Monetary System 101
History is clear that “inflation is everywhere and always a monetary phenomenon”. However, our shadow banking / repo based monetary system is so complicated that people can’t understand or judge “monetary phenomenon”. People often quote, but do not understand, what shadow banking, M1/M2, “bank reserves”, or QE, are or what they mean and therefore can not easily judge if the money supply is expanding or not.
An economy is a complex system and money is the “medium of exchange” that allows trade to happen. Money conducts trade. As the nodes in the complex system increase (businesses and people connected) there is a non-linear increase in transactions and therefore a non-linear increase in demand for money to clear those trades. This is why money needs to be “elastic”.
With the number of participants in the global economy growing, especially the number of institutions using the dollar (the global reserve currency), there is a non-linear increase in demand for money.
In a fractional reserve system money is created via lending (not by the Federal Reserve, which can only incentivize “bank reserves”). Since the entire globe needs dollars to clear trade, this has made Wall Street, and the prime dealers of the shadow banking system, very wealthy for creation of this collateral. Via lending, the dollar creation expands in tandem with resource creation — after all, they’re collateralized loans.
However, the banking system has made too much money lending out dollar denominated assets that it has ignored due diligence for preventing malinvestment in the underlying assets.
It is therefore my view that it is now painfully obvious that dollar creation has grown at too slow of a rate to sustain global economic growth, and that the reserve assets could dramatically decrease in value. Decreasing money supply during increasing (or steady) demand is every financial crisis — 1873, 1893, 1929 and 2008.
First, let me dispel the myths regarding the “excess liquidity” and then we can move onto the definition of inflation.
Quantitative Easing (“QE”) is an asset swap.
There is no money printing. It is not fractional lending, nor money creation at all.
QE is an asset swap.
QE is simply moving digits on the Fed balance sheet from one place to another. It is often moving prime dealer account balances from T-Bills to IOER.
You and I have checking accounts with JPM, but JPM has a checking account with the Fed. But sometimes they choose to keep their balance in higher yielding assets, unless incentivized with higher yields by the Fed to keep those reserves in the Fed saving accounts of sorts — IOER.
The idea is that in a fractional reserve system the banks will have plenty of money to lend, but there is no increase in the money supply simply by changing the type of reserves a commercial bank has.
The Fed is well aware that they can’t force the banks to lend and this is why they put a temporary ban on the banks from repurchasing shares. If the Fed is going to supply them with cash (or rather “bank reserves”) they want it to be lent out into the economy 10 times over (this is fractional reserve money creation). However, the banks just waited til that time was over and are now doing repurchases again with their “reserves”. Didn’t work.
But note that when supplying “cash” to prime dealers, they are simply buying distressed assets of the commercial banks — which is why the Fed bought $2.5 trillion in mortgage backed securities in 2020. They simply save the bad investments of the banks, but the Fed can later go sell the same assets back into the market. And they do. There is no new money creation here, QE is simply an asset swap.
Bank reserves don’t matter. Lending happens in repo.
As mentioned, the global dollar monetary system does its lending in the repo market. Repo was originally a way to clear trades, but it’s now a way to lever up portfolios with overnight loans.
It was in repo where Bear Sterns (in 2007) and Lehman (in 2008) failed to roll over the overnight loans needed to provide dollars for their long term obligations.
Repo is the heart of our monetary system and the majority of lending and trade clearing happens there. In turn, that is where our modern failures happen, or as the BIS called it, “dollar shortages”.
So the Fed wanting the banks to have cash actually strips the repo market of collateral needed to clear trade, gain leverage and therefore create money.
The “dollar” being the global reserve currency doesn’t refer to dollars we keep in our wallets, but “EuroDollars” — dollar denominated assets. This is why mortgage bonds and commercial paper was so overvalued going into 2007 and why their decline was so devastating. They are used for collateralized loans to maintain leverage and to acquire dollars to clear trade.
However, when one type of dollar collateral declines in value it funnels everyone into treasury bills. Bear and Lehman were forced to go get treasuries.
See, a major money market fund can’t keep cash parked at the Fed, so the safest place to keep money is to put up the cash in repo and get the safest collateral possible — treasury bills.
This is why Buffett said the other day that there are times, like 2008, where treasuries are the only form of money accepted. Not “cash”. Not commercial paper. Definitely not mortgage related assets. But only T-Bills were accepted as collateral to clear trade.
However, in some QEs the Fed buys treasuries back when the system needs it most. This accentuates a treasury short squeeze and why we see the price spike up in events like March 2020. Treasuries are the only collateral accepted in times of uncertainty and “bank reserves” don’t help at all.
M2 is a meaningless metric
Because it’s a fraction reserve based shadow banking system, the money supply is completely untracked. We can track bank reserves and we can even track basic consumer loans, but this is a fraction of the global dollar supply.
The Fed realized M2 was an increasingly obsolete metric in 1974 and temporarily created M3 in another effort to track dollars.
For whatever reason, our Fed doesn’t require disclosure of shadow banking or derivative activities. Even the things that are required are easily skirted via offshore accounts and other basic accounting trickery.
Most importantly, due to the Federal Reserve Act of 1937, the Fed does not have the power to increase the money supply. They can only do open market operations and buy assets with other already existing assets.
Notice how the Fed “balance sheet” scales liabilities and assets up and down in tandem. It can buy mortgage backed securities, but it now has an asset it can sell back. But more relevantly, there are no new dollars in the monetary system — they had treasuries and now they have MBSs, or maybe the other way around. The Fed can not create money!
Lastly, the Fed doesn’t control rates or inflation.
Whenever I hear anyone say the Fed controls rates I ask them how. No one actually knows but the theory is that they have a short term lending rate that makes up a small portion of dollar lending and it’s only on the short end. You could just as easily say JPM controls rates when it changes its short term lending rate. Does JPM “control” inflation? Obviously not.
There is zero evidence (nada) that this controls inflation.
Furthermore, mark my words, the Fed will follow the market, not the other way around! They have tried many times to raise rates and the market may follow temporarily but it always continues its journey downward and then the Fed changes its mind.
Rates are set by how productive the lending of the past has been, and the Fed can’t change that with a tiny change via a little overnight lending.
If the Fed could simply create inflation they wouldn’t have to lower their target year after year. After the GFC Bernanke had to answer to congress about why they weren’t hitting their 4% target. Then 3%. Now 2%.
Yes, the CPI is up now, and it’s up globally.
There was a global supply chain shortage in 2008 and CPI spike… and yet it was followed by deflation.
Dollar squeeze coming
Lending / margins are based on volatility of underlying assets. When the market is stable or growing, leverage is high. But with volatility in rates or assets, both of which we have now, there is a decrease in leverage.
It is my opinion that this is the greatest bubble in history and it will end soon, when corporations can no longer rollover their loans. That is, when previous lending has been so unproductive that they can’t even lend out underlying assets as collateral and no longer have incentive to keep lending to unproductive uses and companies.
Like mortgages and commercial paper starting their decline in 2007, the ponzi to create dollars for the global monetary system ends. It is only on the back of bad lending that we have enough dollar collateral to clear all trade.
I believe this decline is already starting.
I was just in Sri Lanka in March where they don’t have enough dollars to import food and fuel. They are having rolling power outages and the line for diesel is hundreds of people long.
I just left Nepal today, where they are curbing imports of items like cars in order to preserve dollar reserves.
These countries can not get enough dollars to do basic trade and these economies are dependent upon imports. You are seeing this globally.
Just look at the Fed’s RRP which just hit its highest overnight lending ever, $1.906 trillion. And guess who is using it and why? It is for foreign banks to clear trade.
This is why Yellen has gone to other countries like China and New Zealand to open dollar swaps. The world is telling our Fed, “if all trade is going to be cleared in dollars, then we need more dollars!”
8 dollar shortage trade bets:
- I’m long on-the-run long term treasury bills. Especially 30 year zero coupons, which is the best of the best collateral in repo.
- Corporate bonds, especially junk bonds, are about to have a historic crash. The stock market is full of unprofitable companies living on rolling over debt. That’s a ponzi, and ponzi’s always end eventually.
- Mortgage related assets will eventually crash.
However, if you recall in the Big Short, mortgage swaps went up in value well after Burry was right about the mortgages. This is because the system is so desperate for dollar collateral that it is willing to overlook malinvestment until the last minute.
Post 2008 the majority of the real estate bubble has been in commercial mortgages, but home prices still hit a historic high, well above the 2006 “real estate bubble”.
If CMBSs go up, I’ll enter a short. - The S&P will be liquidated like an Archegos fund.
Hedge funds can lever up by lending stocks for cash to buy more stocks, which then gives them more cash to get more stocks. Combine that with unprofitable companies repurchasing shares with high interest debt, like GE… you get the craziest bubble in the history of stocks. (Add forcing your pension holders to buy GE stock, and buy on margin! This is truly the craziest bubble in history).
I have way out of the money puts and will continue to buy, extending the dates, until judgement day. However, I buy them when there is zero volatility since they are priced via volatility and are much cheaper.
Currently a lot are up in volatility but that could change — Boeing, GE, Tesla, ARKK, ARKQ, ARKW, ARKF, HUBS, SHOP, CRM, ROKU, etc… - Berkshire is the only safe stock I’d guarantee.
$150 billion in cash, largest company by net asset, and a company built on recession proof businesses like energy and insurance. These are the only businesses, and the only balance sheet, I know can continue on in a crash.
Since Berkshire holds hundreds of millions of its float in stocks, in a stock crash they would have to record a loss (mark-to-market accounting is insane!). My hope is that Berkshire is not only subject to the same Wall Street liquidations but that Wall Street will see Berkshire is losing money when it isn’t (they don’t understand or check balance sheets) and I can scoop it up at a steal. If I’m wrong and Buffett buys back his own stock to moon or something, I’ll kick myself, because it is the only stock I trust. However, I’m fine staying all cash and puts. That said, this is still a reasonable valuation for Berkshire if you have to park your money somewhere other than in cash. - International stocks are not a safehaven.
Jeremy Grantham keeps saying international stocks are cheap, but as mentioned, it is these emerging markets that struggle to get dollars first. Depleting reserves and a dollar shortage could be devastating for these economies which don’t produce their own oil, food, cars, etc… - Bitcoin is not a currency.
It isn’t an asset swap, so it isn’t money. In terms of monetary systems, it’s more like a Beanie Baby than a currency. And as Buffett says, its intrinsic value is nothing. It’s a ponzi scheme that has lured people hoping to get rich.
Conclusion
I’m not saying CPI can’t temporarily increase further as there are still coming supply shortages. But again, we saw this same increase in supply chain issues and CPI in 2008 and the end result with a decade+ of deflation.
However, the price of the dollar will go up. And it is deflation, money shortages, that is the cause and result of the Great Depression and Great Financial Crisis, not inflation.
