Archive for How To – Page 2

The 13 Biggest Investing Mistakes to Avoid

I really liked this concise view on investing mistakes to avoid via Ben Carlons at A Wealth of Common Sense:

The Bill Russell investment strategy is about avoiding the crippling mistakes that so many investors make on a consistent basis.

Here’s my list of the biggest mistakes to avoid:

  • Making investment decisions based on your political views.
  • Confusing your risk profile and time horizon with someone else’s.
  • Consistently trying to time the market.
  • Losing site of your long term financial goals.
  • Paying high fees on investments.
  • Having high trading activity.
  • Letting fear and greed take over at the extremes in market sentiment.
  • Having the majority of your investments tied up in one asset (company stock, your house, etc.).
  • Basing your decisions on what you heard on CNBC or Fox Business News.
  • Following every tick in the market and constantly checking the value of your portfolio.
  • Making too many short term moves with long term capital.
  • Basing your investments on the most recent performance.
  • Not saving enough.

Government Bonds in a World of Moneyness

When you learn about the monetary system from the perspective of Monetary Realism you learn about a world with the concept of “moneyness” (see here for details).  The concept of “moneyness” helps us decipher how different financial assets fit into our traditional thinking of “money”.  It’s important to differentiate between the different types of financial instruments we utilize so we can better understand exactly how the monetary system is designed and operates.

“Money”, at its most basic form, is simply that which serves as the dominant medium of exchange.  In a world of “moneyness” lots of things can meet this definition, but some items apply more widely than others.  For instance, Bitcoin is a medium of exchange, but it has a low level of moneyness because it’s not very widely accepted as a means of payment.  Bank deposits, on the other hand, have a very high level of moneyness because they are so widely accepted as a means of payment.  You can buy almost anything these days if you have access to bank deposits.  I argue that, in our electronic age, bank deposits have usurped even cash in terms of moneyness.  Of course, there are lots of different instruments in the financial world that have money-like properties.  For instance, stock options are often used to pay employees, but you can’t buy much with your stock options.  You have to convert them into something with a higher level of moneyness like bank deposits.  So stock options don’t have a very high level of moneyness.

When we think of “money” it’s best to think of it as the medium of exchange.  But we must also understand that “money” is simply one type of financial asset that exists in a financial world with a plethora of financial instruments. In fact, our stock of financial assets is primarily made up of assets that aren’t of the highest moneyness.  Things like stocks, bonds and other assets comprise the vast majority of the financial instruments in our world.  We all want money to be able to spend in the present, but we also want to hold other financial instruments so we can plan and prepare for our future spending.  If we get too bogged down in the concept of “money” we can begin to think too narrowly about its impact on the overall economy.

More importantly, when we begin to think of all of these other types of financial instruments that comprise our financial world we have to consider why there are instruments with varying levels of moneyness in the first place.  For instance, when a corporation issues common stock they are giving the buyers of this stock a claim on future cash flows in exchange for money today.  The company is essentially trying to convince investors that they should give up their cash today so they can have more of it at a later date.  And in doing so, they have to convince someone that they should forego using their money today and instead hold onto an instrument that will potentially allow them to spend more in the future.  The investors have money they don’t need today.  The company has a cash flow machine they believe can generate higher future potential profits.  So there is a mutually beneficial financial arrangement that provides investors with an instrument of lower moneyness today with the hope that they can convert it into something more valuable with a higher level of moneyness in the future.

It’s important to understand the structure of this relationship, however.  Entities that need money must issue an instrument that convinces the buyers that they can utilize that instrument in the future to convert it into something in the future with a higher level of moneyness and greater purchasing power.  Otherwise, there is no point buying a financial instrument that is more risky than the cash or deposit they would otherwise hold.

And this brings us to a crucial point that John Carney of CNBC discussed today – are US government bonds “money”?  I would argue that US government bonds are an instrument with a high level of moneyness because they can be easily converted into something of higher moneyness (like deposits) and because they are backed by the taxing authority of the US government as well as a productive economy.  But they are not “money” in the same sense that bank deposits are because, as Scott Sumner notes, they aren’t a very useful medium of exchange for practical purposes.  And this brings us to an even more important point.  Our monetary system is designed so that the US government must obtain bank deposits.  In fact, it cannot spend if it cannot obtain these bank deposits and the US government cannot just force everyone to hold new bond issues or new currency issue (although I think such a scenario is incredibly unlikely).  And if the US government cannot convince the users of government bonds to hold these instruments (for whatever reason) then the government suffers a catastrophic demise as the collapse in its bonds would almost certainly coincide with a collapse in its currency.

This brings us to the most interesting point here.  The moneyness of different instruments can change!  And in fact, we find that in a hyperinflation or high inflation many instruments lose their moneyness.  In a hyperinflation something like gold and even common stock becomes a more viable form of money while government currency virtually dies.  So it’s important to understand that currency and US government bonds are instruments that are issued just like any other financial instrument and they serve a specific purpose under a specific institutional framework.   These instruments must find willing owners who want to hold onto these instruments with the expectation that their purchasing power will be maintained.  In the case of cash currency it is issued through the US banking system to facilitate the use of deposit accounts (mainly through ATM usage).  Currency in the form of reserves facilitates the use of deposits in the interbank system.  And US government bonds are issued because our government is structured in a manner that the Executive Branch cannot merely credit its own account and spend.  This is the result of very specific legal and institutional structures that are in place.  So, despite the fact that the US government is a currency issuer and a very powerful one at that, it is not exempted from the fact that it must always be able to find willing holders of the instruments that it issues to facilitate its cash management needs.  And under the current monetary design, US government bonds resemble something like corporate bonds much more than they resemble something like bank deposits.  Therefore, government bonds should best be thought of as financial instruments with a high level of moneyness, but a lower level of moneyness than something like bank deposits.


Credit IS Money

It’s common in economics and in general, for people to differentiate between “money” and “credit” (Scott Sumner did it here today).  This is largely the result of gold standard mythology when gold was viewed as the primary form of money and “bankers” would issue notes that were redeemable for gold.  They were, in essence, issuing a claim on gold.  When we went off the gold standard economists didn’t really change their model much.  They just substituted central bank reserves and cash for gold and said that when banks were lending they were issuing claims on central bank money and vault cash.  I think this is totally wrong.

The system we reside in today is not one designed around central bank reserves and cash.  In fact, central bank reserves and cash are playing an increasingly less important role in the economy as time goes on.  Reserve requirements are no longer necessary in well managed banking systems, cash is becoming a less common form of money and the importance of inside money (bank money or deposits) has become increasingly evident to the economy as the credit crisis proved.

The problem with this focus on central bank money and reserves is that it seems to get the entire focus of the monetary system wrong.  We start from the government and build out from there without realizing that the private sector steers the economy and the money the non-bank private sector primarily uses (inside money) dominates how output is created, where prices settle and how we engage in the economy.

It’s also important to note that everything that involves outside money (central bank money) is a facilitating feature of what is clearly an inside money system.  That is, reserves exist primarily to help settle interbank settlement.  And cash exists primarily to allow an inside money bank customer to draw down an account to transact more conveniently.  These forms of money like reserves, cash and coins (outside money) all facilitate the use of the dominant money – inside money.   Saying that inside  money or credit is just a claim on outside money is clearly false.  For instance, a transaction occurring between two customers in credit at Bank of America doesn’t even involve outside money.  But more importantly, what we’re all really after in the economy is not claims on outside money.  We’re all seeking the real money – bank deposits.  The primary way cash comes into circulation is when an inside money holder draws down a bank account.  And the non-bank private sector cannot even access bank reserves so it’s totally illogical to build a real understanding of the economy around outside money.

Focusing on outside money and building a world view around it is like trying to understand how a man walks by studying the crutch he uses.  Outside money is merely a crutch while inside money is the legs!  Yes, outside money is important and it can be particularly important when your legs break (during a credit crisis), but that doesn’t change the fact that the legs are the form of money that “rules the roost” 99% of the time.   There are hardly any schools of economic thought that get this balance correct.  Which is a big contributing factor to why the entire “dismal science” appears so dismal at present.


Understanding the Modern Monetary System

The Lead Role of the Private Sector & “Inside Money”

Understanding Inside Money and Outside Money

Understanding why Austrian Economics is Flawed

Austrian economics has been through quite a rollercoaster ride over the last 10 years as the housing bubble appeared to vindicate many of their views and then the economic recovery proved many of their dire predictions completely wrong.  I think Austrian Economics is deficient and Austrian Business Cycle Theory is inherently flawed and built on misunderstandings about the way the modern monetary system actually works.  Allow me to provide three core reasons why I believe this:

1)  Austrian economics is a political ideology that masquerades as an economic school of thought.  Like most of the economic schools in existence today, Austrian Economics is predicated on a political ideology.  Austrians tend to be vehemently anti-government and pro-market.  So they build a world view that conforms to the world they want and not the world we actually have.

We’ve seen this time and time again in the last 5 years during the recovery as the government picked up spending when the private sector cratered.  There is always an excuse within Austrian Economics that implicitly assumes government cannot spend dollars any better than a household.  This might be true in a general sense, but it is not always true.  For that implies that households and businesses always make rational decisions.  As if choosing to have our government spend money on wars and welfare is all that much different than households spending money on the next release of the tech gadget they probably don’t need or the McMansion they can’t afford.

Austrians aren’t the only offenders of this (see here).  We see it in Keynesian approaches, Market Monetarist approaches, Monetarist approaches and just about all of economics these days.  Economics is built primarily on a bunch of political agendas designed to look like a science.  Austrians (particularly the Rothbardians) are so vehemently against government involvement in the economy that they are among the very worst offenders of trying to pass an ideology off as a school of thought.  It results in a very unbalanced presentation of our reality.

2)  Austrian Business Cycle Theory Misunderstands Endogenous Money.  Like many other economic schools of thought, Austrian economics is predicated on a loanable funds model with a world view designed to demonize just about everything the central bank does.  As I’ve explained before, the primary purpose of the central bank is not a conspiratorial attempt to enrich bankers, but to help oversee and regulate the smooth functioning of the payments system.

The act of targeting interest rates and implementing monetary policy are very much secondary to this primary purpose and the powers of such policy, as presently constructed, are vastly overstated by most economists.  Yes, the central bank controls a component of the interest rate that helps determine the spread at which banks can lend, but the central bank does not determine the rate at which banks borrow to customers.  It merely influences the spread.  Overemphasizing the Fed’s “control” over interest rates misunderstands how banks actually create money and influence economic output.

The primary flaw in the Austrian view of the central bank has been most obvious since Quantitative Easing started in 2008.  Austrian economists came out at the time saying that the increase in reserves in the banking system was the equivalent of “money printing” and that this would “devalue the dollar”, crash T-bonds and cause hyperinflation.  It was standard operating procedure to see charts of the monetary base like this one followed by dire predictions of high inflation or hyperinflation.  Of course, none of this actually panned out.  The high inflation never came, the hyperinflation definitely never came, the T-bond collapse was a terrible call and the USD has remained extremely stable.

So why was Austrian economics wrong on this point?  Because their model is predicated on the same faulty loanable funds based model that most other economists use.  So they assumed that more reserves would mean more “multiplication” of money and thus hyperinflation.   Of course, as I’ve explained numerous times here before, banks are never reserve constrained and do not make loans when they have more reserves.  Further, QE is a simple asset swap that changes the composition of private sector assets.  Referring to this as “money printing” is highly misleading (see here for more details).  Austrians got this wrong because, in an attempt to attack government, they have devised a government centric view of money creation that misunderstand the way money is created primarily by private competitive banks endogenously.

3)  Austrians misunderstand inflation.  Austrian economists actually change the definition of inflation to serve their own ideological needs.  In Austrian Economics inflation is not the standard economics concept of a rise in the price level.  Inflation in Austrian economics is just a rise in the amount of money.  This leads to all sorts of emotional commentary, the most common of which, is the idea that the USD has declined 95% since the creation of the Fed in 1913 (which is true).   But this misunderstands several concepts and misleads us in understanding how the monetary system works.

First of all, the private sector creates lots of “money like” instruments that are not technically included in the money supply but comprise the vast majority of private sector net worth.  I use a “scale of moneyness” to help better understand this concept so that we don’t place an undue specialness on the idea of “money” when trying to understand inflation.  Instead, I try to explain that spending is a function of income relative to desired saving.  And that saving is comprised not only of “money”, but money-like instruments like stocks, bonds, options, etc.  To completely understand how the economy is impacted by inflation we shouldn’t merely focus on narrow definitions of “money”, but should understand the aggregate economic balance sheet.  For instance, if you sell a stock at no gain and obtain cash you’re not necessarily more likely to spend than you were before because your net worth is the same.  Your income relative to desired saving is precisely the same as it was before.  This is basically what QE is.  It is a swap of one type of asset for another and doesn’t actually alter the net worth of the private sector.  Changing the moneyness of private assets does not necessarily mean there will be higher inflation!

But there is a more egregious and nefarious error in this “decline” of the dollar myth.  It completely misunderstands how living standards can rise even while the money supply rises.  In our credit based monetary system the money supply rises primarily when banks make loans which create deposits.  In a highly productive economic environment these loans are distributed by private competitive banks and provide the borrower with the capability to invest in a manner that actually enhances the living standards of society.  So, you borrow $100,000 from the bank, you invent and distribute the washing machine and suddenly we’re all better off because we no longer have to go to the river to wash clothes.  The technological advancement enhances our lives by giving us more time to consume and produce OTHER goods and services.  In other words, the money supply has technically increased, but we’re not worse off because of it.  We’re better off because of it!  What’s happened since 1913 in the USA is just one gigantic version of the washing machine example where our living standards have exploded through the roof in tandem with a rising level of credit and an innovation boom that human beings have never come close to experiencing in the past.

Austrians, in their fervor to demonize the fiat money system, make several errors here.  First, they assume the government controls the money supply (which they don’t).  It’s actually controlled primarily by private banks in a market system that Austrians should love.  Second, they move the goal posts on the definition of inflation to imply that inflation is always and everywhere a bad thing (which, it can be, but generally isn’t).

That really just scratches the surface on some of the flaws in Austrian Economics.  I think Austrians provide some good insights on the way the economy and money works, but these are glaring flaws in the school of thought that render it highly inadequate in helping us understand the world of money in a balanced and objective way.

See also: 

Understand the Modern Monetary System

Monetary Realism Recommended Reading

“Don’t Work Harder, Work Smarter”

One of the cornerstones of Monetary Realism is understanding the importance of time.  We’re all here for a finite period and we can choose how we use that time and whether it’s going to work for us or against us.  Now, I’m not good at many things, but I think one of the few things I really understand is time management.  I really value my time.  And I use it wisely.

The saying “don’t work harder, work smarter” is one of those cheesy taglines that you hear all the time and never quite find any real world application for, but it’s dead on.  Here are a few thoughts about working smarter rather than working harder:

  • Don’t conform to everyone else’s schedule.  Yes, I know, most of us work for someone else and have to conform to their schedule, but that doesn’t mean you have zero flexibility within that schedule.  So what if you have to show up at 9 and leave by 5.  Does that mean you have 8 hours to do an allotted amount of work or does it mean you can design your 8 hours however you like?  Most of us have deadlines we have to meet and we build a schedule around your employer’s deadlines.  But you can still design your own deadlines and use your time how you like.  You don’t have to meet a deadline by Friday just because that’s when it’s due.  Can the work be done by Thursday so your Friday is open to focus on other things?  If so, why wait?  Don’t let everyone else control your schedule….
  • Stop procrastinating and create a sense of urgency.  Most of us procrastinate and wait until there’s a sense of urgency to get something done.  Create your own sense of urgency right now.  Set your own personal deadlines by creating goals and forcing yourself to work smarter.
  • Organize your schedule.  I spend a huge amount of time organizing a schedule.  I usually spend every Sunday evening planning my week.  When do I work on this project, that project, when I eat, when I workout, when I read, when I relax, etc.  If you’re not organized then working smarter is never going to work for you.
  • Make the robots work for you.  Don’t let the “world is ending because of robots” meme get you down.  All that technology is out there to help you work smarter so you don’t have to work harder.  Take advantage of it, learn about it and use it to become more efficient.
  • Stop getting distracted.  Are you on Twitter, Gchat, the phone, email or Facebook all day?  Why?  It’s a waste of time unless it’s helping you achieve your goals.  Cut out the waste!  Learn to stop filling your email box with clutter.  Stop spending time on the phone with people who are just chewing up time.  Stop Gchatting about what you’re going to do next weekend.  Stop checking Facebook.  It’s so easy to get distracted these days.  Yes, it’s perfectly fine to take time off, but don’t let it control the time when you should be getting things done.  Block out your time for social interaction so that it’s working to benefit you and not working against you. You don’t live to work, you work to live, but when you’re working you need to actually be working!

That’s my thought process about managing time efficiently.  If you have more tips or thoughts please add them in the comments.


Stop With the “Money Printing” Madness

I never stop seeing the term “money printing” all over the place.  It has to be the most abused term in all of economics and finance.  The madness must end!  So let’s try to make this so simple that a 6 year old could understand it.

1)  Banks create most of the money in our system.  Loans create deposits and deposits are, by far, the most dominant form of money in the economy.  So, if you want to say someone “prints money” you would be most accurate saying that banks print money.

2)  The government is a user of bank money.  When the government taxes Paul they take Paul’s bank money and redistribute it to Peter when they spend.

3)  If the government runs a budget deficit (taxes less than it spends) then Paul buys a bond from the government and the government gives Paul’s bank deposit (which he used to buy the bond with) to Peter.  Paul gets a bond which the government created in much the same way that a private corporation creates a bond when they issue corporate debt.   If you want to say these entities “print” financial assets then fine.  Corporations print stocks and bonds every day and you don’t hear the world exploding with hyperinflation rants because of it….

4)  When the Fed performs quantitative easing they perform open market operations (just like they have for decades) which involve a clean asset swap where the bank essentially exchanges reserves for t-bonds.  The private sector loses a financial asset (the t-bond) and gains another (the reserves or deposits).   The result is no change in private sector net financial assets.  QE is a lot like changing your savings account into a checking account and then claiming you have more “money”.  No, the composition of your savings changed, but you don’t have more savings.

5)  Cash notes like the ones you have in your wallet are created by the US Treasury and are issued to the Federal Reserve upon demand by member banks.  This cash is literally “printed” by the Treasury, but serves primarily as a way for banks to service their customers.  In other words, if you have a bank account you can exchange your bank deposit for cash from the ATM or the bank teller. Cash is preceded by the dominant form of money, bank money.  But it doesn’t get printed off the presses and fired into the economy as some would have us believe.

See, there’s no “money printing” in any of this unless you want to distort the role of cash in the economy or refer to lending and security issuance as money printing.  Yes, QE alters the composition of private financial assets, but that’s about it.  No real “money printing” there either.   So, next time someone goes off on a “money printing” rant just point them in the direction of these 5 easy to understand steps.

* Confused?  See the following pieces:

1.  Understanding The Modern Monetary System

2.  Understanding Inside & Outside Money

3.  Understanding Moneyness

4.  Where Does Cash Come From?  

Towards a (Mostly) Cashless Monetary System

I often talk about the misconceptions of money being a physical thing.  Austrians tend to tell us that money is something like a physical commodity while many Keynesians tell us that the ultimate form of money is paper or cash.  There’s a smaller group of (mostly economists) who believe that the ultimate form of money is currency (bank reserves, cash and coins).  I think they’re all wrong.  Money is no longer dominated by a physical thing (though it can be) or by what the central bank or government creates (cash, coins and reserves).  Today’s money is created almost entirely by private banks and tracked electronically for record keeping within a payments system that they control and the rest of us have to be members of.

Of course, our textbooks also tell us that government money matters most.  They tell us that the central bank creates some amount of money and the banking system “leverages” or “multiplies” this money, but that’s not really true.  Banks create loans first and obtain reserves second if necessary.  The money multiplier is a myth.  And that puts the private banks squarely at the center of the money creation business.  When a bank makes a loan it results in the creation of a deposit.  And those deposits are what we are all chasing in a system that is dominated by electronic bank money.

The mainstream media is nearly as oblivious to this reality as the economic textbooks.  In the mainstream, the belief is that the government “prints money” as if it’s just running a printing press running up government debt all day long to pay for things.  But the reality is that the government is a massive redistributor of bank money.  That is, when the government taxes you they’re just taking bank deposits from person A to pay person B with bank deposits.  When the government runs a budget deficit they’re selling a bond to Person A and giving person A’s bank deposit to Person B.  There’s no “money printing”.  There’s only redistribution of bank deposits.  And because these bank deposits dominate the US payments system as the means of settling payments in the process of transacting business, we are all seeking out these deposits so we can interact within that payments system.

The reality of banks “ruling the monetary roost” has only become that much more apparent as technology has developed in recent decades.  In fact, I would argue that we’re becoming increasingly bank dependent as technology begins to reduce the importance of cash and other forms of government money in the economy.  Canada, for instance, has no reserve requirement as technology has made their interbank payments system extremely efficient.  The cash market for transactions is also taking a back seat to other transactions around the world.  In the USA, cash transactions account for just 27% of all transactions. That’s down from 80% just 50 years ago.  Credit and debit cards account for over 60% of transactions.  Cash is still the most frequently used form of payment  (because cash transactions tend to be in small denominations), but in total dollar volume it is becoming less and less significant.   If we include wire transfers in the volume of payments data the electronic market already dwarfs the cash market (via the Cleveland Fed):

And although the US has been ahead of the trend in many regards here, other developed nations like Sweden and Canada are already on the fast track towards a cashless economy.  For instance, in Sweden, less than 3% of all transactions occur in cash.

This doesn’t mean cash as a form of money is going away entirely.  But it is becoming increasingly less significant.  And that’s precisely due to the way our money system has been designed.  Banks have been placed in charge of managing and driving the payments system around the world.  So their money dominates that system.   That’s not going to change any time soon.  In fact, we’re becoming increasingly dependent on bank money as technology makes other forms of money less and less competitive/necessary with a highly efficient electronic (bank controlled) system.


Understanding Moneyness

Understanding the Modern Monetary System

Understanding Inside Money & Outside Money

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)

Understand Your REAL, Real Returns

Just passing this paper along from the comments section.  It’s a very good read on real, real returns on various asset classes.  This is crucial to understanding how different assets generate total returns and how they can be viewed in totality:

“Investors often focus on nominal return — or the return they see quoted in the paper or on a financial news site — on a given investment. Unfortunately, there are several factors that often stand between a nominal-return figure and the building of real wealth. Sophisticated investors frequently refer to the real return, which is a nominal return adjusted to take inflation into account. At Thornburg, we take that analysis a few steps further and adjust stated performance numbers for additional factors — taxes and investment expenses among them. We believe that investors should be attentive to this return figure, the number that’s left after accounting for inflation, taxes, and investment expenses.”

Read it here.

Source: Thornburg


“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.

On Using Technical Analysis

There’s been a broad discussion in recent weeks about the efficacy of technical analysis in investment strategy (see here & here).  I’ve touched on this briefly in the past (see here), but my position is rather simple and I think it’s a position most people should adopt, because, obviously, you should adopt my views of the world!  Just kidding of course.  You’re free to do with my thoughts as you wish and I am only here to provide one guy’s perspective and not pretend to offer some holy grail view of the world.

Anyhow, much of the confusion on this discussion starts with definitions. Technical analysis often gets a bad rap for being labelled as charting.  But they’re two different, but related things.  Charting is the use of chart reading in various ways to formulate strategies.  Technical analysis, on the other hand, is simply the use of past data to analyze future market direction.  Of course, a chart is merely a picture of past price action so charting is a subset of technical analysis, but does not comprise the universe of technical analysis – some of which can be extremely complex and sophisticated.

I find that understanding the past is an essential element in any good form of portfolio construction.  Perhaps you study the past to conclude that market timing is silly.  Or perhaps you study the past to conclude that buy and hold is silly.  But in the end, what most of us end up doing is essentially a branch of portfolio construction that begins with understanding past performance.  Of course, past performance is not indicative of future returns and while history rhymes, it rarely repeats perfectly.  So understanding past price performance and the history of price action is merely one building block in the development of a portfolio.  But that doesn’t mean it is a useless piece of the puzzle.  Whether you’re a trader or a buy and hold investor it’s useful to understand technical analysis and past price performance in order to better understand how one should go about attacking the future.

Of course, I am a very fundamentally driven analyst so I take the view that technical analysis is a good complement to good fundamental analysis, but to each his own.  In sum, keep an open mind.  There’s no holy grail to the world of portfolio construction and understanding and embedding many different approaches into your own will only make you a more well-rounded and informed investor/saver.

The Difference Between Central Banking and Market Manipulation

The kids are over on the internets using the Tweet machine to ask Ben Bernanke some questions.  There are also some adult questions mixed in there.  For instance, Jim Grant asks:

“Could you help me understand the difference between central banking and market manipulation?”

 Now, I’m no Ben Bernanke, but I would like to take a stab at this one.

First of all, it’s important to understand what central banking really is.  For instance, in the USA, the Fed system exists because rogue independent banking like we had in the 1800′s proved highly unstable.  In essence, payment processing was inefficient and extremely unstable during times of crisis.  The primary role of the Fed system is to bring payment clearing into one place.  We call this the “interbank” market in the USA.  It is where all the banks settle interbank payments.  They do so by being required to maintain deposits at the Fed.  You can think of it as being the best of all worlds between having a nationalized money system (like one national bank that clears ALL payments smoothly) and maintaining private competitive banking.   The Fed is a buffer of sorts.  It is neither a pure public entity nor a pure private entity.

But this system is a bit of an inconvenience for private banks who would really prefer not to have to engage in all of this “oversight” and central clearing to begin with.  In a perfect world they’d monopolize the money game and tell the government to take its ball and go home.  Obviously, that’s not what we have.  So we have a reserve system.  And to the banks who participate in this system it is, by mere existence, “excess”.  You can think of all reserve balances in this interbank market as being “excess” to private competitive banks.  So, they would prefer not to hold them.  This puts pressure on the overnight rate because the banking system will naturally try to rid itself of excesses.  So the Fed must make a choice.  Will it let the overnight rate drop to zero or will it support it in various ways?  Obviously, the Fed chooses to support the rate.  In other words, it manipulates the rate higher.

Things get a bit tricky here.  In addition to facilitating this essential clearing system, the central bank can manipulate the spread at which banks make a profit on their loans.  This can have a significant impact on profits generated by banks.  The problem is, this manipulation is far from an exact science.  And when you layer operations like QE on top of that we have to start worrying about market disequilibrium and potential unintended consequences of this intervention.  But yes, make no mistake, there is a clear distinction in the roles of the central bank.  Its most important role is as a facilitator to a smooth payment system.  Its secondary role is in influencing the price of inside money (bank money) in order to steer the economy.   The primary role is unquestionably positive.  The secondary role of what is definitely “manipulation” is up for debate.