Monday, January 26, 2026

A Grand Unifying Theory: Trade, Money and Banking

This post is one of six posts in a series on this topic. The full list of posts are linked here for convenience.

Trade, money and banking are the concrete, water and aggregate in the foundation of all modern economies. They improve the overall efficiency and productivity of an economy by

  • aiding in the specialization of labor
  • facilitating the exchange of goods and services produced through that specialization using agreed-upon symbols of prior labor exerted
  • allowing those symbols of prior labor exerted to be accumulated over time to ensure ready access when needed.

Understanding how these factors work independently and in concert with one another iteratively over time is vital to understanding how current policies claiming to solve perceived problems in these areas actually impact these elements and -- in many cases -- are magnifying those problems rather than correcting them.

While complex, these three topics are the easiest to map to physical activity in the real world and the easiest to illustrate with numerical examples. Some of the analysis will include some math to supply the more crucial formulas used when discussing these concepts. However, like everything in economics and social sciences, actual world behavior can never be predicted or even analyzed after the fact with 100% accuracy using equations. The key to the equations is understanding the sensitivity / volatility they reflect when making small or large changes to their inputs.


Specialization Leads to Trade

The prior installment in this analysis series addressed the nature of creativity and productivity and stated that the most obvious method for improving productivity at a task is practice through sheer repetition. Any sufficiently complex or physically challenging task will require both processing memory and muscle memory to improve the quality and speed with which the task can be performed. Human societies figured this out early on and quickly learned that five people could get fifty tasks done more rapidly if each person specialized in ten tasks rather than all five having to learn fifty tasks. Why?

Learning usually lessens production rates for the teacher of a task as they slow down to explain the process being taught and obviously the student is nowhere near as productive as the teacher to make up for the lost input. Also, as tasks become more complex, the student must usually be taught predecessor skills A, B and C before being taught D. If every worker must progress through the learning curves of fifty tasks, the collective is deferring off into the future the point where anyone will be optimally productive at all fifty tasks or the workers may never reach ultimate productivity rates on any task ("jack of all trades, master of none").

Specialization of labor allows a group to avoid spending time teaching everyone every tasks and allows each person to get further up the mastery curve on the tasks they retain. If all of the people involved are in the same family unit, it's clear the collective output will benefit the group so the value of specialization is immediately apparent. Everyone knows the amount of labor that went into each unit of each type of output so if

  • Grog was able to produce 3 units of squirrel in 8 hours of hunting
  • Og was able to obtain 3 units of clean water in 8 hours of searching
  • Thag was able to 3 three pairs of moccasins in 8 hours
  • each of them needs exactly one of those other units

then specialization allowed the three to produce everything they needed in 8 hours instead of presumably more hours with each doing all three tasks less efficiently. The three are better off keeping 1 unit of their work and trading the remaining two units for the other things. When everyone can see all of the work being done and the degree of specialization is relatively small, this form of pairwise bartering A for B and B for C or even different ratios such as 2A for B, etc. can suffice.

But specialization also works across larger groups that span family units or even communities. However, as the degree of specialization increases and more work is done out of sight, greater uncertainty must be accommodated as part of the trading process. It becomes very difficult for everyone in the system to understand all of the pairwise trade exchange rates. Mathematically, an economy with N unique products would require N(N-1)/2 distinct exchange rates. For example, a world of A, B and C requires A:B, A:C and A:C rates (3). A world with products A, B, C and D requires A:B, A:C: A:D, B:C, B:D and C:D or 6 rates. A world with 20 products would require 20(20-1)/2 or 190 prices.

Clearly in an economy of even modest complexity, attempting to determine HUNDREDS of exchange rates and use them fairly during trades becomes unworkable for all participants. Attempting to do so either wastes time as participants attempt to master the exchange rates or it requires them to trust many different people to appropriately exchange A for B then B for C into (eventually) product Q. It also becomes readily apparent to Grog that carrying his stash of dead squirrels (A) around while trying to trade them into units of Q becomes very, ummmm, unpleasant.


Trade Leads to Money

As communities increased the number of distinct goods and services they were willing to trade within the community or between communities for other goods and services, the idea of generalizing "prices" away from ratios between two direct "goods" into a single "universal" good probably took relatively little time to take root. It is likely that people realized that everyone seemed to know the "value" of their particular product expressed in bushels of corn or square yard of fabric or hunting tool. From that point, traders likely made the connection that prices are not required to always be expressed in ratios involving two ACTUAL products. One of the elements can by arbitrarily chosen because it always gets converted back to something of value at the conclusion of every trade. This is the concept of money. It is a "common denominator" to the price of any product that allows that product's value to be compared against any other product.

A subtle but CRUCIAL idea underpinning this origin story of money is that after all of the abstractions of trade between two workers and exchanges of the products they make, the use of money in a transaction acts as a generic representation of prior value being provided or work being performed. After thinking through the evolution of how Grog and Og reached a point of trading A for B and B for A by direct bartering, the ratio at which both are willing to execute that trade is based upon three factors ALONE:

  • how much work PartyA must exert to create his units
  • how much work PartyB must exert to create his units
  • the competitive advantage of each at doing their single task versus the other

As one example, if both PartyA and PartyB must exert 8 hours of labor to create their units and both are equally competent at both types of work, neither has a competitive advantage so the price for A and B will essentially be 1 A for 1 B. However, if PartyA only takes 4 hours to create his units, that doesn't mean B pays half as much when buying units of A. If PartyB is not equally as productive at making A as making B, PartyA holds a competitive advantage and the price might still remain 1 A for 1 B. But regardless of those considerations, at the core of it, those PRICES always reflect a perception of WORK having been performed. Nothing changes when the parties agree to price their work in terms of units of an arbitrary form of money so... MONEY MUST ALWAYS REFLECT THE VALUE OF PRIOR WORK TO BE ACCEPTED AND USED IN AN ECONOMY.

Beyond that basic tenet, there are additional traits that ANYTHING used as money must possess in order to facilitate trade within an economy.

  1. It must be widely accepted as a means of facilitating a transaction ("legal tender")
  2. It must hold value predictably over an arbitrary period of time -- not forever but hopefully for days, weeks or months ("store of value")
  3. The token or symbol must be difficult to forge so members of the community are confident the person presenting it actually performed work at some prior point representing that much value
  4. The token or symbol chosen CANNOT be so difficult to create that it cannot be created at rates that keep pace with the growth of population and value being produced in the economy
  5. The token should be physically convenient to use in commerce -- money using stones that weigh 3 tons a piece are not convenient for commerce between communities

In this analysis, the term "money" will generally be used to refer to these underlying concepts while "currency" will be used to refer to a specific symbol chosen to embody these traits. Conceptually, coins and currency are interchangeable within this framework so coins won't be referenced here much if at all.

The subtle point between all of these requirements is that they all influence each other but in some cases they contradict each other as well. For example, ensuring acceptance of a currency as legal tender among a sufficient portion of the community may require some collective coercion by that community's government. If half of the community doesn't trust the valuation of the currency and won't accept it, that conceptually halves the trading scenarios that can utilize the currency, making it less convenient and valuable for the remainder.

The store of value requirement can conflict with means of making the currency easy to use. If the community decides slips of paper with Grog's likeness are more amenable to transactions than 3-ton stones, that's great but what if everyone is able to easily draw Grog's likeness on a piece of paper? Everyone has an incentive to forge units of currency which breaks the trust users require between a unit of currency and a unit of value ("prior work"). If you operate in a community with total currency of 1000 and you hold 50 slips worth 50 hours then you find someone has forged 1000 new slips of paper into existence, all of that currency is worth HALF what it used to be worth. Your share of 50 now only has the buying power of 25.

This risk of forgery and limited technologies to counteract forgery in other materials that might be used for currency led to the adoption of what we now term precious metals as units of money. Historically, "precious metals" had value in large part because they were both beautiful to humans for jewelry AND they were relatively hard to find in nature and required special skills to refine and form into useful shapes. That made them natural fits to address concerns about forgery so gold and silver coins became widely used.

The coercion point becomes particularly important BETWEEN communities that might adopt different currencies. It is still possible to facilitate trade between currency Y and Z but that requires the two communities to agree upon their relative exchange rate. As hundreds of years of history and later portions of this analysis will address, trading between economies with different currencies requires trust which can be broken by a variety of internal factors. If community Z somehow doubles the amount of its currency without actually doing WORK, attempting to sell products with a prior Y:Z exchange rate is essentially cheating anyone accepting Z currency for goods made in community Y priced in Y currency. If members of community Y not only accept payment with Zs but hold those Zs for use later in other transactions, they are losing value because of actions within community Z. As one can imagine, these scenarios lead to conflict between the communities. What are the options in this scenario for community Y?

  • immediately adjust pricing to the new rate and eat prior losses?
  • cease trade with community Z going forward?
  • retaliate with alternate economic measures to recoup the loss or force Z to revert to the prior state?
  • attempt to enforce the prior exchange rate through military force?

The ultimate, albeit cynical, point here is that coercion of one type or another (social or physical) and of some level (mild or extreme) is an inherent requirement for any currency to achieve broad adoption and provide value to an economy. Any object (physical or virtual) suggested for use as a currency is worthless if it can be repudiated and rejected without consequence.


Money Leads to Banking

So far, an attempt has been made to link creativity and productivity, then link those factors to greater wealth, then link those factors to greater trade which then accelerated all of those factors leading to the adoption of money. It will now be argued that the evolution of money made it easier to identify the creation of greater wealth which led to centralizing services related to housing and protecting wealth - the essence of banking.

Banking services evolved because continued specialization and wealth creation highlighted timing issues associated with aggregating wealth. With farming as an example, a farmer's "work" is exerted over months of time, resulting in a single big "payoff" when a crop can be harvested, then stored in a silo for use and sale over the next year until the next crop is ready for harvest. Farmers quickly realized that creating a barn or silo to house a crop and keep it out of the weather and reasonably free of vermin allowed them to break this feast or famine cycle and enjoy more economic security over longer periods. As the use of money took hold to denominate transactions and wealth was represented in money units instead of bushels or bales, the same concepts were applied to money and incorporated into banking.

After seeing wealth creation accelerate via trade, economies quickly identified the housing and protection of money as a new service of great value to a community. The means for providing these services obviously evolved over time but the idea of building a facility with specially secured "vaults" to guard against theft or fire and protecting it with armed guards eliminated the need for each worker to worry 24x7 about their own wealth. The bank operator could charge a small fee to the depositors to cover the cost of the building, the vault, and the labor to guard the contents and provide a small profit for the bank and still protect the assets more effectively than individual workers. Specialization of labor at work again.

History and archaeological artifacts reflect variations across the planet over thousands of years but "banking" of assets in centralized locations and "lending" evolved hand in hand over history. It takes little imagination to understand why. As specialization of labor facilitated the accumulation of wealth and that value was easier to observe when abstracted into money, workers recognized certain problems with the timing of "cash flows". At some point, the same type of "cash flow" timing problems that led to deposit accounts as a banking service led to the concept of lending money. In our example, Grog harvested his crops and converted his silo worth of corn into 100 units of currency good for spending down over the next year. His neighbor did the same thing with the cattle brought to slaughter. Now the bank has 200 units of currency sitting in two accounts... That will be spent down fairly evenly / predictably over the next twelve months... That are doing NOTHING for anyone until the depositor withdraws the currency.

That's not efficient.

The owner of the bank can see someone else moving into the community who needs to set up shop as a blacksmith but needs money for a building, a forge and an anvil. The total cost of those items is 50 currency units. The new arrival doesn't have the 50 units. The bank has 200 units in its accounts but they belong to two other people. But the banker is reasonably sure they won't be withdrawing all of that 200 over the next few months. Banking thus evolved into combining deposit accounts with lending to essentially arbitrage these cash flow timing differences in ways that a) kept the money "at work" in the economy and b) collected additional fees for the banker as they sat in the middle between depositors and borrowers and managed the flows.

As this framework was adopted, it aided higher productivity in the community. Bankers saw more depositors with balances that didn't just vary between zero and X over months or years, they saw balances that certainly varied but overall, tended upwards over long periods as sustained wealth was being created. Bankers eventually realized that a larger share of deposits could be lent out without risking getting caught short for redemptions and that increased lending would further increase lending profits and grow the economy. Rather than lending 25% of deposits, the bank could lend 50%. Or 60%. Or 75%.

This practice is called fractional reserve lending. The economic consequences of fractional reserve lending might be a bit difficult to visualize but the mathematical result is simple to express as an equation. For a bank holding D units of original deposits, if the bank retains r percent (e.g. 20% is r=0.2) of those deposits on hand to handle daily withdrawals and lends out the rest to other customers, the ACTUAL value of total "money" that will come into existence from that initial deposit D is calculated by this formula:

M = D / r

For example, for a reserve ratio r = 20%, initial deposits of 1000 currency units will result in a total of M = 1000 / 0.20 or 5000. That money is created over the following iterations:

  • initial deposit of 1000
  • retain 20% of 1000 or 200, lend the other 800
  • 800 goes out but re-enters the banking system when spent, returning 800
  • retain 20% of 800 or 160, lend the other 640
  • 640 goes out but re-enters the banking system when spent, returning 640
  • retain 20% of 640 or 128, lend the other 512

If this cycle is repeated, the numbers get smaller but add up to 5000 units on deposit in the bank. This fractional reserve lending literally created money out of thin air.

To REALLY understand what banking entails, it is crucial to explicitly describe the work being performed by bankers in an economy. In this simple example, the first function the bank had to master was operating a physically secure facility and hiring personnel that members of the community could trust with their money. Without lending in the picture and no other way to make a profit, the bank owner had to set a price for the cost of handling deposit accounts and depositors had to agree that cost was LESS than their internal cost of trying to house and protect their money at their home. At that point, the banker is specializing in physical risk security and "retail" procedures for handling deposits and withdrawals.

Once the bank identifies lending as a profit opportunity, the bank must develop skills at evaluating risks associated with would-be borrowers. Where did you come from? Is your face on a wanted poster three towns away? Do you owe any money to someone else? How is your business going to operate? How much do you think you'll be able to earn per year? How much will you be able to afford for a loan payment? If I lend you 50 and you skip town after making 10 in payments, how can I get my other 40 back?

At scale, those are vastly different skills than running a deposit-only institution. The bank needs to have loan officers who understand different types of businesses and their revenues and costs. The bank needs loan offices with "people reading skills" to guard against fraudsters. The bank likely needs employees with relationships with law enforcement to help research the background of would-be borrowers who may have skipped out on prior lenders in other communities. Because of these inherent risks of lending, the bank realizes a fee should be paid by the borrower to balance out these extra risks being taken by the lender.

The extra premium collected from a borrower through the series of loan payments is termed interest but, as the examples above make clear, that interest charge isn't a one-dimensional reflection of a single risk. It reflects ALL of the risks being taken by the lender between the time of the initial loan and final payment of the loan months or years later. But the interest charge also reflects something called the time value of money. Even in a risk-free world where the lender somehow knows the borrower will pay back the loan exactly as expected, giving X units of money for Y years is costing the lender something. What, exactly? The opportunity to use the money for something else over that time. If the lender could identify something to invest the money in that earned 9% interest, lending the money to someone else to earn a 7% return would represent a 2% reduction in the lender's potential income.


Lending Leads to Cycles

This concept of the time value of money is INTRINSIC to the adoption of trade, money and lending with fractional reserve lending. When banks adopt fractional reserve lending, they are literally providing extra fuel for commerce out of thin air because of the multiplier effect where a 20% reserve ratio turns a single 100 unit deposit into 500 total units. Fractional reserve banking puts bankers in an incredibly powerful and lucrative position. Bankers can literally grow an economy by lending money which adds to the bankers' profits which begets more lending which grows profits which begets more lending... ad infinitum.

If bankers want to make even MORE money, they can lower the reserve ratio they are trying to follow. If 20% with a multiplier of 5, why not 15% with a multiplier of 6.67? Or 5% with a multiplier of 20? (As a real-world aside, the Federal Reserve previously set minimum reserve ratios that its member banks had to meet but that Federal Reserve reserve ratio minimum was eliminated in March of 2020 amid the COVID financial contraction. Separately, the FDIC still enforces a minimum reserve ratio on banks that is around 2%, a multiplier of 50. Capital requirements also rein in lending as well but the key point here is that the multiplier factor in US banking is quite high.))

Over time, bankers realized this model for lending worked and had enough predictability to make it profitable even if some share of lenders failed to pay back loans. The interest paid by all borrowers was enough to cover the cost of the portion that defaulted. In fact, banks realized that if they ran low on money to lend, they could relax fees charged to depositors or even pay them a small percentage on deposits to attract new money to then lend out at higher rates. This is the core dynamic at work in banking today. Historically, banks have paid low rates in the 2% range on deposit accounts while charging 7-9% on loans, allowing themselves to pocket a 5-7% return without much difficulty or risk. (Over the past decade, rates on deposit accounts have gotten much lower and rates on loans are often in the 12-16% range due to poor regulation but that's another topic.)

Stop and consider the larger pattern and incentives from this cascade of productivity growth, growth in wealth, use of money, adoption of lending and fractional reserve lending that synthesizes new money for use in creating new wealth. It sounds magical. It can seemingly produce wealth out of nothing. But the recursive cycle still requires raw ingredients to contribute to the cycle -- labor and creativity. When the supply of those resources is exhausted, growth is not possible and loans made in the last stages of this expansive cycle start defaulting, bankers start losing money on loans and begin restricting new loans which slows growth which slows requests for new loans which lowers bank income which further lowers lending... ad infinitum

The same seemingly infinite virtuous loop becomes a death spiral when certain market limits are reached and all of these behaviors become reductive and the economy contracts. Sometimes cataclysmically.

Does this boom / bust cycle sound familiar?

It should. These self-reinforcing economic and psychological mechanisms do not just drive the basic business cycle. They drive every economic bubble and resulting economic collapse in history save for those directly attributable to natural disasters.


An Optimal Level of Inflation?

The economic and psychological factors that create typical business cycle patterns seen over centuries and more acute periods of extreme growth and sudden collapse from fraud also lead to other lessons that are absolutely not intuitive to average people without a background in mathematics, finance, and government regulation. Even those with expertise in those areas are likely to disagree on specifics, if for no other reason than their particular occupation or employer provides them incentives to manipulate policies in other directions.

The first crucial lesson stemming from business cycles and their contributing factors involves distinctions between interest rates and inflation. Both metrics are expressed as percentages and are frequently mentioned as though they are identical forces. In reality, they DO influence each other but they ARE distinct factors. To explain the difference between the two, it's useful to examine two extreme examples, then move towards the center for a more nuanced perspective.

In an economy with high inflation, say 20% per year, a product that costs 1.00 units of currency today will cost 1.20 units in a year. Or stated in reciprocal terms, 1.0 units of purchasing power today will have only 0.83 units of purchasing power in a year. In an economy facing hyper-inflation of 20% per MONTH, prices rise by a factor of 8.92 (792 percent) on a yearly basis. 1.0 units of purchasing power today will only have 0.11 units in a year. In that environment, that "money" is NOT meeting its requirement of serving as a reliable store of value and no one in the economy will want to hold units of that money for even a few hours or days. Thus, extreme INFLATION creates a harmful incentive to spend nearly everything, which drives up prices more which feeds inflation, perpetuating the harmful cycle.

Because of that, virtually everyone understands that high inflation is explicitly BAD for any economy. However, that understanding is often reversed into a second "understanding" that is entirely wrong. If high inflation is bad, surely after a period of high inflation, having a period of DEFLATION to return prices to prior "good" levels would be beneficial, correct?

Wrong.

In an economy with trade, money and fractional reserve lending, DEFLATION is just as undesirable as high INFLATION. Again, imagine a more extreme scenario. If prices in an economy are dropping 5% yearly, a product that is just beyond affordability NOW might become affordable in a year. This encourages saving so money is deposited rather than spent. While this provides more resources for the bank to lend out, other businesses are seeing less spending (cuz things will be cheaper a year from now) so borrowing to grow businesses declines, and the chain of recursive factors starts working in reverse towards CONTRACTION. If the rate of inflation is significant, the economic contraction can be severe and trigger massive job losses and business failures.

Between these two extremes of high INFLATION and high DEFLATION, there must be a sweet spot for price levels. It might seem that optimal level of inflation in an economy with fractional reserve lending would be ZERO percent inflation. In reality, this is NOT the case. No two economists have been identified on the planet who agree on what a single best level of inflation might be but the general consensus is around 2 percent. There's no equivalent of some physical or chemical process in the natural world that makes that number optimal. However, across dozens of economies over nearly one hundred years of "modern" theory regarding economics and finance, anything below that range seems to trigger contraction and anything above it seems to stimulate the host economy for two to three years before forces begin snowballing and prices skyrocket ahead of income triggering a decline on a different path.

More importantly, as mention earlier, inflation rates and interest rates both involve the same mathematical impact on financial calculations but they reflect different risks. In a world where prices are optimally stable and only growing at 2 percent yearly, it is very logical for a bank to charge an interest rate of 7% on a loan to a business. Why? Because the extra 5% between 2% and 7% is reflecting actual business risks the bank is accepting by loaning money to the business. This risk is distinct from changing price levels in the economy reflected by current inflation statistics. Obviously, high inflation rates might make a firm's product less affordable and thus increase its risk of defaulting on a loan. That could trigger a higher interest rate on a loan but in that case, a risky loan in an economy with 7% inflation might require an interest rate of 12% for the bank to lend.


WTH
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