MISUNDERSTANDING THE MONETARY SYSTEM IS BAD FOR YOUR PORTFOLIO

I’ve been incredibly vocal over the last year about QE2 and its likely impact on the US economy and US government bond market.  Time and time again I have said that the policy was largely a waste of time and effort and unlikely to have any real substantive effect on the economy (see here and here).  The policy was flawed primarily due to one rather simple mistake – it focused on size and not price.  This resulted in no real transmission mechanism through which it could impact the economy and failed to control interest rates.

Most investors did not believe this perspective and maintained that QE2 would not only cause surging inflation, but would also cause US government bond yields to surge when the program ended.  This was primarily due to the many myths that have persisted surrounding QE2.  These were the myths of “debt monetization“, “money printing” and “stimulus”.  These are nothing more than common misunderstandings, but investors who listened to these myths failed to assess how QE2 would impact the asset it targeted – US government bonds.  None of these misinterpretations was more famous than Bill Gross who incorrectly analyzed QE1, but also misunderstood QE2.  Yesterday, the WSJ discussed the investment performance of the PIMCO Total Return Fund as a result of this analysis:

“Bill Gross, long a rock star in the fixed income universe, has been a laggard this year as his bearish view on Treasurys has been confounded by their bull run during the past few months.

Mr. Gross, 67 years old, manages the world’s biggest bond fund–the $245.5 billion Total Return Fund–at Pacific Investment Management Co. The fund has handed investors a return of 2.99% this year through Wednesday, ranking 157th out of 179 funds in the category of intermediate-term bond funds tracked by Lipper.

Over the past three months, the fund just broke even, with a return of negative 0.04%, compared to a return of 2.7% from the benchmark Barclays Capital Aggregate Bond Index, according to data from Morningstar Inc.”

Unfortunately, the WSJ doesn’t appear to connect all of the dots.  You see, what PIMCO misunderstood, was not just the impact of QE2, but the actual operational realities of the US monetary system.  We’ve tracked PIMCO’s comments in real-time and called them incorrect at several points in the last year.  For instance, earlier this year, Bill Gross said June 30th could be “D-Day” when the US government could experience a shortage of buyers in government bonds which would lead to surging yields.  Bill Gross asked “Who will buy the bonds?”  Mr. Gross misunderstood how QE functions to “finance” the US government (they don’t).  And in doing so, he misinterpreted how government bond auctions work.  I said these funding fears were unfounded and unlikely to impact bonds.  Last year at this time, I vigorously argued that US Treasuries were not in a bubble.  And just days before an epic 10% surge in long bonds I said US Treasuries served as part of “the perfect hedge” in this environment.  I followed-up to these pieces in greater detail than I cover here (I’ll spare you the repetitious commentary).

The point here is not to say “hey look at me, I was right and Bill Gross was wrong”.  The point is that understanding the monetary system matters.  Economics is largely “dismal” because the myths of neoclassical economics dominate our classrooms and media commentary.  This causes an extraordinary disconnect between the way investors perceive the economy and the markets.  And it results in underperformance by fund managers who make mistakes by incorrectly assessing the US monetary system.  It doesn’t have to be this way.  Hopefully, as time goes on, more and more investors will better understand the monetary system in which we reside.  Not only will this avoid investment losses such as the above, but it might actually translate to better public policy.  Unfortunately, we’re a long way from that reality….

Cullen Roche

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

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Comments

  1. One point missed in the above discussion is that QE counters the crowding out effect of fiscal policy. That is, where government borrows and spends, the crowding out effect to some extent negates the effect of the spending. There is widespread disagreement on the size of the crowding out effect, but whatever the size of this effect, QE negates it.

  2. “Krugman misses this point. He says that for each debtor there is a creditor – why wouldn’t the creditor spend?”

    It’s a good question. It seems to me that the answer is that most of the credit in our system is locked up in:
    - pension plans and pension funds (held until retirement)
    - insurers (float held for solvency)
    - banks (held as required capital)

    And credit that is locked up can’t be spent.

    At first one might think that the banks are the biggest creditors. However, the banks can’t be the ones to spend (in the way Krugman means it) because banks don’t have free equity. Banks are the first creditor in line, but banks have creditors of their own: the textbook example is a bank with 90 dollars in liabilities for every 100 dollars in assets. The remaining 10 dollars are the bank’s capital. The textbook bank has no room for spending: it must hold 90 dollars against its liabilities, and it must hold the other 10 dollars as required capital.

    The question is: where is the free equity (wealth)? It seems to me that most of this will be locked up in pensions, float and required capital. I don’t think Krugman is making a case against insurers holding reserves or banks holding required capital. It seems to me that his case is really one against pensions. Most western nations are collectively saving for their retirement (eg. baby boomers). Making a case for spending today is making a case for forcing people to spend their retirement money early.

    • Great point and the other part of the puzzle hidden in “macro” aggregation and “accounting identities” is the economic effects from wealth concentration. Said, differently, if the high wage earner group after making some threshold of income, begins to “hoard” money and invest those funds in “unproductive asset speculation” rather than more “productive” spending or creating new businesses we would expect from capitalism.

  3. going back to national accounting

    and breaking savings down to corporate and individual levels

    we can see that there is a corporate savings glut at the highest levels its been since i can find numbers for which is 1985

    http://2.bp.blogspot.com/_Et4TQ-a0gGU/TRO8AiXywiI/AAAAAAAADZ8/vPxUOBinhfY/s1600/3-sector_chart.jpg

    the economy has never done well since 1985 when corporate savings has been at a high level

    it seems to me that spending cuts are necessary to cut into the corporate savings glut

    the problem will be where to cut off the cuts before they become too deep and we end up in a clinton/bush cycle again

    i personally wont mind that cycle since i will be properly armed this time thanks to Cullen and Crew

    • I think you are on the right track but I do not agree with your conclusion. Consider if you breakdown consumer and corporate savers in top saver, middle saver and bottom savers, what you will find is that deficit cuts will continue to skew savings to the top savers away from the bottom and middle.

      MMT completely ignores the income approach to GDP, and by focusing on the expenditure approach, they conclude the appropriate policy choice is higher government spending. Rather then an approach of lower or negative taxation that the income analysis may lead one to conclude.

      Also by focusing on the expenditure side of GDP, their analysis failed to predict and understand that the last stimulus disproportionately benefited corporations rather than the wage earners.

  4. Dear Mr. Roche,

    I’ve been exploring your site – it’s very interesting and provocative, thank you. MMT is startlingly new to me, but where I struggle is not the concept (which seems quite simple, in principle), but its seeming inconsistency with FRB documents and research papers. I wondered if you could help me with one example (“Why are banks holding so many excess reserves”). It seems germane.

    http://www.newyorkfed.org/research/staff_reports/sr380.pdf

    Which claims that the excess reserves simply reflect the size of the Fed’s interventions and that they are not inflationary. You may agree.

    Yet, beginning at the bottom of page two, it diverges sharply (I think) from your description of how this arises.

    It describes how a stressed bank, imminently faced with a deposit withdrawal, may be helped by the Fed crediting it with reserves which it can use to honour the deposit obligation without shrinking its balance sheet. I don’t think the MMT description allows this “withdrawal of reserves”. Under MMT, the stressed bank has to reduce its assets or go to the discount window. Perhaps it can do the former by buying UST from the Fed, which debits its reserves, and selling those UST. Perhaps it can do the latter using reserves as collateral. But both of those are quite different operations to the one described. The former is a monetary operation.

    Do you have a source which states quite categorically that reserves may not be used for settlement within a bank’s lending and borrowing operations ? Eg a clear legal distinction between reserves and money used in the settlement of commercial transactions. (I have read that notes are reserves, but that may be wrong, and may be de minimus.)

    Sorry for the long question – I see you have a missionary’s zeal but it must get quite tiring. Anything you can do to help would be appreciated. As you (I hope) see, on my side I’ve been giving this a lot of thought and working the internet hard.

    • Hello Kim,

      Since this is my expertise within MMT, I hope it is ok if I respond.

      “It describes how a stressed bank, imminently faced with a deposit withdrawal, may be helped by the Fed crediting it with reserves which it can use to honour the deposit obligation without shrinking its balance sheet.”

      I don’t actually see that example, though there is something similar on page 4 that is an extension of the example beginning on p. 2. I don’t see any problem with that example starting on p. 2 and running several pages from our perspective. I do have a problem with the suggestion that banks need the reserve balances before they can make a loan–and there’s quite a bit of Fed research to back me up on that which I have cited in the past–but that’s not germane to your query.

      “I don’t think the MMT description allows this “withdrawal of reserves”.”

      Yes it does. It’s central to it.

      “Under MMT, the stressed bank has to reduce its assets or go to the discount window.”

      How do you suppose the bank received the reserves from the Fed? The Fed never “gives” the reserves away, it lends them either overnight (discount window or other standing facility) or intraday (overdraft) or does an asset swap (open market operations). The article is describing this process.

      “Perhaps it can do the former by buying UST from the Fed, which debits its reserves, and selling those UST. Perhaps it can do the latter using reserves as collateral. But both of those are quite different operations to the one described. The former is a monetary operation.”

      I have no idea what you’re referring to here, unfortunately. I think you’re reading something into MMT that isn’t there.

      “Do you have a source which states quite categorically that reserves may not be used for settlement within a bank’s lending and borrowing operations ? Eg a clear legal distinction between reserves and money used in the settlement of commercial transactions. (I have read that notes are reserves, but that may be wrong, and may be de minimus.)”

      Again, I don’t know what you are referring to. MMT’ers make no claim whatsoever that “reserves may not be used for settlement within a bank’s lending and borrowing operations.” Indeed, I have stressed in my research that this is the primary thing they are used for.

      I hope that helps. If not, you might cite the portions of MMT that appear to you to support your interpretation above and we can go from there.

      Best,
      Scott

      • Scott,

        Many many thanks for taking your time to read my post, download and read the file and for the extensive reply to what I now realise was a badly informed question. Your reply switched the lights on for me.

        I do need to rethink MMT to adjust my understanding of its implications but in short:-

        The reserves created by QE are neither given away nor returned to the bank holding them (that would be printing money). Rather, they are lent.

        The fact that the Fed holds so many reserves right now just means that it has a “demonstrably” large capacity to support the private banking system in lending. But it always did, just this time it has created the reserves in advance, rather than on demand. This does not in itself stimulate bank lending (whether reserves are relevant or not), nor increase the risk of inflation.

        Once again, many thanks for your effort and patience. I shall keep reading !

        kim

        • Hello Kim,

          Please feel free to keep asking and keep critiquing!

          Best,
          Scott

  5. ocean,

    I could be wrong but I think MMT ignores income on the basis that it all comes from govt spending.

    I make the assumption that individual savings will naturally be higher than corporate savings and therefore assume that spending cuts will have minimal effect on individual savings when corporations stop saving. That is until the cuts go too deep.

    • GDP from income approach (aka gross domestic income) as reported from BEA is

      GDP = W + NOS + D + T, where
      W = wages
      NOS = Net operating Surplus (profits)
      D = depreciation
      T= Taxes on Imports less Subsidies

      First thing to note is that direct government spending does not appear in the GDP income approach. However, government does tax on imports shown explicitly in the equation and taxes both wages and profits (implicitly).

      This suggests another policy choice to grow GDP is negative targeted taxation to wage earners and/or small and large businesses (i.e a small government solution). As opposed to a top line deficit spending big government socialization.

      The point is from an sectoral accounting sense one can argue a low/negative tax rate solution. And the detail to the productive impact of wages vs profits is so much richer in this view, I’m baffled why MMTers ignore this and focus on the expenditure view.

  6. ocean,

    we know that raising taxes causes an increase in the current account. A current account surplus has equaled bad times in the U.S since the 70s. It also does a good job of getting the president fired.

  7. Cullen I’ve a question for you re QE and money printing that is not clear in my head:

    The Fed credits the banks reserves when it purchases Treasuries. These reserves could theoretically be lent out, expanding the money supply via the money multiplier mechanics. Expanding the money supply.. Is this not like printing money?

    I would appreciate your view                                           

  8. Don’t forget the impact of commodities (especially oil) priced in USD and the relationship with the Foreign Currency Reserves. If all oil were priced in EUR, Yen or CAD starting today then the USD would go down the drain and US interest rates would go through the roof tomorrow. But those things are “”a bit too original”" for the braincells of TPC, aren’t they ?

    When one disregards that it’s bad for one’s portfolio as well.

  9. http://pragcap.com/resources/understanding-modern-monetary-system

    There are couple of things missing in understanding MMT

    - Dollar does not derive it’s value from money management of FED / Treasury / Tax – it purely derives value from ability to exchange dollar for Petroleum, hence the term Petro-Dollars. The Iraq war conclusively proved it.

    - Understanding MMT does not explain the impact of fractional reserve banking on the economy. for eg. When bank creates “fractional” credit/loan from thin air to a corporate entity it can go out and buy capital assets then charge rent on the assets to pay back the bank. When the bank gets the loan money back, bank can again buy assets with that money. This gives the banks huge advantage, the only reason why all large oil companies are owned by the banking families.

    - MMT + Fractional reserve banking system is sinister, it needs to be dismantled.

    • What Iraq war exposed is the very basis of Keynesian money management system of Central Bank / Treasury / Tax. What it proved is money as a social contract is based on redeem-ability of money in terms of energy.

      The financial crisis of 2008 has exposed the “fraud” in the fractional reserve banking system. The legs of the fractional banking has been broken it is now limping along on “bail out” crutches.

      Solution
      ———

      Now the question is there a viable alternate money system possible. Answer is yes ideal money system did exist in many parts of the world – using food grains as money – food grains = ideal money commodity – does not need redemption to realize value = energy.

      Today using food grains directly is not practical, but issuing redeemable food grain bonds as backing for currency system is practical for central bank of every country in the world or even a world bank, becuase to para-phrase Keynes – without food grains we are all dead.

      The banking system fix is to remove cheque issuing capability from banks make all money transactions real time online settlements and central banks should issue large denomination currency notes – transactions of which has to be registered online. This will remove “fractional fraud” from the banking system.