Read this section about monetary hierarchies, risk, and fractional reserve lending.
The Hierarchy of Money
Let's begin to formally defi ne layered money. Keeping in mind
the example of a gold coin and a gold certificate from the
Preface, let's take a look at an example from Renaissance
Florence and the famous Medici banking dynasty. We
begin this layered approach by thinking about the difference between a gold coin and a piece of paper that says,"The
Medici banking family will pay one gold coin to the bearer on
demand". The gold coin is a first-layer money and the form of
final settlement. The piece of paper only exists because of the
gold it represents; it's a second-layer money, created as a liability on somebody's balance sheet. All second-layer monies
are IOUs (I-owe-you) or promises to pay first-layer money.
They all have something called counterparty risk, or the risk
that comes with holding a promise made by a counterpart.
Counterparty risk is an essential concept in the monetary science, especially because all forms of money in today's financial system have some degree of it. Trust in counterparties is
required for our financial system to operate, or else we'd all
still be using gold and silver coins for every single transaction.
Layers of money came to exist because people trusted forms
of money that carried counterparty risk of the issuer. They
are a way to show how monetary instruments are related to
each other based on a relationship between balance sheets of
financial institutions. Take a look at Figures 3 and 4, which
closely mirror the Preface's example of layered money.
The layers become a way to think about money's natural hierarchy whereupon monetary instruments are ranked
in order of superiority from top to bottom, instead of placed
next to each other on accounting tables.
Each layer represents a side of somebody's balance sheet, and therefore we
must also identify the actors that exist in between layers of
money. In Figure 4, the Medici Banking Family is the actor
between the first and second layers. It issues second-layer
money - bills of exchange, which are promises to pay first
layer money - gold and silver coins. Key word: promises, with
the risk of being broken.
Bills carried default risk by the issuer because they were a form of deferred settlement. Default risk is the risk that the actor between money layers cannot or will not fulfill on the promise to pay. Any bill issuer can default, leaving the holder of second-layer money with a worthless piece of paper. Despite the default risk, bills served as an instrument of monetary exchange and an accelerant to the velocity of money. Bills also greatly increased the elasticity of money; coins cannot be fashioned out of thin air, but bills could. Rubber bands are elastic: they can expand when stretched. Money can also be elastic: it can be expanded but only when it doesn't have to be fully reserved with gold coins in a vault. To merchants and their bankers, elasticity trounced default risk, and bills became the preferred monetary instrument to coins. Those willing to accept bills and other forms of deferred settlement demonstrate to us that money is fundamentally hierarchical. If a merchant demanded gold payment upfront for the delivery of goods, it was his right to do so. But if another merchant accepted a bill that represented a promise to pay gold later, his willingness to defer final settlement is proof alone that the layers of money are not a construct of bankers but immanent in the human tendency to keep tabs with each other. We began to see a system in which different layers of money served in different capacities. First-layer money emerged as a better way to store value over longer periods of time, and second-layer money emerged as a better way to transact because it was more flexible to use than coinage.
Source: Nik Bhatia: Layered Money
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