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Lessons From the Newest Electronic Money – Bitcoin

One of the more interesting developments of the modern electronic age of money has been the rise of Bitcoin, a decentralized digital form of money.  If you’re not familiar with it or you’re confused by what Bitcoin is, you’re not alone.  It’s a fairly new, innovative and complex form of money.  And that’s right, Bitcoin is definitely money.

Today’s Dominant Form of Money Versus Bitcoin

Anyone who understands the basic tenets of Monetary Realism know that many things can serve as money and many things DO serve as money.  After all, anyone can create money, but the trouble is in getting others to accept it.  And since money’s primary purpose is in the means of exchange, just about anything can serve as money as long as it meets that primary purpose.  The thing is, there aren’t all that many things that meet that need on a broad level.  For instance, lots of people like to claim that gold is money (which it is), but gold isn’t accepted for payment in many places.  Therefore, MR says that gold has a low level of moneyness (to better understand the concept of moneyness please see here).  Gold is money, but it’s just not a very good kind of money.  Bitcoin is actually very similar.  If you have Bitcoins you can buy certain things online that only a Bitcoin merchant will allow you to buy.  These merchants accept Bitcoins as a form of final payment.  To them, it’s a form of money with a very high level of moneyness.  But to a company like Wal-Mart a Bitcoin is like a gold bar.  It doesn’t give you access to anything in their store therefore its moneyness is virtually nil in a Wal-Mart.  Most retailers around the world view Bitcoins similarly.

In the USA, the primary form of money is bank deposits because bank deposits are the form of money that dominate the US payments system.  The US payments system, which is maintained by private banks, is the primary playing field for the purpose of exchanging goods and services.  In other words, if you want access to the most convenient and widely accepted form of payment (bank deposits), you need to become a member of the US payments system usually by becoming a bank client.  This gives you access to credit cards, debit cards, a bank account that allows you to withdraw/deposit cash, etc which allows you to interact on the US payments system.  Becoming a bank client is kind of like opening a Ticketmaster account so you can obtain access to the means of exchange to gain entry into a theater performance (you just want access to the tickets that give you access to a performance).  In the case of banking, you open an account in order to gain access to the US payments system so you can access the performance that is the US economy.  Obtaining Bitcoins is similar in many ways, but very different as I’ll describe below.

Bitcoin is a Truly Endogenous Decentralized Form of Money

Bitcoin is very different from bank deposits.  The US payments system is overseen and regulated by the US government.  In other words, the government has deemed the US dollar as the unit of account in the USA (in other words, money is denominated in US Dollars in the USA) and the government has given private banks the unique privilege to control and maintain the creation of the bank deposits (denominated in USD) that populate the payments system they operate.  This system isn’t decentralized (even though it’s controlled primarily by private entities) because it is regulated by the US government.  Bitcoin, on the other hand, is entirely decentralized, unregulated, etc.

Decentralization could be both good and bad for Bitcoin.  I think there’s a certain missing element of trust in an online money that has no oversight.  One of the key ingredients that stabilizes and maintains the US payments system is the backing of laws that enforce and regulate the proper use of bank deposits.  Banks can’t just issue deposits (loans) without working within the regulatory structure of US government law.  And the users of bank deposits can’t use this payments system for things that the US government might deem inappropriate.  When you legally exchange goods and services on the US payments system there is a certain level of trust derived from the fact that you have a legal system protecting your rights to use that system in a particular way.  In other words, the government helps embed a certain element of trust within the system by ensuring that its users operate within strict guidelines and by providing those users with certain protections against fraud, misuse, etc.  It’s by no means perfect (some might even argue the government has too much control over the laws binding the payments system), but having an institutionalized form of money helps to solidify the trust that is one component of its viability.  Bitcoin has no such integrated legal protections or oversight, which is both liberating, but worrisome in some regards.

Bitcoin is also interesting in that it circumvents the banking system.  In the US banking system money is created as debt in the form of loans which create deposits.  This means the money supply in the USA is market based (created by banks who compete for the demand for loans), but it’s debt based AND can therefore be costly to utilize.  In other words, you have to “pay to play” within the US payments system.  By decentralizing their payment system, Bitcoin is able to reduce the costs associated with money.  They’re also able to create money that is not directly tied to debt.  This is both innovative and liberating.

One of the more interesting elements of Bitcoin is its rise as a purely endogenous form of money.  I often refer to bank money as endogenous in that it is created entirely INSIDE the private sector, but even bank money exists on a centralized system (the US payments system) that is regulated by US government law.  But Bitcoin is completely decentralized and a purely endogenous form of money.  So the decentralization creates a form of money that has grown entirely independent of government and its taxes.  In other words, Bitcoin proves that money can exist ENTIRELY for the private purpose for the means of transaction. This not only shows that money can be entirely endogenous and independent of government, but that it can also grow entirely independent of government taxation.

The Bitcoin Money Supply and the K-Percent Rule

Bitcoin’s money supply is also automated.  It kind of reminds me of Milton Friedman’s k-percent rule to automate the growth of the money supply.  I won’t get into the way the Bitcoin money supply is automated because the computer based growth is WAY over my head, but all you really need to know is that it’s not controlled by a central bank or any bank at all.   This is a very interesting approach to managing the money supply.  The innovative thinking and creativity behind this concept should be embraced and explored further as money evolves in the future.

Where Does Bitcoin go From Here?   

Bitcoin is an extremely interesting and innovative concept that shows that money can be entirely endogenous and exist entirely independent of government.  But can it be sustained within our economy without the laws that help bind money as a social construct?   Can the element of trust be borne into such a decentralized digital money?  And more importantly, is this form of decentralized digital money inherently at odds with the existence of a money system and economy whose primary payment system exists on a government regulated and government taxed playing field?  Call me hopeful, but skeptical.

I think the innovation and creativity behind Bitcoin is brilliant.  It’s an incredibly cool and forward looking form of money.  But money is a social construct and within any nation that social construct is designed in such a manner that it serves primarily private purpose, but ALSO public purpose.  In other words, without a system of taxation attached to that money it is at odds with one of the essential components of money as a social construct.  After all, it is through taxation that public purpose is generated so a money system that is entirely for private purpose could be seen as being at odds with one of the main purposes of money.  The US government organizes and institutionalizes money within the government regulated banking system so that it can maintain a private market based money system that has strict oversight and tracking.  This not only allows for enforcement of rules and regulations, but also helps the government ensure that this money can be used for public purpose.  A truly decentralized form of money like Bitcoin has no such government attachment allowing for any form of public purpose.

I think Bitcoin can continue to exist as a subordinate form of money with a very low level of moneyness, but if Bitcoin were to grow to a point where it becomes a highly competitive form of money, but circumvents the laws, regulations and taxation of a system like the US banking system, my guess is that the US government will make it illegal for merchants to receive Bitcoins for payment.  And then 100 FBI agents get a few thousand Bitcoins each, buy something from US based Bitcoin merchants and parade them out on national TV for the entire nation to see why Bitcoin acceptance results in a $250,000 fine and 5 years in prison.  In other words, Bitcoin could very well become a victim of its own success as the US government would never allow another form of money to detract from public purpose due to high levels of monetary competition.  Of course, I am referring to the US government, but this view would likely be embraced by many governments around the world.

So Bitcoin is an interesting and extremely innovative form of money, but probably not a viable form on any grand scale since its inevitable competition with the US banking system will likely render it at odds with the goals of the US government.  I know the anti-government and anti-banking crowd won’t like that conclusion, but that’s how I view it.  A purely private purpose money is at odds with the formation of money as a social construct that partially serves public purpose as the US banking system does.

Hopefully, Bitcoin will continue to exist on a smaller scale so we can see how this de-centralized, electronic, innovative and forward looking form of money evolves.  There is much to be learned here and I think the US government should proceed with caution regarding any potential clamp down on this money system.  While we wouldn’t want the Bitcoin money system to detract from public purpose I think it is useful and educational to see how this form of money evolves and takes form over time.  But I worry that the party could come to an end as soon as the US government recognizes it as a very real threat to the US banking system and the payment system it regulates in the means of public purpose.


Understanding Inside Money & Outside Money

Understanding the Modern Monetary System

*  It’s more accurate for me to describe Bitcoin as being endogenous up to its fixed level at which point it becomes a purely exogenous fixed money supply.  

Some Thoughts on the Future of Home Prices

I was reading this report from Zillow on the future of home prices and it got me thinking about some of the macro trends in real estate.  I’ve turned much more constructive on housing in the last year than I had been for the past 5-6 years.  Before about 12 months ago I wouldn’t have told anyone to purchase a home in the USA, but about a year ago I started saying:

“If you’re planning on living in a house (as in, 10 years of actually living in a home) then you should have no great fears about buying today.”

Admittedly, the year over year surge in home prices has been greater than I expected, but the halt in price declines doesn’t surprise me at all.  After all, we’ve fallen 30%+ from the peak in many areas so the risk/reward structure of the real estate market has shifted favourably for buyers.   But I do worry that the misconceptions regarding housing persist as this quote from the Zillow report implies:

“We’ve just finished compiling our Q1 2013 Zillow Home Price Expectations Survey (ZHPES), where professional forecasters provide predictions for housing market growth in the near term. This survey marks a break with the past in that the survey benchmark is now the national Zillow Home Value Index rather than the Case-Shiller index. The prediction for appreciation in 2013 is 4.6 percent, with the lowest projection at 3.5 percent depreciation and the highest at 8.5 percent appreciation. This edition of the survey was compiled from 118 responses, including the projections of economists, market and investment researchers and real estate experts.

It’s also interesting to break up the market by growth periods to compare historical annual average rates to expectations, as done in Figure 2 above. Covering expectations for annual average growth to the end of 2017, the average of all respondents, at 4.1 percent, is above the pre-bubble average of 3.6 percent. Indeed, the optimists, on average, seem to expect the recovery to continue modestly picking up speed. And while on average the pessimists expect things to slow, it would not be too far below the pre-bubble average.”

Real estate returns are not rocket science.  Because they’re such a huge portion of the consumer balance sheet they tend to be tied very closely to wage growth.  Wage growth, by definition, is very closely tied to the rate of inflation.  That explains why the long-term historical return of real estate is roughly in-line with the rate of inflation.  But this survey from Zillow shows that real estate “investors” are probably still too optimistic.

I’ve compiled the same data using the Case Shiller nominal price index in figure 1 below.  US real estate has averaged about 3.7% since 1890.  That’s just a tad above the average historical inflation rate of 3.2% in the USA.  When I started calling housing a bubble back in 2005 it was largely due to this one simple mathematical reality – house prices cannot deviate from wage growth in perpetuity.  So when Robert Shiller started posting his famous inflation adjusted house price chart (figure 2) all over the place it should have sent us all into a worried frenzy.  But it didn’t for some reason.  Instead, most people shrugged it off and it directly contributed to one of the worst economic calamities in US history.

Looking forward, I wouldn’t expect house prices to break their bubble peak until about 2025.  Figure 1 shows the historical Case/Shiller data with Zillow survey results.  The most probable scenario (historical average) assumes a real return of about 0%.  But the average respondent to the Zillow survey expects 4% nominal growth.  That sends us back to new highs by 2022.  That’s not terribly unreasonable.  But the most optimistic real estate investors are expecting something closer to bubble-era nominal growth of 6% per year.  That gets us back to the bubble peak by 2019 and sends us shooting 41% over that level by 2025.  That’s just not realistic and not sustainable in any way.

Of course, the future won’t play perfectly to the averages or even my practical assumptions.  It’s entirely possible that the Fed’s implicit asset targeting approach will veer us closer to something like the “most optimistic” scenario.  Combine that with the broadly held myth that housing is a good “investment” (it’s actually a crappy investment in terms of  real, real returns) and we might have all the ingredients for the highly unusual post-bubble bubble.  I for one, hope prices stagnate with inflation rates and basically move sideways per the Case-Shiller chart, but I’d be lying if I didn’t say I am getting at least moderately worried about the impacts of the Fed’s policies at present.  It’s way too early to start declaring this an environment consistent with a disequilibrium like 2005, but we should be proactive thinkers, not reactive like our friends at the Fed.

(Figure 1 – Housing Scenarios via Orcam Research)

(Figure 2 – Real House Prices via Orcam Research)


Deficit Hypocrisy

I was watching this video on Yahoo Finance this morning with Jim Rickards of Austrian economics fame.   He calls the low interest rate policy of the Fed a “tax on savers”:

“[Interest payments] would have gone into the pockets of savers so they could invest and spend – people rely on it for their retirements.  This is looting savers.”

But there’s a contradiction in his commentary.  Rickards has stated that the “Obama deficit” is making things worse.  In an article last year Rickards wrote:

“Citizens who insist that government stop talking about cuts and start the actual process of cutting spending now have got it right.”

The problem here, is that the Fed’s zero interest rate policy has substantially reduced government interest payments.  In other words, if the Fed raised rates on government debt you’d start earning a lot more on your savings because all those retirees who own US government bonds would instantly start getting a government subsidy via the interest payments.

Interest outlays are part of the annual budget deficit.  For instance, at present, the government pays about $225B a year in interest outlays.  That’s about 1.4% of total debt with the current interest rate structure.  Let’s say the government decided to raise interest rates structure to something equalling 4% of total GDP.  That means the government would be paying total interest outlays of about $600B a year.  That’s almost $400B+ more per year for savers to “invest and spend”.   That’s a lot of money.  And it’s a significant rise in the government’s budget deficit since the interest outlays are a cost to the US government.

So, Rickards is contradicting himself here.  He wants higher interest payments so savers stop getting “looted” and a lower government budget deficit at the same time!   So which is it?  If you want higher interest rates on government debt (which makes up a huge portion of private saving since most of the government’s debt is owned by retirees, pension funds, etc) then you’re implicitly in favor of more deficit spending.  You can’t have it both ways here Austerians….

The Inherent Fragility of the “Wealth Effect”

You probably thought the boom/bust cycle experiment that started with Alan Greenspan was over when Ben Bernanke came to the Fed.  Or maybe you weren’t that naive to begin with. Either way, Bernanke is implementing very similar and in my opinion, dangerous economic policy.

When Greenspan was head of the Fed, he made it well known that the stock market was a favorite target of his.  This became known as the “Greenspan Put”.  This was the levitating effect of stock prices that placed a “put” or floor under the equity market.  Greenspan was even more explicit a few weeks ago when he said:

“the stock market is the key player in the game of economic growth.”

I believe this is an incredibly misguided view of what the stock market is.  The stock market is a secondary market where SAVERS exchange shares of stock in what is nothing more than an allocation of their savings. The price of those shares reflect the GUESSES of future expected cash flows.  And as we all know, what you have in stock market gains is not real until you cash out of the game and exchange your shares with someone else.  Of course, everyone can’t cash out of the game at the same time since all shares issued are always held by SOMEONE.  So there’s an inevitable bagholder if the you-know-what hits the fan.  There is no escaping that simple fact.

The risk of course, is that a stock market has the inconvenient truth of both a “poverty effect” as well as a “wealth effect”.  Owners might feel better off if shares increase in value.  But owners feel just as poor when they decline.  Of course, if you can keep it going in one direction it’s like a good ponzi scheme.  But if the shares deviate from their underlying fundamentals and a disequilibrium occurs you’re asking for big time trouble from an inevitable “poverty effect”.  It ripples through the economy as stocks take the stairs up and the elevator down when panic sets in.  Anyone whose been awake during the last 15 years knows how that feels.

The danger here is the illusion of real wealth where there is only nominal wealth.  And that illusion appears to have at least some impact on spending.  As you can see in the following chart (figure 1 via Orcam Financial Group), the personal savings rate is inversely correlated to stock prices.  So, the increased wealth makes savers feel better off temporarily and then when the air comes out of the market those savers suddenly realize that their stock portfolio is just an allocation of their savings and they stop spending as the poverty effect kicks in.

There doesn’t appear to be any question that such a strategy can work in brief periods of time.  But the question is whether we should be designing policy around such an inherently fragile part of the economy (stock prices).  More importantly, we should ask ourselves whether a policy of targeting stock prices will create a disequilibrium where stock prices become detached from their fundamentals and create the illusion of a saver who is wealthier than he/she really is.

Me, I prefer to let prices float as they will and implement policy that actually helps the underlying corporations.  If I were running a public company I wouldn’t waste my time talking up my stock price.  I would run the corporation to maximmize earnings per share.  Global central banks obviously think this is nonsense.  And so the whole stock price targeting theory reeks of ponzi finance and putting the cart before the horse.  Of course, no one can know when the boom turns into the bust, but it appears as though this sort of policy substantially contributes to the bust when it does occur.   And that’s where we are.  We are in the boom phase.  The bust will come (just as it always does) and when it does we’ll likely all turn to the same institution who helped the boom get out of control in the first place.

(Figure 1 – Personal Savings Rate vs SP 500)

Understanding Moneyness

This section will be a new addition/clarification to my paper on Understanding the Modern Monetary System.  

Modern forms of money are largely endogenous (created within the private banking system), but are organized under the realm of government law.  The specific unit of account in any nation deems what money will be denominated as.  The government therefore decides the unit of account and can restrict/allow certain media of exchange.  The unit of account in the USA is the US Dollar.  Organizing money under the realm of law increases a particular form of money’s credibility in the process of transaction.  The government also helps oversee the viability of the payments system and can decide what can be used within that payment system as a means of settlement.  In the USA the primary means of settlement are bank deposits and bank reserves.  Therefore, these forms of money serve as the most widely accepted forms of payment within the money system.

There are different forms of money within any society and they have varying forms of importance and “moneyness”.  Moneyness can be thought of as a form of money’s utility in meeting the primary purpose of money which is as a medium of exchange or a means of final payment.

In the USA the money supply has been privatized and is dominated by private banks who issue money as debt (which creates bank deposits).  Banks are granted charters by the government in the USA to maintain the payments system in a market based system.  Banking is essentially a business that revolves around helping customers settle payments.  So it’s helpful to think of banks as being the institutions that run the payments system and distribute the money within which that system operates.  Outside money (or money issued OUTSIDE the private sector – notes, coins and reserves) plays an important role in helping facilitate the use of the payments system, but primarily plays a supporting role to inside money (money created INSIDE the private sector such as bank deposits) and not the lead role.

Outside money could theoretically serve as the most dominant form of money in the system (for instance, if the government did not choose to use bank money to spend, but instead chose to simply credit accounts by issuing money directly), but takes a back seat to inside money by virtue of design.  That is, outside money always facilitates the use of inside money by serving as a support feature for inside money.  Cash, for instance, allows an inside money account holder to draw down their account for convenience in exchange.  Bank reserves help stabilize the banking system to serve interbank payment settlement.  These are facilitating roles to inside money.  Therefore, we place inside money as having the highest level of moneyness in the monetary system.

Inside money and outside money, however, are not the only types of money that exist in the money system.  It is helpful to think of money as existing on a scale of moneyness where particular forms of money vary in degrees of utility (see figure 1).  As Hyman Minsky once stated, anyone can create money, the trouble is in getting others to accept it.  Getting others to accept money as a means of payment is the ultimate use of money.  And while many things can serve as money they do not all serve as a final means of payment.

Since currencies are fungible on a foreign exchange market most foreign currencies have a moderately high level of moneyness. For instance, a Euro is not good in most stores in the USA, but can be easily exchanged for US Dollars of various forms.  SDRs and gold, which are broadly viewed as universal mediums of exchange, can be viewed similarly though they vary in degrees of convenience for obvious reasons.  Gold for instance, is widely viewed as money and can be easily exchanged for money, but is not widely accepted as a means of final payment.

Most financial assets like stocks and bonds are “money like” instruments, but do not meet the demands of money users in terms of having high liquidity or acceptability as a means of final payment.  These financial assets are easily convertible into instruments with higher moneyness, but are not widely accepted as a final means of payment.  Therefore, their “moneyness” is relatively low.

Lastly, most commodities and goods are low on the scale of money since they are unlikely to be accepted by most economic agents as a means of final payment.

(Figure 1 – The Scale of Moneyness)

On CPI and Owners Equivalent Rent

I noticed this story on Owners Equivalent Rent on the Atlanta Fed’s blog today.  It discusses the rationale behind using what the Bureau of Labor Statistics calls “Owners Equivalent Rent” in their CPI calculation.   Specifically, they say:

“This begs the question: In light of the recent strength seen in the housing market—and notably the nearly 10 percent rise in home prices over the past 12 months—are housing costs likely to exert more upward pressure on the CPI?

Before we dive into this question, it’s important to understand that home prices do not directly enter into the computation of the CPI (or the personal consumption expenditures [PCE] price index, for that matter). This is because a home is an asset, and an increase in its value does not impose a “cost” on the homeowner.”

The BLS says housing is not consumption, but investment so they don’t include it in the CPI calculation.  They rationalize this thinking by stating not only that housing “does not impose a ‘cost’ on the homeowner”, but also that “House prices frequently appreciate; in this respect they differ from consumer durables such as vehicles.”  These two statements are highly misleading.  Let me elaborate.

First of all, most houses are definitely depreciating assets.  From the second you build a new home someone else is building the same home with more innovative and updated technologies.  The primary reason why homes don’t decline in value is because the land appreciates in value and the home is frequently updated (in addition to other reasons).  This is a real cost to the homeowner over the life of the house.

The other substantial cost in “owning” a home is the mortgage.  Most of us do not buy our homes outright and the mortgage imposes a massive cost on the homeowner.  The word mortgage is derived from the latin meaning “death contract”.  Not only is mortgage debt the largest portion of consumer debt (approximately 75% of all debt), but it also accounts for about 75% of the cost of the home over the life of a standard 30 year mortgage (ie, you will pay about 75% of the cost of the home in interest ALONE over a 30 year period).  In other words, a mortgage is a lot like consuming your home bit by bit.  Taken together, the mortgage and the upkeep of homeownership are substantial costs that most people simply don’t include in their total return calculations of real estate prices leading them to say silly things like “house prices frequently appreciate”.    But the BLS completely ignores this by using their Owners Equivalent Rent calculation.

This was clearly a problematic view during the last 10 years when the real cost of a home caused huge problems for the economy as mortgage resets were one clear cause of the balance sheet recession.  Had we been paying more closely to house prices we might have noticed a disequilibrium in the economy a bit sooner than we did.  But the Fed and the BLS were focused largely on OER and thus a benign looking CPI reading.  My adjusted housing price index is far from perfect, but were we using something like this in conjunction with the CPI I think we would have had a much clearer picture of the potential problems in the economy and the supply imbalances that were potentially creeping into the housing sector.  Instead, this flawed view of the consumers most important asset price helped lead us blindly right over a cliff.

(Chart via Orcam Financial Group)

Why Recession Forecasting Matters….Still

Last October I wrote an important Orcam Research piece that described why recession forecasting can make a big difference.  Not only are recessions important in understanding future policy (since high unemployment tends to result of recession, but from the perspective of portfolio management, recessions tend to be when the worse loss of capital occurs.

Now, if one is able to build a cyclical model that helps decipher when recession probabilities are high, you can protect your portfolio from the periods when the market is at the highest risk of resulting in a permanent loss environment.   Likewise, calling a recession when one is unlikely to occur, results in being out of the market during a strong likelihood of gains.  Obviously, anyone who has been out of the market over the last few years has suffered from this.

Anyhow, it was nice Bill McBride at Calculated Risk elaborating on this point in a weekend post.  Like me, he was not calling for a recession in 2011 or 2012.  I call this “getting the direction of the tide right”.  In the macro world, if you get the direction of the tide right you’re very likely to look like a pretty good swimmer.

Anyhow, here’s more from Bill (via Calculated Risk):

“Imagine if we could call recessions in real time, and if we could predict recoveries in advance. The following table shows the performance of a buy-and-hold strategy (with dividend reinvestment), compared to a strategy of market timing based on 1) selling when a recession starts, and 2) buying 6 months before a recession ends.

For the buy and sell prices, I averaged the S&P 500 closing price for the entire month (no cherry picking price – just cherry picking the timing with 20/20 hindsight).

The “recession timing” column gives the annualized return for each of the starting dates. Timing the recession correctly always outperforms buy-and-hold. The last four columns show the performance if the investor is two months early (both in and out), one month early, one month late, and two months late. The investor doesn’t have to be perfect!”


Lessons From a(nother) Fund Collapse

I saw this story over at Josh Brown’s site about an “apple only hedge fund” that has apparently imploded.  These sorts of stories are nothing new, but it does get frustrating to see how people keep falling for these sorts of investment schemes.  And yes, they are schemes because they can’t deliver what they promise.  This doesn’t mean the fund manager is always a bad person or that they have malicious intent, but it often means they don’t have a sound understanding of portfolio construction or they don’t fully understand the role that savings/investment plays in your life.

I try to teach people who work with me through Orcam that their savings is not a replacement for their primary income source.  In other words, the savings you generate from your primary source of income is a repository.  You can gamble with it.  You can blow it all on booze and women/men if you want.  But like most of us, you need to protect it.  But too many people reach.  They get greedy with these funds.  Or they fall for the usual Wall Street sales pitch that they can/should beat Warren Buffett.  You know, if you don’t “beat the market” you’re a loser.  The truth is, most of us don’t need to “beat the market”.  We need to max out our primary income source and protect the savings repository in a manner that achieves one thing:

  • We need to allocate our savings in a manner that protects us from the loss of purchasing power and the risk of permanent loss in a manner that is consistent with positive risk-adjusted returns.
I’ve discussed this in more detail in an Orcam research piece titled “The ‘Investment’ Myth”.   When you start reaching out on the risk curve with your savings in a scheme that isn’t truly “investing”, but is actually an allocation of savings, you become susceptible to putting too much of your savings at risk in the type of allocation that could cause severe personal hardship.  And most of us don’t realize that this “investment” is actually your life’s savings until too much of it is gone.

There’s a place for true “investment” in all of our lives.  Most of us only truly invest in ourselves and don’t actually invest in anything else (except maybe your kids or the people you love).  But understanding proper portfolio construction is all about understanding the difference between savings/investment and designing portfolios that don’t put you in front of the permanent loss steam roller….

Stanley Druckenmiller is Very Worried About US Government Debt

Stanley Druckenmiller, the great money manager who made a fortune trading with George Soros and running his own firm thereafter, is on a media blitz regarding the trajectory and sustainability of US government debt.  He claims that a crisis far larger than 2008 is on the horizon.  I wasn’t going to comment on this piece in the Wall Street Journal from a few weeks back, but I can’t seem to turn on the TV or pick-up a newspaper without seeing similar pieces or interviews by Mr. Druckenmiller.

I should start by saying that it’s clear that Mr. Druckenmiller is a great macro investor.  But I am fairly confident that he’s misinterpreting a few things here.  First of all, his WSJ piece sends up a few red flags.  For instance, the piece says:

“First, the country’s existing entitlement programs are not just unaffordable, they are also profoundly unfair to those who are taking their first steps in search of opportunity.”

Unaffordable is an unfortunate way to describe this.  Let’s remember how the US monetary system is designed.  In this country, government spending is ALWAYS a redistribution of existing money.  Our money system is designed around banks who create almost every dollar in the economy.  If you want to call something “money printing” you should call the loan process “money printing”.  The government is what Monetary Realism refers to as a “strategic currency issuer” in this system.  That is, it is a self determined user of bank money, but never has a problem procuring funds.  When the government taxes you they take Peter’s bank money (inside money because it’s created by banks INSIDE the private sector) and redistributes it to Paul.  When the government deficit spends (spends in excess of tax receipts) it gives a t-bond to Peter who gives the government inside money and the government redistributes the inside money to Paul.  The private sector has a net financial asset in the form of the t-bond (that is, there is no corresponding private sector liability), but the amount of actual inside money is exactly the same after deficit spending as it was before.  It just got redistributed.

Is this process of taxation and deficit spending “unaffordable”?  It’s only unaffordable if you believe that the government will run out of its ability to tax or deficit spend.  Of course, the tax system could collapse, but that’s only likely in a hyperinflation, which is a highly unlikely scenario in the USA due to huge amounts of output and continually weak aggregate demand (in addition to a lack of real money printing by banks, ie, we’re in a balance sheet recession still).  The US government’s ability to sell bonds is also not at risk for several reasons.  First, the Primary Dealers are required to make markets in US government debt.  If they want to be in the Primary Dealer system and reap the rewards of the system, they have to abide by the rules.  The only situation in which they might revolt against the US government is in a hyperinflation, which is unlikely.  The Dealers are always able to sell these bonds because of the attractiveness of US government paper.  That is, in an environment where asset risks and economic growth remain high, anyone with a 0% interest bearing savings account is clamoring to find any interest at all.  Long bonds, which yield just over 3% and provide a risk-free return (aside from loss of purchasing power) look pretty good in comparison.  So, the ability to procure funds is never an issue except maybe in a worst case hyperinflation scenario.

In addition, the US government always has a rescue valve if it should ever need money.  As a strategic currency issuer the US government can always call on its central bank to create the money it needs.  Some foreign governments (such as Canada) already have central banks buying bonds in the primary market (as opposed to the secondary market as the Fed does).  So a debt that is denominated in a money you can theoretically create, does not create a solvency risk.  But of course, there’s no free lunch here.  The US monetary system could certainly fall victim to inflation risk and credit disequilibrium.  But these are very different problems than not being able to “afford” something in the sense that I cannot afford to buy 10 Ferraris today.

He goes on to mention the national debt clock, which is a fearmongering tool of epic proportion:


Second, while many in Washington pay lip service to the long term, few act on it. The nation’s debt clock garners far less attention than the “fiscal cliff” clock.

But what about the national wealth clock?  The US private sector has amassed a net worth of over 65 trillion dollars.  Why does no one ever point that out?  We are a phenomenally wealthy country.  The national debt is a piece of the private sector’s overall net worth (those savings bonds represent a big piece of grandma’s saving).  So we have to keep this conversation in perspective.  The national wealth substantially dwarfs the national debt.

Could government spending “water down” the private sector’s ability to produce growth, possibly increase inflation and cause disequilibriums in the US economy?  Yes.  I am not saying that there is no potential ill-effects of government spending.  But the question of “affordability” and debt needs to be kept in the proper perspective.  The USA has an inflation constraint. Not a solvency constraint.   And if you’re worried about high inflation in a world where the real money printers aren’t printing because their clients are recovering from a debt crisis, then you’ve probably misunderstood the operational realities of the US money system.

Is A “Great Rotation” Underway?

The following is an excerpt from a recent Orcam Investment Research piece:

Thoughts on the “Great Rotation” 

It’s been difficult to escape discussion about the “great rotation” in recent weeks.  In case you’ve been hiding underneath a rock, the idea of the “great rotation” is that investors are presently in the process of “rotating” out of bonds and into stocks.  There are three big misunderstandings being made behind this thesis:

  • First, investors don’t “rotate” out of stocks and into bonds.
  • Second, the end of the bond bull implies an end to easy Fed policy.
  • Third, the bond bull has been weaker than most presume.

The first point is a very fundamental fact about secondary markets.  We must understand that all securities issued are always held by someone.  There is no such thing as “getting out of” stocks or bonds.  You can sell to someone else who exchanges you their cash position, but in the aggregate there is no such thing as “getting out of” stocks and moving into bonds.  All securities issued are always held by someone.  It’s better to think of money as moving through securities and not into them.

Ultimately, what determines the price of these securities is the desire of the buyers and sellers to acquire or dispose of those securities.  But the idea of a “great rotation” is a great misnomer.  It implies something similar to switching from Makers Mark to Jim Beam as your preferred form of whiskey.*   But stocks and bonds are not consumer products that we can switch in and out of.  They are savings vehicles issued as liabilities of the entities who issue them and they are always held until retired.

The second point revolves around the idea that government bonds are no longer an attractive asset class.  This might make sense were it not for such an accommodative Fed policy.   Ultimately, Treasury Bond prices are pegged to economic conditions and the Fed’s perception of economic conditions.  Bond traders will adjust their holdings of Treasury bonds based on their perception of future Fed policy.  But future Fed policy is contingent upon future economic conditions.

Thus far, the Fed has been very clear about future policy due to the continuing weak economic environment.  They will not ease off the accommodative pedal until they see 6% unemployment.  That means we’re staring at a 0% Fed Funds Rate for the foreseeable future.  Since long rates are an extension of short rates I wouldn’t expect huge deviations in t-bond prices unless we see a roaring economy in the coming years (IF we see a roaring economy at all).  And while I’ve long been optimistic about the economy I would not peg high odds on the sort of growth that would lead to 6% unemployment in the coming 12-18 months.

It’s also helpful to put this into perspective by looking at the current guesses of those bond traders trying to front run the Fed.  At present the Fed Funds Futures curve is much steeper than it was just a few weeks ago (see figure 1).  Traders are now pricing in a rate hike as soon as early 2015.  I think this is probably optimistic.

(Figure 1 – via Orcam Investment Research)

The risks to the US economy will remain many in the coming years as the Balance Sheet Recession lingers and government spending slows.  It’s also highly unlikely that the unemployment rate will drop below 6% before 2015.  That likely means the bond market is overly optimistic about future rate hikes and we’re likely to see that curve shift to a flatter position.

Lastly, I think it’s important to keep the bond bull market in perspective.  Since 1928 the average annual return on Treasury Bonds was 5.4%.  Meanwhile, the trailing 10 year returns on Treasury Bonds has been 5.76%.  In other words, the recent returns have been far lower than most presume and much more in-line with the average annual return.  While it wouldn’t be surprising to see this rate of return revert further to the mean I think it’s a stretch to imply that the bond market is as deeply into “bubble” territory as we constantly hear about.

(Figure 2 – via Orcam Investment Research)

In sum, I think it’s important not to get too caught up in these dramatic sort of concepts that imply we are presently in the middle of some sort of paradigm shift.  Bonds aren’t going away.  They’re not going to become a less important part of people’s portfolios.  Investors aren’t “getting out” of bonds.  And while the next 10 years are not likely to be as favorable to bonds as the last 10 years I wouldn’t fall victim to the idea that you need to dramatically shift your portfolio to account for what sounds more like a marketing ploy than sound advice.

*  While we are not in the business of providing specific investment advice to clients, we would highly recommend against ever making this “rotation”. 



Did Keynes Understand Endogenous Money?

One of the core understandings of MR is the endogeneity of money. Endogenous money is based on the understanding that the money supply is high powered money + broad money and that these variables are determined by the private sector’s demand for money. That is, almost all of the money in our monetary system is created by banks almost entirely independent of the government.  It is created INSIDE the private sector.  The government has essentially outsourced the creation of money to a private oligopoly of banks who compete for business.  This fact is largely untouched in most of mainstream economics.  And there might be a fairly good reason why.

JM Keynes is clearly one of the most influential economists of all-time.  Perhaps THE most influential economist of all-time.  His General Theory is a veritable bible for many economists.  So it’s interesting to note that while many economists during the era of Keynes were aware of the endogeneity of money (Soddy and Fisher for instance), Keynes himself appeared extremely confused on the subject.  In the General Theory he wrote:

We can sum up the above in the proposition that in any given state of expectation there is in the minds of the public a certain potentiality towards holding cash beyond what is required by the transactions-motive or the precautionary-motive, which will realise itself in actual cash-holdings in a degree which depends on the terms on which the monetary authority is willing to create cash.

“In the case of money, however—postponing, for the moment, our consideration of the effects of reducing the wage-unit or of a deliberate increase in its supply by the monetary authority—the supply is fixed.”

Thus we can sometimes regard our ultimate independent variables as consisting of (i) the three fundamental psychological factors, namely, the psychological propensity to consume, the psychological attitude to liquidity and the psychological expectation of future yield from capital-assets, (2) the wage-unit as determined by the bargains reached between employers and employed, and (3) the quantity of money as determined by the action of the central bank

These are various forms of a money multiplier or government centric money system and they’re inapplicable to the way the system is actually designed.   It’s clear that JM Keynes did not have a solid grasp of endogenous money.  And perhaps that explains why so many modern day economists and economic models simply ignore the reality that banks rule the monetary roost.    Perhaps the confusion over so much of modern macro stems directly from the master himself?   Was the most influential economist of our times actually woefully misinformed?  It appears so….

“Loans Create Deposits” – In Context

By JKH (cross posted at Monetary Realism)


Loans create deposits. We’ve heard it many times now. But how well is it understood? The phrase is typically invoked accurately, in conjunction with a rejection of the ‘money multiplier’ fable found in economic textbooks. From an operational perspective, banks do not “lend reserves” to their non-bank customers. “Loans create deposits’ is an operation in endogenous money. And where central banks impose a level of required reserves based on deposits, the timing of the demand for and supply of reserves in respect of such a requirement follows the creation of the deposit – it does not precede it. The money multiplier story is bunk. And ‘loans create deposits’ is correct as an observation.

Nevertheless, there is a larger context for deposits, which includes their fate after they have been created. Deposits are used to repay loans, resulting in the ‘death’ of both loan and deposit. But there is more. As part of the birth/death analogy, there is the lifetime of loans and deposits to consider. This sequence of birth, life, and death in total may be helpful in putting ‘loans create deposits’ into a broader context. There is potential for confusion if ‘loans create deposits’ is embraced too enthusiastically as the defining characteristic, without considering the full life cycle of loans and deposits. Indeed, we shall see further below that ‘deposits fund loans’ is as true as ‘loans create deposits’ and that there is no contradiction between these two things.

Monetary Systems

The monetary system and the financial system are constructions of double entry accounting. It has been this way for a long time. This did not start in 1971. The fact that there was gold serving as a fixed value backstop for certain monetary assets shouldn’t obscure the fact that a monetary system is a fiat construction at its foundation. Gold at one time was a hard constraint on the behavior of the monetary authorities. But the authorities will inevitably create paradigms of operational constraint and guidelines in any monetary system. These restrictions include central bank balance sheet constraints (e.g. gold backing; Treasury overdraft constraints; supply and pricing of bank reserves that are consistent with the monetary policy interest rate target) and other guidelines (such as the reaction function of the policy rate to various measures of inflation, output, or employment). The full category of potential constraints is broad and varied. But none of this alters the fact that a monetary system is basically a bookkeeping device for the intermediation of real economic activity. It is a construct that enables moving beyond a barter economic system that can only be imagined as a counterfactual.

The Choice for Banking

Starting from this monetary bookkeeping foundation, a fundamental choice exists. Will the system include a competitive banking sector? More broadly, will financial capitalism exist in substance and form? Will there be competition? Within this landscape, will there be more than one bank? While a banking singularity (a single, concentrated, nationalized institution) is usually considered to be non-pragmatic, it serves as a useful theoretical reference point for understanding how banks actually work. The competitive framework that is often taken for granted is in fact a choice for banking system design – including the presence of a reserve system that enables active management of individual bank balance sheets.

‘Loans Create Deposits’

When we say ‘loans create deposits’, we mean at least that the marginal impact of new lending will be to create a new asset and a new liability for the banking system – typically for the originating lending bank at first. A bank makes a loan to a borrowing customer. That is a debit under bank assets. Simultaneous, it credits the deposit account of the same customer. That is a new bank liability. Both of those accounting entries represent increases in their respective categories. This is operationally separate from any notion of reserves that may be required in association with the creation of bank deposits.

In another version of the same lending transaction, the lending bank presents the borrower with a cheque or bank draft. The lending bank debits the borrower’s loan account and credits a payment liability account. The bank’s balance sheet has grown. The borrower may then deposit that cheque with a second bank. At that moment, the balance sheet of the second bank – the deposit issuing bank – grows by the same amount, with a payment due asset and a deposit liability. This temporary duplication of balance sheet growth across two different banks is captured within the accounting classification of bank ‘float’. The duplication gets resolved and eliminated when the deposit issuing bank clears the cheque back to the lending bank and receives a reserve balance credit in exchange, at which point the lending bank sheds both reserve balances and its payment liability. The end result is that the system balance sheet has grown by the amount of the original loan and deposit. The loan has created the deposit, although loan and deposit are domiciled in different banks. The system has expanded in size. The growth is now reflected in the size of the deposit issuing bank’s balance sheet, with an increase in deposits and reserve balances. The lending bank’s balance sheet size is unchanged from the start (at least temporarily), with loan growth offset by a reserve balance decline.

Money Markets

In this latter example, it is possible and even likely, other things equal, that the lending bank additionally will seek to borrow new funding from wholesale money markets and that the deposit issuing bank will lend funds into this market. This is a natural response to the respective change in reserve distribution that has been created momentarily for the two banks. Without further action, the lending bank has lost reserves and the deposit bank has gained reserves. They may both seek to normalize these respective reserve positions, other things equal. Adjusting positions through money market operations is a basic function of commercial bank reserve management. Thus, this example features the core role of bank reserves in clearing a payment from one bank to another. The final resolution of positions in this case is that the balance sheets of both banks will have expanded, indirectly connected through money market transactions that follow on from the initial ‘loans create deposits’ transaction. However, this too may be a temporary situation, as the original transaction involving two different banks will inevitably be followed up by further transactions that shift bank reserves between various bank counterparties and in various directions across the system.

The Money Multiplier Fable

The money multiplier story – a fable really – claims that banks expand loans and deposits on the basis of a central bank function that gradually feeds reserves to banks, allowing them to expand their balance sheets with new loans and reservable deposits – according to reserve ratios that bind the pace of that expansion according to the reserves supplied. This is entirely wrong, of course. In fact, bank balance sheet expansion occurs largely through the endogenous process whereby loans create deposits. And central banks that impose reserve requirements provide the required reserve levels as a matter of automatic operational response – after the loan and deposit expansion that generates the requirement has occurred. The multiplier fable describes a central bank with direct exogenous control over bank expansion, based on a reserve supply function – which is a fiction. The facts of endogenous money creation have been demonstrated by empirical studies going back decades. Moreover, the facts are obvious to anybody who has actually been involved with or closely studied the actual reserve management operations of either a commercial bank or a central bank. In truth, no empirical ‘study’ is required – the banking world operates this way on a daily basis – and it is absurd that so many economics textbooks make up stories to the contrary. The truth of the ‘loans creates deposits’ meme is pretty well understood now – at least by those who take the time to learn the facts about it.

Central Bank Reserve Injections

A central bank that imposes a reserve requirement will follow up new deposit creation with a system reserve injection sufficient to accommodate the requirement of the individual bank that has issued the deposit. The new requirement becomes a targeted asset for the bank. It will fund this asset in the normal course of its asset-liability management process, just as it would any other asset. At the margin, the bank actually has to compete for funding that will draw new reserve balances into its position with the central bank. This action of course is commingled with numerous other such transactions that occur in the normal course of reserve management. The sequence includes a time lag between the creation of the deposit and the activation of the corresponding reserve requirement against that deposit. Thus, there is a lag between two system growth impulses – ‘loans create deposits’ as the endogenous feature and a subsequent central bank reserve injection as an exogenous follow up. The required reserve injection is typically small by comparison, according to the reserve ratio. The central bank can provide the reserves in different ways, such as by purchasing bonds or by conducting system repurchase operations with investment dealers. In the case of either bond purchases or system repurchase agreements, additional system deposits might be created when the end seller (or lender) of the bonds is a non-bank. And that second order creation of deposits may be reservable as well. But what might appear to be a potentially infinite series of reserve injections is in fact highly controlled in the real world – because the reserve ratio is relatively small. Some countries such as Canada have no such required reserve ratio. Indeed, the case of zero required reserves nicely emphasizes the nature of the money multiplier as an annoying analytical error and distraction from accurate comprehension of how banks actually work. But as a separate point, central bank injections of required reserves illustrate how not all deposits are necessarily created by commercial bank loans. ‘Loans create deposits’ is true, but not exclusive. This aspect is made clear also by the example of central bank ‘quantitative easing’, noted further below.

The Growth Dynamic

The ‘loans create deposits’ meme is best understood as a balance sheet growth dynamic, distinct from any reserve effect that might occur as part of an associated interbank clearing transaction at the time (e.g. the second example above) or as part of a deposit ratio requirement that might be activated at a later date. The banking system can be visualized in continuous time, punctuated by discrete banking transactions that are reflected as accounting entries. If one divides time into very small time intervals, individual banking transactions can be isolated as the only transactions that occur during a given interval of time. Thus, the growth dynamic of ‘loans create deposits’ can be conceived of as an instantaneous balance sheet expansion at the point of corresponding accounting entries. As noted in the examples above, this expansion may then migrate across individual banks when the lending and deposit issuing bank are different.

‘Deposits Fund Loans’

Some interpretations of the ‘loans create deposits’ meme overreach in their desired meaning. The contention arises occasionally that ‘loans create deposits’ means banks don’t need deposits to fund loans. This is entirely false. This is the point that requires emphasis in this essay.

There is no inconsistency between the idea that ‘loans create deposits’ and the idea that banks need deposits to fund loans. Bank balance sheet management must respond to both growth dynamics and steady state conditions in the dimension of nominal balance sheet size. A bank in theory can temporarily be at rest in terms of balance sheet growth, and still be experiencing continuous shifting in the mix of asset and liability types – including shifting of deposits. Part of this deposit shifting is inherent in a private sector banking system that fosters competition for deposit funding. The birth of a demand deposit in particular is separate from retaining it through competition. Moreover, the fork in the road that was taken in order to construct a private sector banking system implies that the central bank is not a mere slush fund that provides unlimited funding to the banking system. In fact, active liability management is important in private sector banking – in the system we actually have. Other systems have been proposed, in which central banks intervene in some way to adjust the landscape of competitive liability management (e.g. the Chicago Plan; full reserves) or to subsume this competition more comprehensively (e.g. the MMT Mosler plan). These are ideas for significant change that should not be confused with the characteristic of competitive banking as it now exists. Some analysts tend toward language that conflates factual and counterfactual cases in this regard. To repeat – bank liability management is very competitive in the system we have, by design. The ‘loans create deposits’ meme, while true, only touches on this competitive dynamic.

We note again that loans are not the sole source of deposit creation. A commercial bank’s purchase of securities from a non-bank will typically result in new deposit creation somewhere in the system. There are cases where deposit creation results from other liability or equity conversion – commercial bank debt redemption and stock buybacks are examples of this. Existing fixed term deposits can convert to demand deposits and vice versa. And central bank quantitative easing most often results in new deposit creation – because the bonds that the central bank purchases are typically sourced from non-bank portfolios, and exchanged for deposits. Nevertheless, ‘loans creates deposits’ is a reasonable reference point and standard for the process of deposit creation.

Bank Asset-Liability Management

The ‘loans create deposits’ dynamic comprises the production of much of the money that serves as a basic source of liquidity in a monetary economy. The originating accounting entries are simple – a loan asset and a deposit liability. But this is only the start of the story. Commercial bank ‘asset-liability management’ functions oversee the comprehensive flow of funds in and out of individual banks. They control exposure to the basic banking risks of liquidity and interest rate sensitivity. Somewhat separately, but still connected within an overarching risk management framework, banks manage credit risk by linking line lending functions directly to the process of internal risk assessment and capital allocation. Banks require capital – especially equity capital – to take risk – and to take credit risk in particular.

Interest rate risk and interest margin management are critical aspects of bank asset-liability management. The ALM function provides pricing guidance for deposit products and related funding costs for lending operations. This function helps coordinate the operations of the left and the right hand sides of the balance sheet. For example, a central bank interest rate change becomes a cost of funds signal that transmits to commercial bank balance sheets as a marginal pricing influence. The asset-liability management function is the commercial bank coordination function for this transmission process, as the pricing signal ripples out to various balance sheet categories. Loan and deposit pricing is directly affected because the cost of funds that anchors all pricing in finance (e.g. the fed funds rate) has been changed. In other cases, a change in the term structure of market interest rates requires similar coordination of commercial bank pricing implications. And this reset in pricing has implications for commercial bank approaches to strategies and targets for the compositional mix of assets and liabilities.

The life of deposits is more dynamic than their birth or death. Deposits move around the banking system as banks compete to retain or attract them. Deposits also change form. Demand deposits can convert to term deposits, as banks seek a supply of longer duration funding for asset-liability matching purposes. And they can convert to new debt or equity securities issued by a particular bank, as buyers of these instruments draw down their deposits to pay for them. All of these changes happen across different banks, which can lead to temporary imbalances in the nominal matching of assets and liabilities, which in turn requires active management of the reserve account level, with appropriate liquidity management responses through money market operations in the short term, or longer term strategic adjustment in approaches to loan and deposit market share. The key idea here is that banks compete for deposits that currently exist in the system, including deposits that can be withdrawn on demand, or at maturity in the case of term deposits. And this competition extends more comprehensively to other liability forms such as debt, as well as to the asset side of the balance sheet through market share strategies for various lending categories. All of this balance sheet flux occurs across different banks, and requires that individual banks actively manage their balance sheets to ensure that assets are appropriately and efficiently funded with liabilities and equity.

In examining all of these effects, it is helpful to consider the position of the banking system in its totality, in conjunction with the position of individual banks that constitute the whole. For example, the US commercial banking system is composed of thousands of individual banks. Between discrete ‘loans create deposits’ events, the banking system is in continuous balance sheet churn. Specifically, deposits are moving back and forth between individual banks, as a matter of normal payment system operations. They are also moving and inter-converting in the form of term deposits at both the retail and wholesale level. This overall liquidity churn feeds economic activity of all sorts, where households, businesses, and governments are making payments to each other for various goods and services and other types of transactions, and are making choices about the portfolio structure of their liquid assets. This is the core liquidity provided by the banks to their customers. And this is the stuff that involves a good deal of transferring of reserves back and forth between banks, in order to affect accounting completion of balance sheets that are in continuous flux in size and composition.

Bank Reserve Management

The ultimate purpose of reserve management is not reserve positioning per se. The end goal is balance sheets that are in balance, institution by institution – and where deposits fund loans, alongside various other asset-liability matching configurations. The reserve system records the effect of this balance sheet activity. The reserve account is the inverse exogenous money image of the nominal configuration of the rest of the balance sheet. The balance sheet requires asset liability management coordination in order to match up assets and liabilities both in nominal terms and in a way that is financially effective. And even if loan books remain temporarily unchanged, all manner of other banking system assets and liabilities may be in motion. This includes securities portfolios, deposits, debt liabilities, and the status of the common equity and retained earnings account. And of course, loan books don’t remain unchanged for very long, in which case the loan/deposit growth dynamic comes directly into play on a recurring basis.


In summary, the original connection by which deposits are created by loans typically disappears at some point following deposit creation – at the micro bank level and/or the macro system level. The original demand deposits associated with specific loan creation become commingled as they move back and forth between different banks. And they not only move between banks, but they can change in form within any bank. They can be converted into term deposits or other funding forms such as bank debt or common and preferred stock. The task of dealing with this compositional flux falls under the joint coordination of bank asset-liability management and reserve management. The overarching point of observation is that both system growth and system competition for existing balance sheet composition are in constant operation. ‘Loans create deposits’ only describes the marginal growth dynamic at the inception of deposit creation. ‘Deposits fund loans’ is the more apt description that applies to a good portion of what constitutes ongoing balance sheet management in competitive banking.

Barrons Doesn’t Do Monetary Realism

Just when you think the word might be spreading….It was interesting that Barrons ran this great quote from a regular reader here at Pragcap last week:

 We must be careful comparing the federal government with a household (or state or business) because Washington has no solvency constraint. The federal government can’t run out of money (unless Congress decides it should), as it can always call on the banks and the Federal Reserve to serve as agents of the government.

The constraint is inflation, not solvency. But given the weakness in our economy, along with high unemployment, I don’t see much risk of inflation anytime soon.”

And then just a week later runs a cover piece about how the USA is becoming Greece.   Of course, the problem within Europe is that their central bank is entirely independent of the sovereigns rendering none of the European countries pure currency issuers.  They are all strategic users of the Euro because of this lack of political and monetary union between Treasury, Central Bank and government.  The USA, of course, doesn’t have this problem so it is virtually impossible (aside from political choice) for the USA to run out of money.  The comparison Barrons makes is patently wrong.  For a full discussion on this arrangement with a comparison of Greece and the USA please see the section called “Contingencies – The USA versus Europe” in the Contingent Institutional Approach.

Anyhow, the Barrons piece could be right about some things.  Yes, government spending could cause big problems down the road and it might even cause high inflation.  But what it isn’t going to causes is a Greek-like crisis where market participants literally worry that we are running out of money.  It won’t happen in the USA where the true constraint is inflation, not solvency.  

Japan Does the Full Ponzi

I saw this headline over at Calculated Risk regarding the new “monetary policy” in Japan:

And from the Japan Times: Japan’s economic minister wants Nikkei to surge 17% to 13,000 by March

Economic and fiscal policy minister Akira Amari said Saturday the government will step up economic recovery efforts so that the benchmark Nikkei index jumps an additional 17 percent to 13,000 points by the end of March.

“It will be important to show our mettle and see the Nikkei reach the 13,000 mark by the end of the fiscal year (March 31),” Amari said in a speech.

The Nikkei 225 stock average, which last week climbed to its highest level since September 2008, finished at 11,153.16 on Friday.

“We want to continue taking (new) steps to help stock prices rise” further, Amari stressed …

I think this is remarkably silly policy.  It’s the worst abuse of central bank powers and based largely on a misunderstanding of secondary market dynamics.   I wish wealth creation was as easy manipulating stock prices.  Then every country in the world could just have their central bank target a market price and presto-changeo – we’re all rich!  Nevermind if the underlying corporations don’t actually justify the valuation!  After all, the central bank says the cash flows justify THIS price.  They said so!

Of course, this isn’t how reality works.  The stock market is made up of companies selling at a nominal price on exchanges and all shares outstanding are always held by someone looking to find someone else to sell to so the current holder can realize gains (which subsequently leaves the new holder with the exact same problem searching for the next person in line).  Those prices are determined primarily based on the eagerness of the participants in those markets to buy or own shares based on the expected future performance of the actual underlying corporations.

We can implement policy that causes these prices to deviate from where the market would have otherwise set them (largely by making participants more or less eager to own shares).  But what is the point of this?  What does this do other than cause disequilibrium if it does not cause an equal change in the underlying business?  If the market believes the Nikkei is worth 11,000 based on expected future fundamentals then pinning the price at 13,000 only causes a short-term disequilibrium that will result in the same amount of eventual wealth lost that is presently being gained.

Again, stock markets are nominal wealth.  Someone must always hold shares of stock outstanding so someone will always be concerned that they’re left holding the ponzi scheme at the peak if that’s in fact what the central bank explicitly targets.   And that leaves the same underlying downside reversal risks present at all times.  Yes, the Bank of Japan might create some real wealth (for some market participants) in the near-term and might thereby make Japan appear better off than they really are, but there’s absolutely no underlying fundamental change in the corporations that make up this index that should lead one to believe that these price changes are justified.  And when the Ponzi scheme is exposed the market collapses thereby destroying wealth for all the current participants leaving us right back where we started.

This is ponzi based monetary policy.  It’s based on a false understanding of market dynamics, a false understanding of real wealth, and it’s very likely to cause disequilibrium in the long-term.

See also: The Destabilizing Force of Misguided Market Intervention

QE & Stock Prices – A Review of Recent Data

One of the primary goals of Quantitative Easing is the portfolio rebalancing effect and subsequent wealth effect that supposedly occurs as the Fed reduces outstanding private sector bond holdings and forces investors to chase returns up the risk spectrum into other asset classes to replace lost potential real returns.  I won’t discuss the aspects of “money printing” and “debt monetization” here (which I think the mainstream gets mostly wrong), but rather, I’d like to focus on the pure data between periods when reserves are increasing and stock returns.

We’ve now had over 4 years of varying forms of QE so the data is quite a bit more constructive than at times in the past when most of us were just speculating about QE’s impacts.  At first glance, the chart below might lead one to conclude that there is a very strong correlation between between QE and equity market returns, but the data is not so conclusive upon closer inspection.  This has been due to the way the programs were implemented in staggered steps over the years with periods of buying tending to be rather short.  Contrary to popular opinion, during the majority of the time in the last 4 years reserve balances have been stagnant or even declining.  On a weekly basis, reserve balances have been rising just 47% of the time and have actually been declining 53% of the time.

Since QE began in late 2008 there’s a correlation between reserve balances and stock returns of just 0.65.  But that’s not a completely fair look at the data.  There have been four distinct periods when reserve balances were surging or declining/stagnant over the last 4+ years.  I’ve broken this down more clearly below.

Periods when reserve balances were increasing includes (on a weekly basis):

9/10/2008 – 1/7/2009

2/11/2009 – 5/20/2009

6/24/2009 – 2/24/2010

11/17/2010 – 7/13/2011

Periods when reserve balances were declining substantially include:

1/7/2009 – 2/11/2009 (reserve balances fell by 31%)

5/20/2009 – 6/24/2009 (reserve balances fell by 12.5%)

2/24/2010 – 11/17/2010 (reserve balances fell by 20%)

7/13/2011 – 9/26/2012 (reserve balances fell by 15%)

What’s interesting here is that the correlation between stock returns and decreases or increases in reserve balances is not quite as clear cut as most presume.  See below for returns during reserve balance increases:

9/10/2008 – 1/7/2009 (S&P 500 DECLINED by 25%)

2/11/2009 – 5/20/2009 (S&P 500 INCREASED by 6%)

6/24/2009 – 2/24/2010 (S&P 500 INCREASED by 22%).  

11/17/2010 – 7/13/2011 (S&P 500 INCREASED by 11%).  

That looks pretty much as we might expect.  But things get more interesting when we look at periods when reserve balances were declining:

1/7/2009 – 2/11/2009 (S&P 500 DECREASED by -10%)

5/20/2009 – 6/24/2009 (S&P 500 INCREASED by 1%)

2/24/2010 – 11/17/2010 (S&P 500 INCREASED by 8%)

7/13/2011 – 9/26/2012 (S&P 500 INCREASED by 9%)

In other words, regardless of whether reserve balances were rising or falling, stock prices were mostly rising.  Even in the face of substantial declines in reserve balances over the last 4+ years the S&P 500 has risen.  Of course, there are a lot of moving parts in this data, but the correlation between stocks and reserve balances is not terribly clear when we get granular with the data.

( Chart via Orcam Investment Research)