Money is Minted Certainty

Every year or two, I realize I don’t actually understand what banks do and how they work. This happens reliably enough that I keep getting less confident that I, or anyone else, will ever really truly understand what a bank does.

But I’ve recently settled on a model that’s both novel and useful, that neatly synthesizes the two broad schools of thought. We can think of those schools as Hard Money and Bagehot.

• The Hard Money Theory is popular with a motley crew of Bitcoiners, Austrian economists, Ayn Rand’s imaginary pirates, and, oh yeah, 99% of people who ever lived before the twentieth century. The hard money theory holds that the supply of money should be as fixed as possible, and that economic growth should lead to deflation. Hard money is good at preventing inflation — inflationary episodes like Spain’s gold and silver imports from their colonies produced price increases on the order of 1% to 1.5% per year, hardly what we’d consider hyperinflation. However, hard money makes economic crises very severe, because when economic activity slows, liquidity leaves the system and it’s extremely hard to service debts.
• The Bagehot Model holds that central banks should be lenders of last resort. At first, this model was applied to countries with a gold standard, but that’s ultimately a Martingale Bet: if a central bank commits to providing other banks with as much capital as they need, eventually they’ll need more capital than the central bank has reserves, at which point the bank must print more money.