The Re-Solution of the Orientation of George Selgin’s Ruritania and John Nash’s Ideal Money: Addressing the Problem of Bitcoin’s Finite and Inelastic Supply
Selgin is relevant as he was cited by Hal Finney one of the number one suspects for being Satoshi Nakamoto creator of bitcoin.
His writing about Ruritania is a thought experiment that considers how the advent of a commodity money would arise through barter and and how the banking system would evolve in a world without government enforced monopolies over the money policies (aka central banks).
I want to explain a little about the insights Selgin reveals and then explain their relation to Nash’s Ideal Money.
If the writing seems too long, you can consider it an overview of Selgin’s reasoning, and simply skip to the last section for my insight.
From Bailments to Fractional Reserve Banking
Selgin divides his writing into four parts and the first three go from the “storing” of people's wealth for safekeeping to the CONSENSUAL lending of the savings in return of interest to be earned:
In transfer banking of this kind money on deposit is meant to be “warehoused” only. The custodian is not supposed to lend deposited money at interest, and receipts given by the “banker” for it are regular warehouse dockets.
The lending of deposits is (expected to be) a mutually favorable and defined contract:
The lending of depositors’ balances is a significant innovation: it taps a vast new source of loanable funds and fundamentally alters the relationship between Ruritanian bankers and their depositors.
The receipts for the warehoused savings (commodity money) evolve:
Money “warehouse receipts” or bailee notes become IOUs or promissory notes, representing sums still called deposits but placed at the disposal of the banker to be reclaimed upon demand
Fungibility then is created and the process can sustain as long as there is continued savings (commodity money) for investments:
The ability of bankers, in Ruritania and elsewhere, to lend out depositors’ balances rests upon two important facts. The first is the fungibility of money, which makes it possible for depositors to be repaid in coin or bullion other than the coin or bullion that they originally handed to the banker. The second is the law of large numbers, which ensures a continuing (though perhaps volatile) supply of loanable funds even though single accounts may be withdrawn without advance notice.
Where Fractional Reserve Banking Becomes Possible
Such a system evolves to have transferable receipts:
Nonnegotiable checks open the way to negotiable ones, while assignable promissory notes open the way to negotiable bank notes. What distinguishes the latter is that they are not assigned to any one in particular, but are instead made payable to the bearer on demand. Thus Ruritania would evolve the presently known forms of inside money — redeemable bank notes and checkable deposits.
This evolved system creates the possibility for a new type of efficiency gain:
…giving inside money, not only to depositors of coin or bullion, but also to those who come to borrow it. The use of inside money is not just convenient to bank customers. It also makes for greater banking profits…
The efficiency gained is significant:
Of even greater significance than Ruritania’s one time savings from fiduciary substitution (the replacement of commodity money with unbacked inside money) is its continuing gain from using additional issues of fiduciary media to meet increased demands for money balances.
Thinking about Bitcoin
This section is a little tricky but I can explain it if we think about bitcoin as the commodity money. If the economy and population grows there would be an increase for the new paper money that has evolved (to represent claims to the underlying stored bitcoin or commodity money). This becomes a service to be filled in regard to matchmaking people’s savings to investments through loans etc.
Under a banking system without this “paper money” an increase in the demand for money puts pressure on the production and supply of the commodity money (ie gold if gold coins are the commodity money):
By this means every increase in real money demand becomes a source of loanable funds to be invested by banks, whereas under a pure commodity-money regime an increase in money demand either leads to further investments in the production of commodity money,
The next part would be relevant if Bitcoin was the commodity money:
…or, if the supply of commodity money is inelastic, to a permanent, general reduction in prices.
Efficiency is gained:
The latter result involves the granting of a pure consumption loan by money holders to their contemporaries. Thus, fiduciary issues made in response to demands for increased money balances allow Ruritania to enjoy greater capitalistic production than it could under a pure commodity-money regime.
What is Fractional Reserve Banking?
That is the benefit of fractional reserve banking:
Fractional-reserve banking is the practice whereby a bank accepts deposits, makes loans or investments, but is required to hold reserves equal to only a fraction of its deposit liabilities. Reserves are held as currency in the bank, or as balances in the bank’s accounts at the central bank. Fractional-reserve banking is the current form of banking practiced in most countries worldwide.
Fractional-reserve banking allows banks to act as financial intermediaries between borrowers and savers, and to provide longer-term loans to borrowers while providing immediate liquidity to depositors (providing the function of maturity transformation). However, a bank can experience a bank run if depositors wish to withdraw more funds than the reserves that are held by the bank.
Fractional reserve banking allows the money supply to grow in response to the demand WITHOUT implying or relying on an increase in the base money:
Because banks hold reserves in amounts that are less than the amounts of their deposit liabilities, and because the deposit liabilities are considered money in their own right, fractional-reserve banking permits the money supply to grow beyond the amount of the underlying base money originally created by the central bank.
The difference in Selgin’s story and our real global economy is that we have central banks they have a monopoly on influencing the (inside or privately created) money supply through monetary policy and/or the reserve requirements of the (ie private) banks they serve:
In most countries, the central bank (or other monetary authority) regulates bank credit creation, imposing reserve requirements and capital adequacy ratios. This can slow down the process of money creation that occurs in the commercial banking system, and helps to ensure that banks are solvent and have enough funds to meet demand for withdrawals. However, rather than directly controlling the money supply, central banks usually pursue an interest rate target to adjust the rate of inflation and bank issuance of credit.
From Commodity Money to Paper Money to Clearing Houses
The commodity money births an evolution in transferable receipts creating a greater efficiency and this efficiency evolves again. Competition and the usefulness of banks accepting rival banks paper notes inspires the birth of a real “paper money” standard.
Now commodity money (ie gold or bitcoin) can be used simply in large value settlement between banks while the more cheaper easier convenient money can flow in the public:
Because notes from one town come to be accepted in a distant town at par, there is little reason to lug around commodity money any more.
The fractional reserve banking aspect is kept in check by competition:
During that period, banks’ sought to bankrupt their rivals by “note dueling” — aggressively buying large amounts of their rival’s notes and presenting them for redemption all at once.
The benefits of multilateral clearing is clearly explained (less transactions and less cost):
Suppose Ruritania has three banks, A, B, and C. A has $20,000 of B’s notes, B has $20,000 of C’s notes, and C has $10,000 of A’s notes. 24 If they settle their obligations bilaterally, they need to have $20,000 to $40,000 of commodity-money reserves on hand among them, depending on the chronological sequence of their exchange. On the other hand, if they settle their balances multilaterally, they need only $10,000 of reserves among them: A’s net balance to B and C combined is +$10,000; B’s net balance to A and C combined is $0; and C’s net balance to A and B combined is -$10,000. Hence all three balances can be settled by a transfer of $10,000 from C to A. Apart from reducing reserve needs, multilateral clearing also allows savings in operating costs by allowing all debts to be settled in one place rather than in numerous, scattered places.
“From Clearinghouses to an Ideal Money Equilibrium”
George defines an ideal money equilibrium with two conditions (on the assumption that ”free-bank liability issues run up against increasing marginal costs” which he means to show later):
As the public holds only inside money, with commodity money used only in bank reserves to settle clearing balances, these conditions are as follows: First, the demand for reserves and the available stock of commodity money must be equal. Second, the real supply of inside money must be equal to the real demand for it.
Once the first condition is met the second condition is self-discovered through the fractional reserve process:
Once the first (reserve-equilibrium) condition is met, the tendency is for any disequilibrium in the money supply to be corrected by adjustments in the nominal supply of inside money. An excess supply increases, and an excess demand reduces, the liquidity requirements (reserve demand) of the system
Thus the system cannot be considered mature until this equilibrium is met:
On the other hand, if the reserve-equilibrium condition is not satisfied, the system is still immature.
Another Consideration Relevant to Bitcoin
Considering a finite supply of commodity money:
For the sake of simplicity, the analysis that follows starts with a free banking system (similar to Ruritania’s) in long-run equilibrium and assumes an unchanging supply of bank reserves.
Based on this scenario banks cannot exclusively create cheap money (ie lower interest loans):
This result has other important implications. It means that a solitary bank in a free banking system cannot pursue an independent loan-pricing policy. A “cheap-money” policy in particular would only cause it to lose reserves to rival banks.
A Relevant Side Note
In a mature free banking system, commodity money does not circulate, its place being taken entirely by inside money.
On Say’s Law
This monetary equilibrium is an expression of a money supply which perfectly elastically serves the demand for it:
According to Koopmans (1933, 257), who has developed this approach most thoroughly, monetary policy should have the goal of “compensating for any deflation, due to hoarding, by creating a corresponding amount of new money, or of compensating for any inflation, due to dishoarding, by destroying money in like measure.” When this goal is achieved “the money outlay stream should remain constant.” In other words, money is neutral as long as Say’s Law remains valid (that is, as long as excess demand for money is zero).
If net pure demand is nil, monetary equilibrium prevails . . . the monetary equilibrium situation corresponds to Say’s Law [De Jong 1973, 24].
In Comparison to John Nash’s Ideal Money
The orientation of Nash’s Ideal Money is slightly different but it is because it does not function on the caveat that central banking does not arise or exist. Instead Nash’s argument is built on that premise that it has arisen and does exist.
But there is comparable nature to the two orientations and the parallels and differences can be seen as interesting.
We can think of nations (and perhaps currency commons like the Euro) as already evolved banks that have multilateral clearing already in place if only to some degree (ie settlement among nations).
Each of the nations has their own network of smaller banks and sometimes you can trade the money issued with other nations-although, right now this is limited around the world at least to some extent.
However, there is no base commodity money (gold served as this for a period of time for example on the gold standard) and instead we typically, today consider, only the comparison between the domestic perspective of a single single nations and a Ruritanian free banking setup.
But if we think of Bitcoin as the large value settlement medium between nations and perhaps the central banks as clearing houses for the subset of private banks then we can begin to understand how there could evolve an arrangement in which each of the nations are compelled into the equilibrium, Selgin describes, simply by the natural competition that the Ruritian setup implies.
This speaks to what Selgin describes as:
…the ideal of a truly demand-elastic money supply.
This orientation addresses any perceived problems in the shortcomings of Bitcoin’s limited and inelastic money supply.