You have been told by governments and economists that central banks are an absolute necessity as a “lender of last resort” to stabilize the system and to prevent or cushion financial crises like the one the world is now experiencing. Well, they are wrong and I can demonstrate it. There is a far more robust alternative to the central bank, which involves the democratization of banking. I will explain this solution in a minute, but first I will show why the mainstream economists think central banks are so important, and why their solutions are obsolete and their theories are wrong.

The dilemma of banking

In the olden days, when pure gold (and sometimes silver) was money, there were some problems. If you owned gold your values were really safe because gold could not be forged or duplicated and its market value was remarkably stable. However, simply storing your gold under the bed didn’t put the gold to productive work. Banks provided the solution to this, namely to lend out the gold for interest.

But this introduced another problem: unavailability. If you lend out your gold for, say, 10 years, then that money is unavailable to you for spending for 10 years. That’s a shame, because very few people were willing to tie up their money for that long. People wanted interest, but they also wanted the flexibility to be able to take out their money on demand, and end the lending.

Again ingenious bankers provided a solution to this, namely fractional reserve banking. Bankers noted that that most of the time the gold remained unclaimed in the bank. People circulated gold certificates as money, but didn’t actually claim the gold in the bank. So the bankers started printing more paper money than there was actual gold in the bank. In this way, the bank could provide availability and interest at the same time.

In the beginning this practice started out more or less as a fraud, because people didn’t realize that the banks were doing this, and so they treated the paper money as literal claims to gold. People thought that every single money bill was backed by gold in the bank, and what happened after a while was that people discovered that this was not the case and the banks could experience a panic withdrawal of the gold all at once from all its customers. This was called a run on the bank.

This became a painful lesson: fractional reserve banking had provided the convinience of interest and availability by giving up security. The paper money they provided was less secure than actual gold.

Central banks were seen as a solution to this. Before the 20th century central banks had always been created to finance some war, but in the 20th century the idea of the central bank as the lender of last resort, in case of a run on the bank, emerged.

After WWII the United States more or less became the world central bank, and had all the gold in the world in Fort Knox. This went sort of ok, for a while until the Vietnam War, where it turned out that the United States did what virtually every king had done in the past: financing the war by printing money. The French didn’t like this and demanded their gold back. The United States was essentially caught with its pants down and in 1971 president Nixon declared that the gold standard was dead. The lender of last resort had run out of gold.

This brought banking into completely unchartered territory. Every single government abandoned gold in favor of a pure paper money standard. (Fiat money) The result has been the greatest explosion in money printing and the biggest lending spree in human history. That spree is still ongoing, now mostly driven by government spending. At the start in 1971 gold was worth 35 dollars. Today it is worth almost 2000 dollars.

So the lesson of history tells us that central banks do not provide the security that they were supposed to give. On the contrary, not only did they simply send the problems into the future, but by so doing allowed the problems to grow to such huge proportions that they were now not just a a major problem, but a humongous one.

Traditional deposit banks (gold storages) provided security and availability, but no interest. Time deposits (investment banks that lent out your gold) provided security and interest, but no availability. Fractional reserve banking (multiple claims on the same gold) provided interest and availability, but not security.

So that gives us the dilemma of traditional banking: you can have money security, availability and interest, but not all three at the same time.

But given our knowledge of banking and our current technology is it possible to overcome this problem and have all three? Surprisingly the answer is yes.

A new look at fractional reserve banking

Ok, so fractional reserve banking had a somewhat dubious beginning, but why did it stick around for so long? Why didn’t it disappear once people learned about the dubious practice? Well, it turns out that fractional reserve banking was not all bad and not all dubious. In the 19th century there were many successful fractional reserve banks that provided a high degree of security to their customers and without causing inflation.

There were two practices that “cleansed” fractional reserve banking of its fraudulent elements and rendered it into a sound form of banking. First, and most importantly: most of the time people didn’t actually spend their paper bills (the gold certificates). They remained unused in their pockets, which means that in practice it was as if the paper bills were stored in the bank. This meant that even though the fractional reserve banks issued much more paper money than they had gold, it didn’t cause inflation or devaluation of the money because the paper money remained unused most of the time.

Let me give an example: suppose that a bank has 100 dollars worth of gold in its bank and then through lending issues as much as 1000 dollars in paper money. Suppose further that 90% of those dollar bills remain unused on average. This means that on average only 100 dollar bills were in use at any given time, and thereby no price inflation was caused and no devaluation of the dollar bills. In effect fractional reserve banking worked as if the bank had a teleportation device, where dollars were teleported into the customer’s wallets whenever they needed cash, and remained invested in the bank when not in use.

The second practice that “cleansed” fractional reserve banking of its fraudulent elements was competition between banks. What happened was that competing banks had competing bank notes in circulation, and typically businesses had an account in some bank. At the end of the day or at the end of the week the shop owners went to their bank with their bank notes, including the notes from competing banks. As a service to their customers the banks accepted these competing notes if they trusted the bank. Then they would go to that competing bank at the end of the day (or at some agreed upon date) and claim the gold from that bank. (they could Of course, the competing bank would do the same and so in practice very little gold was exchanged between the banks, but this practice kept the banks honest.

The effect was that banks knew that they couldn’t issue more paper money than could be supported by the cash demand. If 20% of their dollar bills were in use daily, they would have to have at least a 20% cash reserve, preferably significantly more in order to prevent running out of gold.

But as we know from history, this “teleportation” technology was far from perfect. Runs on the bank did occur and it was a problem to make this technology stable. Hence, even if it dramatically improved the efficiency in the use of “dead” capital, it also created more risk and instability in the process.

The modern solution

So let us now ask ourselves: 200 years later, have we come any further? Are there any new technological innovations that allow us to solve the dilemma of banking and a better way to achieve what fractional reserve banking attempts? The answer, gloriously, is yes! Two key technological innovations enable us not only to get rid of fractional reserve banking but also central banks while at the same time providing much, much greater stability and security than the “lender of last resort” ever could.

Innovation #1: the internet

Remember that virtual teleportation we talked about? Well, it’s no longer virtual. It’s here and it is called the internet. Today it is possible to transfer information across the globe at the speed of light. You can’t get any closer to teleportation than that. This means that we can get rid of that virtual teleportation device we call paper money altogether and replace it with digital money. Rather than carrying your money around with you, you instead carry around a bank card or an electronic device like your mobile phone and then money is transferred to you instantly from your bank account digitally to any where in the world.

Innovation #2: structured finance

Even though the finance sector has grown way out of all proportions during the last 30 years and has become more of a liability than a benefit to the world economy, a lot of useful innovations have actually come out of that sector in that period, and one of them is structured finance. Yes, I am talking about the same thing as those sub-prime loans that started the financial crisis in 2008.

Even though giving triple A rating to sub-prime loans was a bad idea, the packaging of loans into a liquid sellable product is a fantastic idea, and I’ll explain why, but let me first explain what structured finance is to those who don’t know. A structured finance product means to take many individual loan contracts issued by banks and then package them together into a financial product, like a stock, which can be bought and sold in the global finance market. This package is called a structured loan product. This technology is extremely important and here is why.

In economics we talk about two different types of capital, namely real capital and financial capital. Real capital is any durable good that can be used to do economicly useful work. To a taxi driver his car is the real capital, and to the industrialist his factory and machinery is his real capital. Financial capital on the other hand is typically defined as money employed for business purposes. While these are natural categories and distinctions in economics, they are not necessarily the most useful ways to categorize capital. Another way is to divide capital into liquid capital (=easily sellable) and illiquid capital (=hard to sell). For our purpose this is a much more important distinction.

Almost all real capital is illiquid. A factory that produces, say, diapers generates cash income to the capitalist owner but selling the factory itself may is a lot harder than to sell the diapers. So the capitalist is sitting on a gold mine but if he wants to get rid of it, it is not so easy. Financial capital (money) is by definition liquid, otherwise it wouldn’t be money.

But there are other types of capital that are not goods, but are still illiquid, and some that are liquid but not money. The loans that banks issue to customers behave very similar to real capital, in that they generate income (interest) to the bank, but you can’t sell a loan very easily on the market. The loan itself is illiquid capital.

This is precisely the reason that 19th century banks were so vulnerable to running out of cash in case of a bank run. Oh, how wonderful it would be for the bank to be able to sell its loans whenever it needed in order to raise cash. Then it would never go bankrupt. Whenever it went low on cash it could simply sell some of its loans. But precisely because loans are illiquid capital this is impossible.

Enter structured finance. By packaging many individual loans into an integrated product in a standardized and easily measurable way the banks are able to transform many unsellable items into sellable products. Structured finance transforms illiquid capital into liquid capital!

Even though it was never the intented usage this wonderful technology provides the solution to revolutionizing banking and creating a whole new system. The problems of liquidity crises and bank runs that so mared the fractional reserve banks of the 19th century essentially goes away. By structuring its loans into a liquid product the bank can get cash on the fly by selling loans whenever the customers demand cash.

The new system

Let’s now use these elements to outline a new banking system that doesn’t need fractional reserve banking or central banks.

The first step is to be honest with the customers and tell them that if they invest in such a bank they will not own actual gold because gold does not give any interest. They own shares in a structured finance product — let’s call them bonds for simplicity. These bonds give an interest, they are very secure and they are highly liquid. By building a bank around such a liquid investment portfolio one is able to solve the dilemma of banking and provide all three qualities that a customer wants from its bank investment: interest, availability and security/stability.

If the structured finance products are sufficiently liquid in the global market then the bank may not even have to have any cash reserves to be able to provide cash on demand to the customer. However, as a service to the customer, just to be on the safe side, the bank could have some cash reserves in case the sales volumes for some reason are a bit low during parts of the day.

Even if the customer saves his money in these bonds he is not using the bonds as a means of payment. He is paying with actual gold. Whenever he uses the bank card in a store some of his shares in the bonds are liquidated instantly in the global market into and so he is paying with pure gold (or some other money equivalent that is accepted in the market place). As such this is not fractional reserve banking, even though it provides the same kind of service.

The global market functions as a decentralized provider of cash, not by lending cash as “lender of last resort,” but by simply buying bonds from the banks. Thereby instead of having one central repository of gold one has millions of gold repositories spread across the globe. This provides an infinitely more robust solution than a central bank ever will. You can corrupt a central bank, but you can’t politically manipulate millions of independent cash providers spread across the globe.

Democratization of banking

Another major advantage of this system is that it removes the need for big banks. Before it was absolutely necessary to have big banks to provide a sufficiently large pool of assets and cash reserves. Now structured financing products can replace that functionality of banks entirely.

In effect, this opens up for “mom and pop”-banking. Anyone can start a bank, and it can be ridiculously small, yet provide the security of the biggest banks. Here is how:

Suppose that Joe Plumber has 100,000 dollars that it wants to start a bank with. He lends this money to his neighbor Bubba Nielsen. He knows his neighbor well and knows him as a decent hardworking man with little problems. He also does a background credit check on him and he has an excellent rating.

He creates the loan, and then he goes to a big bank (or some other equivalent institution) which specializes in structuring loans and says that he wants to have his loan included in a structured product. The big bank checks up Joe’s credentials and the credit worthiness of Bubba Nielsen and concludes that the loan is sufficiently secure to be included in their structured loan product. They buy his loan and pay with newly issued shares worth 100,000 dollars in the structured loan product.

So Joe Plumber now owns a share in a loan product that he can sell in a heartbeat in the global financial market. In this way he has been able to lend out his money at interest and still be able to liquidate the loan into cash on demand if he wishes to. Joe Plumber has become a banker!

Objections

But wait a second, didn’t I just say that Joe Plumber had to go to some big bank that specializes in structured loans? Doesn’t this mean that such a system still will have big banks or some equivalent institutions?

Sure. There will be big banks, and there is nothing inherently wrong with being big. However, the character of banks will change. Facebook and Google are big today, but they are big in a different way from the way Microsoft was big. Their primary role is to aggregate information into an useful and easily accessible form, but they still heavily rely on content creation by many independent external users. Big banks will take on a similar role in the system I have described above.

But wait, have I really solved the dilemma of banking? Are you able to have the combination of security, availability and interest in this system? The answer is that this system optimizes the combination of these three variables, and it is far more transparent than fractional reserve banking. Arguably you could get greater security by holding your money in cash only, but consider this: if you are completely unable to liquidate your bonds in the global market, how bad must then the economic state of the world be? Are you really safe with holding cash if things are going that badly in the world anyways?

Conclusion

Current theories of money are stuck in the past. Whenever people today discuss the gold standard, only ancient, technologically outdated alternatives are considered. All versions of the gold standard are based on 19th century technology. Modern fiat banking is also similarly stuck in the past and for a similar reason: technological and business innovation in money and banking is illegal due to the government monopoly on money.

If private money and free banking had been legalized then we would see the same kind of wonderful technological innovation that we have seen in the information and telecom industries. What I have done in this article is to outline the kind of banking we would see if gold and free banking were fully legalized. New technologies provide elegant solutions to the dilemma of banking and would banking more robust to the benefit of all.