How the System works

Paper Alfa's road to figuring stuff out

This is a dive into one of my first threads on how I think the system works. By system, I mean the financial system, reserves, bonds and ultimately, what drives assets in the medium to long term.

For most of my formative risk-taking years, I believed that there was plenty of money to be made by focusing on fundamental data. I created, or so I thought, an understanding of what drives what and how certain data points lead to some forecastability. Except that they did not. It could have been possible once upon a time, but not in the early 2000s.

What economists try to predict is inherently unpredictable, as you can not use linear tools of economic equations to forecast an inherently complex system. Similarly, using a relatively blunt tool of interest rates to steer economies through cycles also did not gel with my view that self-reinforcing reflexive systems are too endogenously interconnected to simply dance by the ruler of rates.

The deeper my quest to find appropriate now-casting economic and inflation models, the more I understood the dichotomy of two varying systems, which pretty much followed the Heisenberg uncertainty principle. Accurately describing the static theoretical economic model could not give you an accurate assessment of either the location or the speed of the financial “reality” and vice versa. So why bother with economics? I was determined to find answers, question all prior understanding, and look more afield for alternative theories.

I was certain that I would need to understand the mechanics of a machine before I wanted to use it. Having the manual might never lead me to really check every bolt and switch. As it happened, the great financial crisis was the ultimate eye-opener and accelerator for me. So, I made my way through tons of papers and books and discovered my personal roadmap as to how the world works. So here it is in a nutshell.

Source: Dall-e

Follow the Coin

The notion of following the coin methodology highlights how money or reserves flow through the system and end up in financial assets of certain risk preference. Think about how every penny or dime that is created by either fiscal spending or credit creation then flows through the economic system. Ultimately, the collective coins end up as a deposit somewhere that can be invested in a variety of different assets of liquidity, duration and risk preference.

The light bulb moment of those findings developed over months and years of reading functional finance books and studying Richard Koo’s balance sheet recession view of the world. In addition, several selected MMT reference books were also helpful in framing an alternative view of the monetary system compared to the then-prevailing theory.

I have to say, it didn’t come easy at first, but it founded my whole view on central banking and my new understanding of how it all ties together. Now, I don’t want to sound over-simplistic and I know all too well that there are tons of caveats around complex systems. All I am trying to achieve is to lay the ground foundations for understanding the monetary engine. I always try to keep it as simple as possible.

The Mechanics

For a long time, it has been reasonably well-understood that the central bank controls the money supply and balances the economy by setting interest rates and fixing reserves which power bank lending. Further, we were taught that more central bank money automatically means inflation and that the federal government needs to borrow the same fiat amount from financial markets (non-public sector) to be able to spend. Ultimately, we were taught through highly praised books that a modern economy needs to grow its way out of its debt burden or expose itself to the risk of fiscal insolvency, which, of course, is the biggest boo-boo of them all.

Pretty much all of these well-entrenched notions fell away one after the other over the past decade.

Starting from the beginning, here is how I now think it all works:

The first coin is created when the fiscal authority gives it to a private citizen in exchange for a good or service like a haircut, a tractor or labour. Think of it as a coupon on nicely coloured paper. In exchange for your haircut, you are given the coupon you or anyone you trade it with can give the treasury/government back to cover taxes when they inevitably become due.

In the meantime, it goes from one person to the next and ultimately gets deposited at a financial institution. The bank then deposits it (forget fractional reserves for now for simplicity) at the mighty central bank. The central bank records this sequence in its little (or gargantuan) spreadsheet.

Liability: One overnight reserve/demand deposit/tax coupon.

Asset: IOU from the fiscal authority’s treasury account (TGA)

When taxes become due, the person withdraws their deposit, pays the dues and the treasury scraps it. Come and gone.

Because of mostly political governance and historical shortcomings, we still demand the treasury department to cover their shortfall at the central bank by swapping the deposit by selling a government bond. Demand for such a government bond can only come from the central bank itself (if they are short in reserves and need to inject liquidity), a bank or a person who has chosen to give up a deposit coupon for a higher-earning savings or investment asset.

By accounting identity, the overall private sector surplus is equal to the public sector deficit plus the current account surplus. Or in equation format:

(S – I) = (G – T) + CAB

where S = Savings, I = Investment, G = Government spending, T = Taxes, CAB = Current Account Balance

In other words, this means that the money ready to be deployed to buy government bonds comes from the government itself. If there aren’t enough coupons/reserves floating around to buy government debt, the central bank will and is mandated to provide them. This is done via adding liquidity through operations, which in this example would see them buying government paper in exchange for coupons. Goold old classic repo.

If, for whatever reason, there is a shortage of required coupons, overnight interest rates would skyrocket. As central banks are mandated to target short-term interest rates, they will have to supply the needed coupons, which are basically identical to treasury bonds and, as such, comparable to a checking vs a savings account.

So, circling back to our spreadsheet analogy, debt monetisation, in essence, is the central bank’s daily record keeping in order to target their overnight interest rate efficiently. The fact, however, that only overnight bills are really fungible as coupons, the built-up savings/investments in usually higher-earning government debt will need a market-clearing mechanism in order to match supply and demand for anyone exchanging their asset into fungible cash to pay for goods and services or pay their taxes when they become due. The price for this exchange mechanism are longer-term, market-determined interest rates.

A central bank, of course, can affect longer-dated rates via either their monetary operations or via QE. The crux of the matter here is that none of those operations has any impact on the functioning of the real economy; in fact, it is the other way around as all the amount of coupons in circulations will force the central bank to tap and exchange numbers on their spreadsheet, boring, isn’t it?

Looking at it through the now well-documented QE, it is, in essence, really only the central bank converting overnight coupons/reserves into government bonds, which is forcing the private sector out of their savings and into cash. An asset swap, essentially.

As I have discussed above, the private sector is net saving, by definition. Moreso, the private sector has saved everything the treasury has ever spent, and it’s held either in cash/deposits or in government bonds. Putting it all together, all government debt outstanding plus the floating-around cash in the system has to equal the cumulative deficit spending. Is your head spinning yet?

The process of QE has resulted in depriving willing savers of coupon income (flat curves and lower rates), which in turn is constraining overall aggregate demand, similarly for banks, who are forced out of duration assets into cash reserves which will not alter their lending intentions one bit. Money multiplier theory is gone. Banks will lend given opportunities and their inherent capital strength. They can create new loans out of thin air keep on lending, and obtain the reserves via the central bank’s monetary repo operations to avoid spiking overnight rates.

QT is the entire process above in reverse, basically. Yes, there are nuances regarding a duration mismatch as you force savers out of cash back into treasuries, but the mechanics are the same.

Further Thoughts

Money is trust inscribed on a piece of paper or shiny coins. Throughout history, governments have violated the trust by overborrowing, misallocating, and paying investors back in debased currency (inflation). From real standards (Gold, Silver) to the current Fiat system, I believe it is a slow and ongoing process. Central banking via targeting overnight rates, debt ceilings and other checks and balances are clear relics of the previous standards. As a fiat system is a process and ultimate monetary system test, naturally, I would argue disinflationary forces should diminish as the engrained trust in the political and constitutional system vanishes and gets damaged over time. The order of past events shows this clearly, as our esteemed fiscal leaders have discovered that fiat money empowers them pretty much limitlessly over their corresponding economies.

Government defaults are entirely a political event, as are hyperinflationary periods. Ultimately, it is all about trust in the strength and trustworthiness of political institutions. It certainly has nothing to do with Debt/GDP ratios, as many are advocating.

There is more that I would like to cover, but I will leave it for future posts. This has been somewhat lengthy, and I hope you followed my logic. It might be wrong, but it helped me frame the workings of the system just after the financial crisis, and it also was the foundation for the belief that bonds and risk assets would be the beneficiaries from such a mix of monetary and, at that time, fiscal prudence.

The current environment is risking the uncovering of the opposite workings of said mechanics, and we have already seen glimpses of it over the past year. I wish this is only a cyclical, pandemic-induced bout of inflation. We shall see. Tail risks remain that the fiat process is ending and that we might enter into a different monetary regime, ultimately rebuilding the financial system. Onwards and upwards! Whatever it is, we shall enjoy the ride.

Your

Paper Alfa

P.S. please comment on anything described above as I would love to hear your thoughts.