Banknotes Require Two Levels

 I have finally discovered a proper anti-libertarian market need. Turns out the usury freaks aren't totally out to lunch. 

 I dunno if I'm simply stupid today or if this one was really mind-bending, but wow my mind had to pretzel itself. Took real work.

 Banks must be artificially prevented from loaning out their banknotes. This should be done by printing two kinds of notes: the demand deposits, and the loan papers. Fiat currency has to work the same way, with gold-standard notes in exchange for gold-demand notes.

 Image a bank with 100 gold. It loans out 10 notes. It has 90 gold and an IOU on 10. Nonfractional reserve: it can still loan out 90 gold. Then the debtor spends the notes, and whoever they spent it on deposits the notes at the bank. Now it has 90 free gold, an IOU on 10, and 10 banknotes. Can the bank now offer a loan worth 100 gold? No, it has to stay at 90, or it will be double-spending the gold. The 10 banknotes here have to be specifically loan paper notes, so the bank knows it's not allowed to re-lend them. When the loan is paid back the loan papers have to be effectively destroyed and replaced by demand notes.

 Note that in a proper system, you can't back loans with demand deposits. The customer must explicitly allow the deposit to be turned into a bill or certificate or whatever they call it. This doesn't have to be exogenously forced, however, the government merely has to avoid irresponsibly enabling financial drug use. (So, ban taxes.) When the guy with ten gold came in, he was given demand papers. The part that has to be compelled is next: he gave the demand paper back to finance a loan, which goes out as loan paper. He can also take the demand notes over to a different bank and back a loan there instead. The demand paper is functionally identical to gold, but the loan can't be.
 Rather than a bank 'having' 100 gold in the vault, it would have 100 gold it was instructed to find an investment for. Rather than being 'able' to offer a 90 gold loan, it must offer that loan. The bank would have no free demand paper and 100 loan papers.

 If it's allowed to re-loan the notes, it will cause debts to multiply beyond the supply of gold. It's inflation, even with unitary reserve. 

 For ease of imagination, now consider one singular bank with all the money in the country, 100 gold. It makes a 100 gold loan. It's re-deposited, and loaned out again. Now the bank is owed 200 notes - of which only 100 exists. In this case it doesn't matter if it's re-loaning demand notes or if it's loaning the gold out directly. Whichever debtor pays back the loan will force the other into default. 

 If the bank isn't the only bank in the country, it can't know whether deposited papers are a transfer from a different bank, or simply the loan returning, unless they're specifically loan-marked notes.

 The forced default is a way of seeing the gold has been spent twice. Someone earned the gold and deposited it. The first guy spent it on their behalf. The second guy spent it again, but without any new production. More money, same goods => inflation.

 The 200 gold of debt is a way of seeing that the effective supply of gold has doubled. 100% inflation.

 

 Note this isn't a public "good," it's merely preventing a public bad. If you can loan out loan paper, the bank has a public costs private profit scheme. Inherently irresponsible. Turns out counterfeiting is a crime no matter how cleverly you make it look and feel benign.  

 If a bank refuses to behave, you have to immediately economically isolate it from your economy. Ban their notes. Nobody is allowed to sell goods for those notes.

 Under fiat currency I suppose you could centrally plan the loan supply. Have one entity responsible for all loans, keeping track of the absolute amount and keeping it below whatever ceiling they happen to decide on. Seems extremely stupid to me, but it's not impossible. The stupid: because the loan entity can't ever spend the money, it will just be fiat inflation and fiat deflation. Deliberately destabilizing prices for the sake of...paper money. 

 So, yeah. Print two kinds of notes. Gold-standard notes can be deposited as investments, and back the loan paper. Though, as always with fiat money, good luck getting the government to behave.

 

 When someone defaults on the loan, the bank must buy loan notes using collateral and give them to the original depositor, who can either re-up the loan or retrieve their gold or demand notes. (Same with fiat and gold standard notes.) Absolutely no printing new loan notes to achieve this.

 Mind that if someone demands their physical gold, the associated demand notes must be destroyed or at least tamper-evidently locked away. 

 Likewise foreigners can't be allowed to loan your money if you can't control their loaning rules. Simply ban the relevant parts of their trade if they try it. Don't let your money enter or leave their country. If any third party accepts your notes from that country, ban them too. 

 Perhaps this whole banknote thing is ultimately more trouble than it's worth. Just have gold coins. Wrap 'em in epoxy for durability. Yeah there's issues and inconveniences but it's better than having to Iron Curtain your country just to stop illicit currency smuggling.  

 P.S. A sound money system almost has the same issue as BTC. When notes are lost or destroyed in e.g. fire, residual gold gets stuck. Paralyzed, just kinda clogging up the vault. Owned by entropy. Likewise the total quantity of BTC in circulation will decline continuously as keys are lost in one way or another. 

 However, gold banks have the option to re-print their notes and replace all old notes with new ones. The gold that isn't claimed can be kept by the bank as part of their operating profit. 

 P.P.S. Money as debt. When someone creates a good, they impose a debt on society, which marks this debt with, ideally, gold. When someone else produces something, the first creator can call this debt using their gold, settling their account, but creating a new debt for the second creator. Production and consumption are asynchronous.
 When a bank loans something out twice, no actual debt was incurred the second time. Hence, inflation. The first guy loaning out his money is transferring his debt to someone else, in the hopes of being paid back an even bigger debt. Since he's giving up his ability to command consumption, that's fine. Net consumption commanded stays the same.
 However, properly arranged, the bank can't use bank notes as investments. It has to be a demand deposit.