Dear Thoughtful Investor,
In my sixth letter, HARD ASSETS AND HARDLY ASSETS, we discussed how what we commonly refer to as ‘dollars’ and ‘cash’ are not actual money, they are miniature promissory notes - loans - from the Federal Reserve. This seventh letter continues the conversation on central banks and the nature of currency. Since the Fed can create and extinguish the existence of these miniature loans at-will they have the control over the money supply, although that control is quite far from absolute or precise. The reason that changing the money supply is a very blunt tool is due to the multiplier effect of fractional reserve banking - it is also the reason central banks exacerbate booms and busts instead of smoothing them.
In a fractional reserve banking system banks take in demand deposits from individuals (these are regular deposits, they are called ‘demand deposits’ because they can be demanded at any time; someone with a checking account can withdraw their funds at any moment; they have complete liquidity - at least in theory), these demand deposits are combined with capital contributed by the bank’s owners/shareholders and this becomes the pool of capital that the bank loans out to businesses and individuals. Banks make money on the spread created by the term structure of interest rates - a fancy way of saying interest rates are higher on long term loans than on short term loans. Banks pay their depositors zero or very low interest rates because the depositors can get their money back at any moment, that cash is then lent out to businesses (for example) on a 5-year loan. If all the depositors ask for their money back at once the bank cannot give it back because it has been lent out for longer terms to others. There is an inherent ‘asset liability mismatch’ - bank liabilities/deposits could be requested at a moment’s notice but bank assets/loans are locked in for a long time. Banks make the bet that not all the depositors will ask for their money back at once. They keep a small reserve of cash to cover the small number of people that request their cash back on any one day, but this reserve is a fraction of total deposits hence the term: Fractional Reserve Banking.
Fractional reserve banking acts as a powerful money multiplier. The effect is that small adjustments to the supply of money by the Fed’s Open Market Committee is magnified throughout the system in all kinds of imperfect ways. Through this mechanism Money Supply is turned into Credit Supply and expansions and contractions of credit supply are pro-cyclical, that is, they magnify the effect of the business cycle and contribute in drastic and terrible ways to manias, panics, and crashes.
Central Banks lobby for their own existence on the basis of saying they have a “dual mandate to maintain full employment and stable prices (i.e. low but positive currency inflation)”. In this way they take on a very academic and intellectual image in the public psyche. With their years of training and complex modeling they akin themselves to the ‘masters of economic universe’.
The Thoughtful Investor sees through the ruse. When pressed, Central Bankers admit that their most critical function is the be the “lender of last resort” in a crisis. The theory being that because of Fractional Reserve Banking, banks may become illiquid without becoming insolvent. A bank can become illiquid if most of its depositors demand their deposits back at once but this does not mean they are insolvent. Insolvent being a math equation where liabilities exceed assets in an irrecoverable way. Insolvency occurs when a bank makes too many bad loans where the principal and interest will never be repaid and must be written off. The bank didn’t lose it’s own money, it lost the money of it’s depositors. When the depositor is sweet old grandma it becomes politically expedient to ‘bailout the bank’ in order to save grandma’s savings account. The bailout is performed by the ‘lender of last resort’, someone that will lend to the illiquid or insolvent bank when no one else will (note: banks first go to other banks to borrow money to cover their reserve requirements, this is the repo market and banks borrow and lend with each other every single night to meet that day’s capital reserve requirements). When someone says that we need lender of last resort what they mean is we need an official mechanism to bail out the banks at regular intervals for the noble purpose of saving grandma’s savings account.
As noble as a bailout may sound when it is sold to the public (remember 2008?), the reality is that creating an official institution dedicated to being a lender of last resort creates both a policy dilemma and a moral hazard. As Kindleberger says in his opus Manias, Panics and Crashes, “if investors know in advance that governmental support will be forthcoming when the prices of securities fall sharply, investors will be less cautious in their purchases of securities and crises might develop more frequently.” Bailouts create a moral hazard. Period.
The publicly stated hope of central bankers is that through their intellect and modeling they can tamp-down the and balance out the cycles of euphoria and then crash by tightening money supply/credit during euphoria and loosening it during a crash. History demonstrates that central bankers do not have any special foresight and their models are often built to predict the last crash in hindsight not the next one in foresight. Further, to quote Kindleberger again, even where “the increase in the discount rate at the central bank sets in motion the right reactions, lags in responses may be so long that the crisis begins before the Marines arrive.” The politically popular sales pitch of both monetary (central bank) policy and fiscal (executive branch/government) policy are always the same talking points: “creating jobs for everyday americans and helping Main Street not Wall Street”. Again, history demonstrates that when credit expands those flows do NOT typically go to true business investment (thereby creating jobs for Main Street), they go into the euphoric asset du jour which feeds the mania/bubble of the popular asset (tulip bulbs in 1637, tech stocks in 1999, and real estate in 2006). Recall Bill Gross’s analysis in the video in Letter #3 Join the Innovation Economy - the capital flows facilitated by 10 years of expanding money supply and credit has NOT gone into the real goods & services economy, it has gone into the financial economy. It has fueled stock prices that are divorced from earnings and dozens of “unicorns” (private companies valued above $1B) that burn horrendous amounts of cash with low or negative earnings.
The takeaways for the Thoughtful Investor are two-fold:
1) A Central Bank in control of a unpegged, fiat currency (not backed or pegged to a hard asset like gold) will (a) constantly manipulate the money supply. This manipulation will be (b) magnified by fractional reserve banking to create very expansive or contractive changes in credit supply (it is respectively easier or harder to get loans). These (c) expansions and contractions magnify bubbles/manias because people borrow to buy the rapidly rising asset then are forced to liquidate when a shock causes prices to decline and their loans must be repaid. Thoughtful Investors would do well to avoid investments in such assets. Which bring us to the question:
2) What assets are being fueled by the expansive monetary policies of the last ten years? Where are the prices of an asset dislocated from the earning potential of that asset? Today this is the equities (stock) market and late-stage venture capital market. This is a good time to take some gains off the table and reduce equity exposure and a good time to pass-up the sexy tech IPO that isn’t backed by earnings.
A Thoughtful Investor