hello, I have a question about Debt Money. Im not sure that is the right phrase so let me give an example.
Person A is out of money so borrows 10 gold coins from his friend person B, and so he does not forget to pay his friend back he gives him an IOU of 10 gold coins.
Person B then goes to the store, and realizes he is also out of money, so asks if the shopkeeper will take his IOU as payment for goods. The Shopkeeper agrees becuase the IOU is basically worth the same.
These small arrangements probably happen all the time.
However, what happens when it turns large scale? Lets say a bank has 100 gold and loans it to Person A for a 5% interest. After the transaction the bank might think " i basically have 105 gold". What happens if someone is willing to accept his IOU, or to make it even bigger, lets say Person B is willing to take a loan of these IOU’s becuase he has seen that they work at the store. The banker could then make the loan and have 110 IOU notes, and the problem escalates.
In a free market, if people are willing to take these IOU loans and stores will accept IOUs instead of real currency, would it be wrong to stop it?
I dont know what would really happen, but with so many IOU notes people would start to default simply becuase there are more notes then actual coins.
Also, the banker is creating wealth out of nothing, similar to FRB, but even under full reserves i see Debt Money being a problem.
If the number of IOU notes were to increase at a faster rate than the supply of gold coins I would suppose IOU notes would be valued less than their nominal value. For instance, if A would keep on trying to “buy” gold coins with IOU notes at some point B will only lend A 9 gold coins for a 10 coin IOU, then 8 for a 10 coin IOU etc. Thus the effective rate of interest of the IOU notes would steadily increase. Hence A would begin to feel the pressure of his future obligations to B which ought to discourage further borrowing. If then B would try to pass on some of the debtor-risk to the shopkeeper, it would be up to the shopkeeper how much he would value a 10 coin IOU from A. Depending on the shopkeepers valuation B could either profit or choose to pay cash instead.
Obviously B could divide all the IOU notes from A into different tiers. Thus tier one would be the first IOU notes to be payed down by A, tier two the next IOU notes to be payed down etc. This way tier one would be worth more to the shopkeeper than tier two. B could also bundle a mix of different tiers of IOU notes from A whereby the right mix of profit and risk could be attained. None of this really causes any problems. It is up to both B and the shopkeeper to make sure that A can pay back his debt. If not they have simply made a bad investment, i.e. wrong evaluation.
The trouble arises, however, when the shopkeeper does not know who A is. How can he evaluate the risk of default of A without knowing anything about A? This is actually one of the reasons for the present economic crisis. It might very well be that the bundles of tiered IOU notes are actually worth something, but the risk is too big since you don’t know anything about the borrowers.
Lastly, IOU notes might seem to be made out of thin air in your example, even with full reserves. But that is because you are disregarding lending standards. With full reserves inflation would probably not be a serious issue. Thus we wouldn’t see the same extent of booms and busts. Without bubbles assets (houses) don’t suddenly decline in value. Hence default risk is not as serious a risk because the asset retains its value. All in all you would have lending standards, greater knowledge of risks and no sudden decline in asset values. In such a setting I can’t see debt money being a problem. At the very least not a systemic problem as we have presently.
[EDIT: Debt money based on sound money and full reserves of course! With unsound money you would be correct, since it would still be possible to inflate the money supply without FRB]
oh sorry, i meant i consider US paper and coins to be “debt money” , but yes it is a different form then what i was talking about so i should not have given them the same name
[notes]They would not because paper is not GOLD. Person B CAN’T at the same time lend 10 coins of gold AND be able to SPEND these same coins by paying the store owner with an IOU.