Friday, February 8, 2013

The Fraudulence of Fractional-Reserve, and Why Bitcoin Can Save the World

Today, the excessive growth of our civilization's industrial development, in the century or so since the discovery of cheap fossil fuels (particularly oil), has, ecologists estimate, exceeded Earth's sustainable consumption rates by roughly 50%, and brought us to the brink of near-complete ecological devastation of the planet.  Many astute observers believe that we have overshot the carrying capacity of the planet, and that later this century we will suffer massive population die-offs and extreme human suffering (not to mention the extinction of enormous numbers of other species).

In a way, the fact that our civilization is on this horrific bubble-and-bust trajectory is not surprising, given that our economy is pervasively controlled by a monetary system that is, in effect, designed to create rapid growth and resource overshoot - namely, the fractional-reserve banking system.  What do we mean?

The Fractional-Reserve Fraud

First, what is fractional-reserve lending?  This practice goes back to the early days of Italian banks, such as those run by the Medici family, which would take deposits of gold for safekeeping, and give back certificates (redeemable for gold) in exchange.  Since these certificates were good for gold, they became, in effect, the earliest bank notes, or paper money.  (Notice that the US dollar bills in your pocket are stamped "Federal Reserve Note," seemingly implying that you can redeem them at a Federal Reserve Bank in exchange for precious metals, although actually this hasn't been true since Nixon closed the gold window in 1971.)

Now, there's nothing wrong in itself with representing gold bars with paper notes; they are much more convenient to carry around, after all.  But, a problem arose when bankers like the Medicis noticed that people rarely actually cashed in their notes - mostly they just exchanged them, and left their gold safely in the Medicis' vaults.  Well, this created a temptation for the bankers.  They said to themselves, what if we loaned out some of the gold deposited in our vault to people in need of money to bankroll some new project?  It is very unlikely that all of the holders of gold-deposit certificates would demand for their gold to be returned all at once.  So, no one will notice that some of the deposits are in fact missing from the vault.  In fact, even the majority of the deposits could be loaned out at any given time - only a small portion needs to be kept in reserve, to accommodate the day-to-day fluctuations in the amount of gold on deposit. 

Of course, the predictable consequence of this practice is that, over time, the temptation increases to loan out a larger and larger fraction of the gold, and keep less and less of it in reserve, and eventually the public realizes how much of the bank's gold is missing, and starts getting nervous about whether their bank notes are really redeemable, and then a large number of people actually try redeeming their certificates, there is a "run on the bank," and the notes are not actually redeemable, because in the meantime some of the loans have gone bad, or else cannot be called in right away, and so the bank collapses.  This happened to the Medicis, and of course also to thousands of other banks, as well as to entire countries' banking systems, throughout history.  The book This Time is Different provides data showing how utterly ubiquitous banking failures really have been. 

One can argue that fractional-reserve lending (this practice of keeping less than 100% of demand deposits on reserve) is a fundamentally fraudulent practice, because it implies making a set of promises that cannot possibly be kept in all circumstances, namely, the promise to all depositors that their deposits of gold (or other fungible valuables) will always be returned on demand - such a promise is of course impossible to fulfill in the event that depositors do demand their deposits back all at once, and in the meantime some of them have been loaned out and cannot immediately be called in.

Moreover, one can argue that this practice overstimulates the economy.  Consider:  Money like gold is supposed to represent real wealth.  Therefore, the total amount of gold deposited in a country's banks represents, in effect, the total wealth in terms of resources accessible to that country.  But now suppose that, through the issuing of certificates and fractional-reserve lending, the illusion is created that the total amount of wealth in existence is greater than it was previously - since the loan-recipients have their borrowed gold, and the original depositors still have their "redeemable on demand" gold certificates.  Collectively, citizens of the country will be misled into thinking that their country has more real wealth (in terms of resources) than they had before.  So they will be fooled into growing their development and consumption patterns beyond what the real resources available to their country can actually support.  They don't do this consciously, but it happens automatically because they have more money to invest than there is corresponding real wealth.

This illusion can work for a while; i.e. the vision of greater wealth can become a self-fulfilling prophecy, in cases where a country has many untapped resources.  The development funded by easy credit and the increasing money supply can lead to the harnessing of those resources, and to increased real wealth for the country overall.  In such cases, the growth of the money supply anticipates future wealth, or reflects the net present value (in the undeveloped country) of its future resource development.  The fractional-reserve lending becomes a means of tapping that future wealth, and making it accessible (in the sense of, being represented by exchangeable monetary tokens) in the present.

However, what if the potential for real economic growth does not really exist, for example because the country is resource-limited, or its available natural and human resources are exhausted?  What happens then?  Well, then the fractional-reserve system and its inflation of the money supply leads to over-building of industrial capacity and infrastructure, to overshoot in consumption patterns, to more-rapid exhaustion of resources, and eventually to economic collapse, a banking crisis, and (frequently also) to sovereign default, if the state is (explicitly or implicity) backing the banking system.  This bubble-and-bust pattern has happened dozens, even hundreds, of times throughout history, in practically every country where fractional-reserve banking has existed.  If we haven't learned by now that fractional-reserve lending is inherently destabilizing, and that it tends to promote economic overshoot and collapse, then when will we?

A Better Way - A Fixed Money Supply

Given that fractional-reserve banking, and the flexible money supply it makes possible, is inherently destabilizing because it promotes excessive economic growth and resource overshoot, what is the alternative?

One solution, which is actually realized beautifully by the Bitcoin electronic currency, is to keep the size of the money supply absolutely fixed.  Bitcoin has, by design, a forever-fixed ultimate money supply of 21,000,000 BTC - not all of that is in circulation yet, because much of it still needs to be "mined," but in principle it is already there, and a large fraction of it (a bit more than half, as of this writing) is already in circulation.

The same could be said to be true for precious metals such as gold, except that, if one contemplates future mining technologies, the development of space resources, the eventual possibility of nucleosynthesis of Au in fusion reactors, etc., it becomes clear that the amount of gold that is already in circulation today is only a miniscule fraction of the ultimate long-term supply; thus, gold has, in the very long run, a rather unstable supply.  Bitcoin is, in fact, more stable in the long run, because its ultimate supply is "set in stone" by the mathematical algorithms used; it cannot be changed via any single party developing some destabilizing technological innovation.  

So, what are the benefits of a fixed money supply?

First is that the over-development of resources becomes unlikely.  In periods when the real economy is growing, prices in terms of the currency will be deflating, because larger and larger amounts of real-world resources need to be exchanged using a fixed supply of coins.  Due to the price deflation, one's money is becoming more valuable over time, so one is encouraged to hold onto one's money instead of spending it.  One only will spend it on ventures that one expects to return more than the rate of deflation.  So, this naturally tends to regulate or throttle back economic activity, to keep it in check - since the faster the real economy grows, the larger the deflation rate, the greater resistance there is to spending, and the more investments get naturally focused just to the places where they are most beneficial.  The economy can still grow, but only in cases where there is real growth, not just a bubble of paper wealth - since there is no paper wealth when all the money is (real or virtual) "specie" like Bitcoin, rather than notes (debt money), and the supply of Bitcoins, by its definition, cannot "bubble."

Some economists worry about a "deflationary spiral," wherein the braking effect of deflation causes economic activity to slow down and down, and come to a halt.  But this makes no sense, since if the money supply is fixed, but economic activity is slowing, then prices will inflate because fewer and fewer goods are circulating and a shortage of needed goods will cause prices to rise again.  Some minimum amount of economic activity is necessary simply to maintain wealth, i.e. to protect it from degradation/depreciation by various causes.  As long as there is economic activity, prices will not fall to zero, and there will be no spiral.  One may, however, arrive at a state of zero-growth, but this in fact is exactly what is needed for a sustainable economy on a finite planet, if technologies are not improving.

What about during when the real economy is slowing, say because production of some critical resource (such as cheap oil) is falling?  Again, the fixed money supply would tend to have a stabilizing effect.  If the real economy is shrinking, but the money supply is constant, then there will be price inflation, as shortages create increasing competition for goods, and the available money supply chases fewer goods.  But, price inflation will spur investment, since the only way to maintain one's wealth during periods of high inflation is to spend it quickly on investments that one hopes will produce a return that beats inflation.  So this spending would spur economic activity that would tend to moderate the rate of decline of the economy.  The economy can still shrink (since if resources are declining, the economy must ultimately shrink, no matter what the spending patterns are), but the rate of decline can be a slow, comfortable slope, rather than the type of sharp crash that can occur in a fractional-reserve system when suddenly everyone realizes that the system is overextended and credit dries up.

In other words, a fixed money supply tends to produce a stable economy.  The economy can still grow as new resources become available, but at a gradual, natural pace; and the economy can still shrink as available resources diminish, but again, at a gradual, natural pace.  In both cases, there would be less painful displacement than is suffered today in the bubble-and-bust cyclical economy that is produced by the so-called "modern" (more accurately, fraudulent) fractional-reserve banking system.

Better Banking with Bitcoin

So in conclusion, I truly believe that the widely adoption of an alternative currency with a constant supply, such as Bitcoin, can indeed "save the world" from suffering the worst depredations of economic overshoot and collapse.  Of course, for this to work, the practice of fractional-reserve lending must be shunned by the public, if not outright made illegal.  Short of changing the law, consumers can "vote with our feet" if we obey these cardinal rules of economic ethics:  
  1. Never lend out money that you owe to another, especially if you've promised to repay it on demand;
  2. Never accept a loan from any institution that might be violating rule #1.
  3. Never deposit money with, or loan money to, any institution that might be violating rule #1.
Making loans would still be possible under these rules, but to loan out money, you would have to actually earn it first - not just obtain it by borrowing (or accepting deposits from) someone else.  Any loan always bears some risk that the money might not be returned, but if it's money that you truly own yourself, free and clear (not obligated to someone else), then you can take this risk upon yourself with a clear conscience.

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