payments between banks is small. The zoologist pays the architect and the architect pays the bookseller and the bookseller pays the fishmonger and the fishmonger pays the zoologist. Money circulates. But around harvest time, many banks struggle to settle because their stones have been withdrawn to pay agricultural workers. Money flows in one direction. The banks fear this night, because often the residual payments are very large. The bankers call this night a credit crunch because the ability to extend credit is restricted, as many banks are suddenly short on stones. The stones do not disappear; they simply leave the banking system temporarily, until the agricultural workers spend their money.
Gridlock. One harvest night, Athena Bank owes Poseidon Bank a large residual payment of one hundred thousand stones, but Athena’s vault is empty because its customers had to pay workers’ wages. As usual, Athena asks Poseidon for an overnight loan, but this time Poseidon says no. Athena argues that while its vaults are empty, this is only due to the seasonal harvest. Eventually, money will flow back into Athena as its customers—many of whom borrowed money to prepare for the harvest—repay their debts. But Poseidon has its own debts to pay very soon and depositers who might ask for their stones back at any moment. Also, Poseidon cannot tell whether Athena made good or bad loans. All Poseidon can see from the outside is that Athena does not have stones. Most of the other banks are similarly constrained by the harvest’s drain on their stones, and Athena simply cannot settle its debt. The problem with the harvest night credit crunch is that Athena cannot create money that Poseidon will accept. Athena can expand its balance sheet to create new deposits that the bookkeeper will accept as money. But these new deposits mean nothing to Poseidon. Money is something that the other party will accept as the settlement for a debt, and so deposits at Athena is not money to Poseidon. But if Athena cannot pay Poseidon, then Poseidon cannot pay Hermes, and so on. The banks cannot settle, and this harvest night, the banking system finally goes into gridlock. The bank leaders and village elders agree to meet the next morning to resolve the crisis.
Backstop. The next morning, the largest bank in the village, Zeus, proposes a solution. It argues that the banks should create an organization that acts as an intermediary between lender and debtor banks during a crisis. Zeus calls this a clearinghouse. The clearinghouse could inspect any member bank’s balance sheet and issue paper certificates against the bank’s assets. Other banks would trust the clearinghouse because it was a neutral third party, run by all the member banks. At first, Poseidon balks at this idea. It argues that you cannot settle a debt by making another one. This is why Athena cannot simply loan itself money and why Poseidon does not want another promise from another bank. But Zeus argues that these certificates are not promises; they are money between banks! If two villagers transact without a bank, the only thing that is money between them is stones. But if two villagers use an intermediary such as a bank, then a hierarchy emerges. One villager can pay another using a banknote and both parties go to bed knowing that there is no debt. The debt is moved up the hierarchy, to debt between banks. But what happens when the banks cannot settle? Zeus argues that the fix is simple and even obvious: the banks should move the debt up the hierarchy by creating a kind of bank-of-banks! Finally Poseidon agrees—what choice did the bank really have any way? —and a clearinghouse is created. The clearinghouse inspects Athena’s balance sheet and then issues a fairly-valued certificate against its assets. Athena pays Poseidon with this certificate, and now Athena has no debt to Poseidon but rather has debt to the clearinghouse. And Poseidon can pay Hermes with a clearinghouse certificate, and so on. And soon, the argicultural workers start buying beer and food and clothing, and stone money starts flowing through the village and back into each bank’s storehouse. Soon, every bank is able to repay its certificate loan, and the banking system survives the harvest gridlock.
Centralization. Over time, the banks agree with Zeus that these certificates were yet another form of money. Between villagers, stones were money and even banknotes were money because neither was any villager’s liability and both were accepted at face-value and without any discount, which the banks called at par. Similarly, between banks, clearinghouse certificates were a kind of money because they were not the liability of any individual bank and they were accepted at par. However, with time, the banks came to dislike the clearinghouse. Zeus was the largest bank and even a competitor and yet had outsized influence in the process. The village elders realized that the clearinghouse, as a bank-of-banks, was the most powerful financial organization in the village. So the village elders stepped in and decided that the village needed an official bank-of-banks, which they called the central bank. They called all the other banks commercial banks. The central bank would serve essentially the same role as the clearinghouse, but rather than being run by member banks, it would be a new administrative arm of the village government.
Reserves. The central bank opened a bank account for every bank in the village. Unlike the clearinghouse, banks had no choice. They could not opt in or out of membership. They were required by law. And rather than issue certificates, the central bank said it would issue reserves. The central bank said that certificates were ad hoc emergency money, issued as part of a voluntary system of member banks, while reserves would be official bank money, issued by the central bank. Furthermore, by law every bank had to keep a certain amount of reserves in its account at the central bank, as a fraction of the amount of deposits it owed its customers. This made reserves money between banks, because now banks needed and wanted to have reserves and because they were accepted at par as settlement for debt between banks. To get more reserves, a commercial bank would borrow from the central bank against the assets on its balance sheet. This moved bank debt up the financial hierarchy, just as villager debt was moved up the hierarchy by banks. And just as villager debt was made flexible by intermediation and money creation, so bank debt was made flexible by the central bank, which could simply create reserves by expanding its balance sheet.
Inflation. Over time, debt in the village grew. The commercial banks were comfortable with the debt in the village, because now they could always settle their debts to other banks by going into debt to the central bank instead. And the central bank was comfortable with all the debt from commercial banks, because it could always expand its own balance sheet to create more reserves. However, as more and more villagers and businesses paid for goods with debt, the price of goods in the village went up. For example, the rancher could only raise so many cows per year, but now people were offering him more stones for each cow. So the prices of cows went up. And so on for other items in the village. The villagers called this increase in prices over time inflation. The villagers speculated that inflation was caused by the village creating money faster than it could create value. A few wise villagers noticed, however, that the problem with inflation was not with stones. The stone supply had barely changed in years. When the village experienced inflation years ago, it was when the flood cut open the river embankment and revealed more special stones. At that time, the impact was moderated because the value of a day’s labor collecting stones was reduced as the value of a stone went down. But now inflation was being caused by the stroke of a banker’s pen, and this labor was essentially free.
Policy. The central bankers thought about the problem of inflation, and they realized that they could control the price and thus the quantity of reserves, which in turn would control the price of money for the villagers. Just as a commercial bank could encourage more villagers to deposit money by offering a higher interest rate on deposits, so the central bank could encourage more banks to hold reserves by offering a higher interest rate on reserves. And since banks were were required to hold reserves as a fraction of the debts on their balance sheet, this meant that the banks would loan less money to villagers. So if the central bank increased the interest rate it offered on reserves, more banks would hold reserves and thus decrease their lending to villagers. And if the central bank decreased the interest rate it offered on reserves, fewer banks would deposit their reserves and thus increase their lending to villagers. So the central bank started to manage the problem of inflation by changing the overnight interest rate on reserves.
Hierarchy. The villagers have constructed a hierachy of money. Villagers settle debts with stones, bank deposits, or banknotes, while banks settle debts with reserves. So reserves are money between banks, while banknotes and deposits are money between villagers. This gave the central bank enormous power. It could change the price of credit throughout the entire village by changing the interest rate on reserves. And in a crisis, it could act as the lender of last resort, creating elasticity in the system by lending when no other bank could. The villagers have built a hierarchical system that allows for both elasticity and discipline in the money supply.
Currency. The village has built a financial system that uses special gray stones as money. But over the mountain pass is another village which uses special red stones as money. And over the river is another village which uses special blue stones as money. And so on. In fact, there are many villages in the region, and they each use their locally available special stones as money. In each village, the villagers refer to their stones as simply money, but when discussing money as an idea that transcends all the villages, they refer to special stones as currency.
Trade. The merchant has a problem. The red-stone village is near rich clay deposits and makes excellent pottery, which he wants to bring back to his village to sell. However, the merchant only has gray money, which is not money in the red village. But after some initial bartering, he convinces the merchants in the red-stone village to accept his gray stones as payment. He argues that while gray money is not money to them, it is not worthless either. They can, for example, spend the gray stones in his village when they travel there for business, or they can exchange the gray stones for red stones with other red villagers who plan to travel to the gray village. The red-stone merchants eventually agree, and they sell their pottery for gray stones. But they include a markup on the price, since gray money is inconvenient and must be converted. Over time, all the villages trade with each other. However, trades are limited, because not every merchant wants the inconvenience of being paid in a foreign currency and because imported goods are expensive due to the markup.
Exchange. An entrepreneur notices that many merchants have red stones that they do not want. They trade with the red-stone village because it is worthwhile, but they would prefer to be paid in gray stones. The entrepreneur thinks that the inverse problem must exist in the red-stone village: those merchants must have gray stones that they do not want. And so she forms a business: she buys red stones from the merchant in her village using gray stones, and then she travels over the mountain pass to the red-stone village and buys gray stones with red. The villagers in town start to call her a currency trader. Just as a horse trader specializes in trading horses, the currency trader specializes in trading currencies. The currency trader quotes her price as exchange rate, which reflects her estimate of the relative value of stones in two villages. This rate fluctuates, as the money supply and the prices of goods in both villages slowly drift. And of course, she adds a markup or spread onto this rate for her services. Currency trading is very profitable, and over time, many exchanges pop up. As exchanging currencies becomes easier and cheaper, the villages trade more.
Correspondence. But the currency trader has a problem: transporting stones between villages is dangerous and laborious. So she opens bank accounts in all the villages in the region, and rather than trading stones, she trades banknotes. The banks notice her work and that their customers are often receiving foreign currency, and they wonder: why not simply accept banknotes from other villages and then perform this exchange themselves? Then they could collect a currency exchange fee. A gray merchant could receive a red banknote, deposit it in his local bank, and receive gray deposits in return. His bank would then warehouse the foreign currency and eventually exchange it for gray money. The process could be similar to nightly settlement in a single village. And so the banks open accounts with all the other banks, and they hire currency traders to manage exchange rates and their growing balances of foreign currencies. The bankers call this correspondent banking. And so just as payments between villagers created debts between banks, trade between villages starts creating debts between banking systems.
Exposure. Correspondent banking made trade between villages easier. Now a gray bank could simply accept a red banknote from one of its customers. However, this red banknote was only a promise from a bank in another village. Ultimately, the gray bank needed to know that the red-stone village bank was good for the money. As with nightly settlement, the residual payment between banking systems was typically small. The gray village bought pottery from the red village, while the red village bought cows from the gray village. Money circulated. But the central bankers worried about the political and economic health of the other villages. They thought about their own struggles with inflation and credit squeezes, and wondered what would happen if these happened in another village. There was no central bank above villages. What if another village failed to repay their debts? The gray village could create gray money, but it could not create foreign currency, force a foreign bank to pay its debts, or enforce its laws on foreign bankers. And so as the debts between villages grew, the central bankers monitored the political stability and economic health of their trading partners. They reasoned that a foreign currency was only as good as the village that issued it.
Default. Like other villages, the red-stone village funded itself through taxes. However, the government also funded itself with debt: banks, businesses, and individuals would give the elders money, and the elders would promise to repay the debt with interest. The bankers called these promises bonds. Many people liked to own bonds, because it seemed like a relatively safe way to make interest. However, over many years, the red-stone village borrowed more and more by selling bonds. The village’s debt became very large, and after a few poor harvests, many local businesses struggled and tax payments dwindled. A wealthy lawyer in the red village worried about his government. He worried that his central bank might pay off its bond debt by issuing yet more bonds, this time by creating reserves and selling the new bonds to commercial banks. The debt would roll from public bondholders to commercial banks, and the central bank would pay for this by expanding its balance sheet, by simply creating money. He knew that when this happened, there would be more red money in the system chasing the same amount of goods, and so the red village might experience inflation. So every so often, this lawyer would go the currency trader in town and convert some of his red banknotes to black banknotes, since he thought the black-stone village had the strongest economy. At first, the currency trader was happy to exchange one red banknote for one black banknote. But soon, as the red-village experienced inflation, many people in the red-stone village wanted black stones instead of red. The currency trader started demanding two red stones for one black stone, then three, and then four. The red-stone village’s economy continued struggle, because now importing goods was more expensive, since red stones were worth less relative to other currencies. Finally, the red-stone village told the other villages in the region that it would not repay its loans, since it could not risk creating more red money without extreme inflation. The bankers called this a default.
Reserve. During the red-stone village’s debt crisis, no one thought that black stones were completely safe. Rather, many villagers simply preferred to hold black stones rather than red. Like the lawyer, everyone trusted the black-stone village more. This is because the black-stone village, which was high in the mountains, was the wealthiest village by far. It had a strong military, a robust economy, transparent monetary policy, and a fair judicial system. People trusted that black money would retain its value. Over time, black money had simply become the most trusted money in the region, and merchants from all the villages found themselves transacting with black money because everyone had some. When a merchant was offered a black banknote, she would happily accept it; often, she would not even bother taking it to a currency trader to convert it. Like the bookkeeper who thought himself paid when he received a banknote, the merchant thought herself paid when she received black money. She did not think, “This money is better than my money.” She simply didn’t bother to exchange it. And during any sort of financial crisis, people would quickly exchange their domestic money for black money. The central bankers noticed this, and they started to refer to black money as the reserve currency. They used the word “reserve” because, much like central bank reserves, black money acted as a settlement asset, this time between banking systems.
Devaluation. The purple-stone village is also struggling. The village specializes in making clothes; it has spinners and weavers, knitters and dyers, tailors and dressmakers. However, the village struggles to export clothes, since other villages also make their own clothes at competitive prices. So the village’s bankers propose an idea: what if the purple central bank expanded its balance sheet to create reserves and then used those reserves to buy foreign currencies. Then there would be more purple stones relative to foreign currencies, which would decrease the price of purple money. The bankers called this currency devaluation. Why, the village elders ask, would they want to do that? The bankers reply that if purple money is cheaper relative to, say, black money, then in the black-stone village, purple clothes would be cheaper than black clothes. And so black-stone villagers would buy more purple clothes. Of course, this would mean that the purple village would struggle to import goods, but it would thrive at exporting them. After much debate, the elders agree, and the purple central bank begins devaluing its currency. Some villages enjoy the cheaper clothing from the purple village and allow their local clothing industries to struggle, while other villages protect their local industries by levying a special tax on imported clothes, called tariffs. Over time, many villages devalue their currencies to become more competitive, while others impose tariffs to protect their domestic industries.
Conference. The central bankers debate monetary policy. They debate topics like currency devaluation, extreme inflation, and banking system defaults. They realize that trade between banking systems is lacking cooperation and flexibility. Each village is engaging in competitive or protectionist policies that limits free trade. And a village default impacts everyone, since there is no backstop. So the elders agree that they should meet and discuss a resolution, and they gather in mid-summer at a beautiful hotel in the black-stone village. After much debate, the leaders decide to formalize a few things. First, they agree that black money would be the region’s official reserve currency, and that a single black banknote would always be convertible into thirty-five black stones. Second, they decide that each central bank would keep its exchange rate with the black currency fixed. They called this dynamic a currency peg. This meant that each central bank would maintain a balance of black money in reserve and would then buy or sell this black money in exchange for its own currency, in order to maintain the exchange rate. For example, if red stones were worth too little relative to black stones, the red central bank would buy red stones for black. The idea behind this system was that that if black money was stable and if every other currency was pegged to black money, then every other currency would also be stable. Finally, they agree that some flexibility was needed in the system, and they create a clearinghouse for the central banks. This would be analogous to a clearinghouse for banks within a single village: if any central bank struggled to defend its currency peg due to liquidity issues, this new clearinghouse could lend as a last resort. In theory, this system would prevent currency devaluations and protectionist policies, limit the fallout of debt defaults, and add flexibility during gridlocks.
Privilege. This status as the region’s reserve currency gave the black village an important advantage. Other villages had to make and sell goods in order to acquire money used to trade. But the black village could, within limits, acquire goods simply by issuing money and debt that everyone else wanted to hold, because people preferred to save and trade using black money, and now because central banks needed to maintain some black money in reserve. This made debt cheaper for the black village, and the black government could fund public programs more easily, because everyone was happy to hold black bonds. Furthermore, black villagers could buy cheap goods and services from across the region, because everyone wanted black money.
Dilemma. However, the success of black money created a dilemma. Over time, the other villages accumulated vast quantities of black banknotes and debt denominated in black money. This meant, however, that there were many claims for black money across the region. And just as the teacher worried about convertibility of his bank deposits into special gray stones, so central banks wondered about convertibility of black money into special black stones. As long as few banks tried to convert, this was not a problem. But as more and more black money flowed through the system, the central banks wondered: was every black banknote really worth thirty-five black stones? And thus a dilemma arose: the more successful black money was, the harder it became for the black central bank to maintain the promise of convertibility.
Float. The black-stone village elders had a problem. There was too much black money in the system, relative to black stones held by the black central bank. To maintain convertibility, they would need to make black money more expensive. They could buy back black money using foreign currencies, but they were constrained here. There was much more black money than any other currency. And they could raise the central bank’s overnight interest rate and thus raise the price of money in the village, but this would discourage villagers from taking out loans. It would hurt the black village’s economy. In other words, the black central bank was struggling to defend its own kind of peg, that of convertibility of a black banknote into thirty-five special black stones. And so after much discussion, the elders of the black-stone village made an extraordinary announcement: the black central bank would no longer exchange its banknotes for special black stones at all. Anyone could trade black stones, but their price in terms of black banknotes would not be fixed by convertibility; the parlance of the central bankers, the price would float.
Fiat. At first, elders and bankers and traders around the region were shocked. Even the black village’s central bankers worried about what would happen next. And yet nothing happened. Everyone in the black village still had to pay taxes with black money. Wages, loans, and contracts were still denominated in black money. Commercial banks settled debts using reserves from the black central bank. And the black-stone village was still the strongest economy in the region, with a large military, a liquid and transparent financial system, and a relatively fair judiciary. People across the region still preferred to hold black money over any other, even though a black banknote was now just a piece of paper which could not be converted into special black stones. The bankers called this new system fiat money, because its value depends on the institutions and economy of the black village, not on convertibility into a commodity whose supply was governed by labor. Of course, the elders of the black village were still constrained. They could create unlimited amounts of black money, but they could not create unlimited amounts of goods from the black village: eggs, bread, cloth, wine, jewelry—these all had to be produced by people in the black village. So if the black central bank created money recklessly, they might experience inflation, and other villages might lose trust in the system. But within reason, fiat money gave the black village immense flexibility and power, while still maintaining the village’s status as the region’s reserve currency.
In the beginning, special gray stones were money. However, the villagers ran into a problem with stone money: it was inflexible. So the villagers created debt, but a villager could not settle a debt by making more promises. And so banks emerged as a layer above stone money. Now villagers could settle their debts with banknotes, because banknotes were a promise from higher up the hierarchy. Then the banks ran into the same problem: a bank could not settle a debt to another bank by creating more of its own deposits. And so the central bank emerged as a layer above bank money. Now banks could settle their debts with reserves, because reserves were a promise from higher up the hierarchy. Finally, the banking systems themselves ran into the same problem but with currencies: one village could not settle a debt to another village by creating more of its own currency. And so a reserve currency emerged as a layer above. Now villages could settle their debts with reserve currency, because the reserve currency was a promise from higher up the hierarchy.
And so the pattern was: within each level, money was whatever the counterparty accepted as final settlement, and this could be promise if it was backed by the level above. The black village sat atop this hierarchy, with a promise to convert black banknotes into real, physical, special black stones. But in the end, this too was just a promise, and the black village was able to decree, by fiat, that black money just is. The black village could do this because black money was the most widely accepted form of final settlement. But the system rests on trust. And if the system rests on trust, then the trust can erode through bad governance, corruption, poor fiscal policy, and competition. But for now, black money is the best money in the world.
I owe my understanding of the modern monetary system to a few excellent resources. First and foremost is Perry Mehrling’s incredible lecture series Money and Banking. I am grateful he has made these available for free. He introduced me to the idea of the “hierarchy of money”, although my understanding is that others predate him in using this phrase, notably Hyman Minksy. I also found the Bank of England’s whitepaper Money Creation in the Modern Economy unusually clear about what money creation actually is. And finally, Joseph Wang’s book Central Banking 101 reinforced much of my understanding from the first two resources.
Source: Hacker News
