Cullen’s View On….

Feel free to use the “Ask Cullen” section to ask a question on my views of certain macro or micro topics.  For instance, if you ask for my view on the gold standard I’ll provide a brief one paragraph answer here in this section.  This section is an attempt to condense some of the “Ask Cullen” questions into important subject matters that are easily accessible and condensed.  I’ll update this section as times goes on.

Investing in general:

I am a macro indexing advocate who believes in utilizing a cyclical and probabilistic based approach to implement a diversified and low fee approach to asset allocation .  That means I think it’s important to understand the financial system and potential future outcomes through the formulation of probabilistic forecasts, but I am not a highly active asset allocator.  I think that it’s important to understand Jack Bogle’s Cost Matters Hypothesis, but not at the detriment of understanding my Allocation Matters Most Hypothesis.  There’s little doubt that low cost index funds are the ideal instrument with which to allocate assets, but we should also recognize that the process of asset allocation is far more important in driving our future returns than merely cutting costs and frictions.

When we look at asset allocation and the global asset portfolio it becomes clear that the idea of “passive indexing” is a misnomer.  Indeed, we are all making active decisions when we deviate away from the global market cap weighting (and yes, we all deviate from global cap weighting because there is no financial product currently available the replicates the global cap weighting).  This makes us all active “asset pickers” to some degree.  Unlike some indexers I think it’s important to forecast the future to some degree and apply the appropriate asset allocation using a probabilistic forecasting methodology.  In my opinion, a superior understanding of the financial system and the monetary system can help one achieve this.

Economics In General:

I think that the field of economics has become too political and veered too far from understanding operational realities.  That is, it has become a pseudoscience as its practitioners have become too closely entangled by political interests and the biases that accompany it.  As a result, its practitioners have fotten away from viewing the world of money, finance and economics for what it is as opposed to what they want it to be.  Theory has trumped reality and as a result we have come away with a discipline that has been rendered far less useful than it otherwise could be.

I attempt to remove politics from my economic analysis as best I can and instead focus on operational understandings.  I try to view the economic system for what it is rather than focusing so much on what it can be.  This approach allows me to provide less biased and more empirically grounded analysis.

I wouldn’t describe myself as being aligned with any single “brand” of economics as I take many understandings from the different schools.  I do tend to lean towards the Post-Keynesians in many of my views though.

Politics in General:

One question I get a fair amount is about my personal politics.  I’ve always thought of myself as a fiscal political_compass-1-300x250conservative and a social liberal.  I like to think I am fairly open-minded to different perspectives and different people’s political views, but it helps to get an unbiased gauge on where things stand.  So I decided to take the Political Compass test.  According to this test I am a slight leftist libertarian which is pretty consistent with centrist views.  Pretty much what I would have expected.

Politics in Economics:

Many people claim you can’t separate politics and economics.  I don’t think that’s true.  I think you can understand the modern monetary system at its core operational roots and devise an understanding that is based primarily on facts rather than beliefs.  There are real truths in banking, finance, economics and the institutional design of the money system that should not be controversial, but remain hotly debated in economics due to competing ideologies.  The creation of Monetary Realism is an attempt to bridge that divide and establish a foundation for understanding the monetary system by taking the politics and ideology out of the discussion.

My View on…The Federal Reserve:

First, it’s important to understand why the Fed exists at all.  Long before there was a Fed system we essentially had rogue banking.  So you had a system where banks issued loans and payment settlement was extremely inefficient and at times impossible (for instance, in a crisis).  This created a very unstable banking system.  What the Fed’s creation did was sustain private competitive banking while establishing a stabilizing mechanism.  This was achieved through the reserve system which helped bring payment settlement all into one place, the interbank market.  Remember, an economy is really nothing more than a series of flows and payments are the most important element of this system.  If payments cannot be made and settled then the flow stops like the blood in the human body stopping.

This was not all that the Reserve System achieved though.  The Reserve system provided an independent body that was able to directly work with and stabilize the banks in numerous ways including monetary policy, regulation and playing a critical stabilizing role during crisis.  Perhaps the most important thing that the Fed system achieves is the private competitive banking system.   Though it’s clearly not perfect it’s far superior to the banking system of the 1800’s which helped lead the USA into SIX depressions in 100 years.

It’s important to understand how the Fed system helps to distinguish between the different types of money in our monetary system and the roles they play.  Banks issue inside money (credit) and the government issues outside money (notes, coins and reserves).  Outside money exists to facilitate the use of inside money, the dominant form of money in our economy.  The Reserve system streamlined the use of inside money as if the banking system were under one roof.  But importantly, it sustains private competitive banking.  The alternative to this design structure is going back to rogue banking or going full nationalization of banking.  One would destabilize the payments system and the other would result in the government managing the entire money supply thereby eliminating the competitive elasticity of money creation.  The fact that extremists on both the left and right are in favor of one or the other is likely a sign that the Federal Reserve System is actually a healthy compromise.  It might not be perfect (certainly in its implementation of monetary policy), but the design feature is very much a necessity given the complexity of our banking system.

For more on the purpose and functions of the Fed please see here.  

My view on…the gold standard:

As for the gold standard – well, I think its benefits are vastly overstated.  First, the gold linked money eras of the 1800s were associated with rampant economic turmoil with SIX different depressions occurring during the century.  But more importantly, in a global economy it’s an unworkable currency construct because of its inherent imbalances.

A gold standard or fixed exchange rate regime is basically what Europe has going on right now.  It’s a really horrible monetary construct that involves no floating exchange rates, a single currency, ties the hands of the government and results in persistent trade imbalances (oh, and results in depressions!).  See, Europe has no floating exchange rates because they all use the same currency.  And there’s no fiscal entity (like the US Treasury) that can offset the fiscal imbalances by distributing funds to those who need it.  No floating FX and no Treasury means the trade imbalances must be rectified through market pricing mechanisms.  The problem is, the market mechanism doesn’t work like all the gold bugs wish it did.  So the trade imbalances persist, the underlying economic imbalances persist and you get a result that’s a lot like Europe where depression basically makes itself nice and cozy.  This restrictive currency design is inherently unstable and reminds me of the thinking that stability creates instability.  It’s a total disaster and trying to go back to a  system like that is madness.

My view on…auditing the Fed:

As far as I can tell, they do get audited.

My view on…the USA going bankrupt:

The US monetary system is designed in such a manner so as to avoid having to ever “run out of money” at the government level.  That is, the banks are harnessed by the government to allow the government to always be able to procure funds.  In this regard, there is no solvency issue at the government level in the USA.  See here for more:

My view on…government spending & taxation:

From a budget perspective a tax cut is the same as a spending increase so much of this debate is political.  But it’s important to understand the details nonetheless.  The govt can “print” notes, coins, reserves and issues t-bonds. So in that regard it’s best to think of the govt as an important facilitator of liquidity and an issuer of some kinds of money.  We call these portions of the money supply “outside money” because they are created outside of the private sector.

But most govt spending is taking bank deposits (inside money because it is created INSIDE the private sector by private banks) and recycling them through the economy. So govt spending can be really useful when the economy chokes up because they eliminate the paradox of thrift in essence by creating a flow of funds (see here for more on this). So yes, most govt spending is just a circular flow taking from the private sector and redistributing it.  So, contrary to popular opinion, fiscal policy doesn’t actually increase the money supply.  It just redistributes it.

But deficit spending involves an important component in that it adds net financial assets through bond issuance which can make the pvt sector more liquid in various ways. That is, when the govt spends it procures funds from the private sector and recycles it into someone else’s account.  But it also credits the account of the bond buyer with a t-bond which adds a net financial asset to the private sector.

I generally prefer tax cuts over spending increases, but I am not ideological here.  It’s just that spending has a tendency to be poorly allocated so I generally prefer stimulus that allows the people to decide how they want to spend their money.  But I am certainly not against government spending, especially if it’s wisely implemented.

My view on….”The Job Creators”:

Late last year I explained the role of the entrepreneur in the capitalist economy.  In short, the entrepreneur seeks to provide superior goods and services that ultimately offer consumers a more efficient means of achieving some end.  This creates efficiencies which result in greater future consumption, economic expansion and more jobs in the future.  The example I’ve used in the past is Alexander Graham Bell, the inventor of the telephone.  When Bell invented the phone he destroyed thousands of jobs.  Messengers and telegram services were slowly defunct.  But Bell created efficiencies through making communication more convenient.  And in doing so he helped generate higher economic growth and ultimately more jobs in the future by streamlining what was once an arduous process – long distance communication.  Bell created countless jobs by creating this efficiency.  In this regard, capitalists, producers and innovators can be seen “job creators”.

But producers are nothing without consumers.  Bell’s telephone is nothing without consumers who want to use it.  So production and consumption are ultimately two sides of the same coin.  You cannot say that producers create jobs without consumers because without the consumers the producer has no revenue stream with which to expand his/her business and hire the workers that allow him/her to leverage the labor into future profits.   The capitalists need the consumers before they can ever consider expanding.  In this regard, demand is the driver of “job creation” and so consumers can also bee seen as “job creators” because they enable the capitalists to be able to hire in the first place.

So the answer to this silly debate is really rather simple.  The real “job creators” are the consumers AND the producers.

 My View on….China boycotting US Dollars and crashing the US Economy:

First of all, let’s go back to basics.  Why does China buy t-bonds in the first place?  Well, China runs a trade surplus with the USA.  So, China sends us pieces of plastic and other cheap goods and services and we send them pieces of paper (or electronic credits if you prefer).  These pieces of paper ultimately end up at the Chinese Central Bank when they are converted from USD to RMB.  So, this all starts because China likes obtaining US Dollars.  Why is this?  Because China generates a huge amount of domestic employment and domestic investment thanks to this continual business coming from the USA.  The USA, in return, gets cheaper goods and services.  It seems like a fair trade for all involved (although the real debate here is whether that’s actually true in the long-run).

So, China wants USDs in the first place.  In fact, China needs USD’s because their economy remains one that is largely built on export growth (thought that’s changing to some degree as time goes on).  So these USDs ultimately end up at the Chinese central bank.  So what can they do with them?  Well, they can either use them to buy something of relative value denominated in USD (like t-bonds or other assets) or they can use the dollars to defend the exchange rate (which China does by pegging the RMB to the USD).

So, long story short – China’s trade strategy directly contradicts anyone who says China is rejecting the USD.  No, they want USDs.  They need USDs.  They enjoy many benefits from obtaining USDs.  And they use many of these USDs to manipulate their exchange rate to keep MORE USDs flowing in.  If China doesn’t want to buy t-bonds then who cares?  If they want to let those pieces of paper sit around collecting dust then great.  That’s less interest we need to pay them!  Also, anyone who understands how a US Treasury auction works knows that indirect bidders are marginal buyers and that the Primary Dealers can ALWAYS take down the entire auction.  So, ignore all this fear mongering about China rejecting the USD. It’s not happening.  And due to China’s growth strategy, it would be against China’s best interest for it to happen.


Cullen Roche

Cullen Roche

Mr. Roche is the Founder of Orcam Financial Group, LLC. Orcam is a financial services firm offering research, private advisory, institutional consulting and educational services.

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