Many people misunderstand the nature of money, and that misunderstanding leads to misunderstandings about "hard money", "fiat currency", and the nature of banking, including "fractional reserve banking" (FRB). In this post, I'll cover these topics and attempt to clear up many of those misunderstandings.
The Nature of Money
Money is not value itself, money is a near universal (within an economy), temporary store of value, it exists solely for the purpose of facilitating exchange/business. Barter is complicated because you have to find buyer and seller who each have something of value to the other one, and the items can be bulky. If buyer and seller don't have items of value to the other, there will be no exchange. Money is the solution to that by creating a universal, easily exchanged, easily carried, unit of value.
It is only necessary for money to maintain it's value until it can be exchanged for other goods. Ideally, its value should be fairly stable for years, however, most money is exchanged within a few weeks, so stability over a period of a few months to a year is more than sufficient for it to function as money. The longer it's value remains stable, the better.
Money is not wealth. The total wealth in the US is ~$95T. Total economic activity (as measured by GDP) is ~ $18.5T. But the amount of money in circulation is ~$1.6T. Clearly, money, economic activity, and wealth are distinct measures. Money supply and economic activity are related, but aren't the same. Money and wealth (stored value) are only very loosely related.
Hard Money vs Fiat Money
Hard money refers to money made of, or backed by, something of intrinsic value, such as gold, silver, copper, platinum etc. The problem with "hard money" is that any such "thing of intrinsic value" has a value that changes relative to other goods, as its supply and demand change. Gold, silver, copper, etc. all change in value relative to other items because they have non-monetary uses that dramatically alter the demand, and new discoveries of deposits (or new ways of extracting them from known deposits) increase the supply. That makes for a money of limited stability of value. When those metals were used only for money and jewelry, it made sense to use them as a form of money, because they were scarce and the demand was largely driven by use as money, while supplies were constrained and usually belonged to the govt/ruler. However, all of those have significant industrial uses now, as does every other conceivable element or mineral.
For something to be an effective hard money, it must meet these requirement:
- Have intrinsic value.
- Be scarce, or have limited access by any means other than the money issuer.
- Have no other demand for usage that could cause a supply constraint.
While #2 can be theoretically be enforced by law (aka fiat), #1 conflicts with #2 & #3. If something has no use other than as money, it has no inherent value. If it has competing uses, then it's either virtually unlimited in supply (which reduces it's inherent value), or it's subject to shortages and "increased value" due to the other demands. It simply can't exist in any meaningful way now. A well-managed fiat currency is actually more stable than any hard money can be. This is obvious when you grasp the nature of "hard money".
Money Supply and Fiat Currency Under FRB
Having established that hard money is not inherently stable, nor more so than a well-managed fiat (established by law) currency, that in fact, hard money is inherently limited in stability of value because it is subject to the same laws of supply and demand as all other goods, it is in fact less stable and thus less ideal than a well-managed fiat currency. It's now time to look at the nature of money supply with a fiat currency, which turns out to be significantly different from that of hard-currency.
The essential factor in maintaining a stable money supply is that money must never be introduced without the receiving party exchanging something of suitable value. As it turns out, this is the same as for any hard money, Thus, the amount of money in circulation is solely a representation of a portion of the wealth, in a conveniently carried and exchanged form.
To see this more clearly, lets look at the oft maligned fractional reserve banking (FRB) system. People deposit "money" into the bank, but the bank lends out more "money" than is on deposit. How does that not devalue the money in circulation? Consider each secured loan (we'll look at unsecured loans and limits to FRB shortly). In order to receive a loan, the borrower exchanges equity in some property for cash, thus making "liquid" some portion of the assets of that borrower. But notice that the total value of the property is unchanged, only which party has legal claim on the property. Now, from an economic view, it literally makes no difference if the bank used money that was deposited by others or whether they literally printed the money (e.g. issued a check), that money is backed by real property of value, exactly as hard currency is. As such, it makes no difference whether the bank lends out 1x or 10x as much as they have on deposit, because it's all secured by property of at least comparable value. The "money supply" has increased, but only because property was made "liquid" by the exchange. This is significantly different than with any hard currency, since the supply of the hard money material itself a constraint on the supply, and thus on the liquidity of the economy.
That additional currency now in circulation will stimulate economic activity (people don't borrow to hoard money, they borrow to buy and/or pay other debts). Likewise, the loan must be paid back, with interest, generating income for the bank to pay it's expenses, employees and shareholders, and to pay interest on the deposits, thus taking the borrowed money back out of circulation. FRB multiplies the ability to liquify property/equity, and increases the bank's ability to make money, and pay interest on, their deposits, effectively lowering the costs of banking.
Now, lets look at unsecured loans. Unsecured loans must be limited to a percentage of deposits, as there always exists the possibility that defaults could hamper the bank's ability to pay out deposited funds. Therefore, there must be a limit on the total amount of unsecured loans made vs total deposits. There is much more to consider with secured or unsecured loans, including creditworthiness of borrower, interest rates, demand accounts vs time deposit accounts, etc. but those are minutia not central to this discussion. The key is that there must be fairly strict limits on unsecured loans by banks.
Back to secured loans for the final portion. Clearly, defaults in either case will leave money out in circulation. For unsecured loans, that money comes out of the bank's profits, so it remains in balance. This creates a natural limit on the amount of unsecured loans, but that doesn't mean there shouldn't be legal limits as well. For secured loans, the bank foreclosing on and selling the property that secured the loan, brings in the money that was borrowed. Any shortfall comes from the bank's profits, thus creating a limit on the amount of secured loans that it's prudent to lend. History shows that bankers don't always act prudently when lending. This brings us to the realization that there should be legal limits on the percentage of deposits that may be issued as secured loans too. It will be a different limit than that for unsecured loans, but there should be a legal limit that prevents banks from being too imprudent in lending.
Thus we see that amount of money in circulation has no impact on the value of money itself, so long as how it enters circulation is controlled by the requirement that it always be exchanged for comparable value. It doesn't cause inflation either, although, the interest paid on loans and deposits are factors that indirectly contribute to inflation. The more interest borrowers pay, and the greater percentage of the economy that is driven by loans, will impact the rate of inflation.
Notes on Banks and Banking in an Economy
Banks occupy a special place in an economy. They don't themselves produce any products of value, but as they do have significant control of the liquidity of assets and the money supply, and they have deposits from many people. Therefore, their stability is vital to local, state, regional, and national economic activity. They also have the unique ability to crash an economy, as we have seen numerous times. As such, no bank should be allowed to exceed a certain percentage of the market/deposits for a given area (e.g. MSA, state, region, or nation), so there need to be established threshold market share at each level at which the bank incurs additional oversight or regulation, and a higher threshold at which the bank must divest itself of assets to get below the threshold. So, while FRB itself isn't a problem, it must be restricted by laws and regulations to limit the damage any bank can cause if it fails.
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