Wednesday, February 23, 2022

Debunking the "Magic Helicopter" Myth

Over the weekend, the WSJ published an opinion piece titled "How Government Spending Fuels Inflation." The piece was written by Tunku Varadarajan, who summarizes arguments made by John Cochrane, an economist and senior fellow at the Hoover Institution.

This was an unfortunate piece, and is especially disappointing for an esteemed publication such as the WSJ. Like most mainstream economists, Cochrane confuses correlation with causation. He notes that federal debt has increased by 30%, then rhetorically asks "Is it at all a surprise, that a year later inflation breaks out?"

Statements like this may sound intelligent on their surface, but his assertions are in no way supported by facts. The below chart compares year-on-year percentage change in total federal debt with the year-on-year growth rate in CPI. There were similar percentage increases in total federal debt in 1983 and 2009. Notably, neither of those periods led to excessively high growth rates in consumer prices:

Indeed, the recent inflationary episode is the exception, not the norm. So if increasing the federal debt has not historically led to an accelerated increase in CPI, why is this time different? There are myriad reasons for this, including the fact that we were going through a global pandemic, temporarily shut down the economy, then reopened it, and are dealing with the consequences. Supply chains have completely blown up. Chip shortages are restricting production of new automobiles by the OEMs. Americans consumed an unusually high amount of goods relative to services. Our national infrastructure is generally degrading thanks to multiple decades of underinvestment. None of this has anything to do with the level of federal debt outstanding.

Cochrane goes on to promote his upcoming book, The Fiscal Theory of the Price Level, in which he will apparently claim that inflation happens when the government borrows more money than people expect it to repay. If this sounds like complete nonsense, that's because it is. First of all, as per the 14th Amendment, the US federal government is required by law to repay all of its debts outstanding. Second, generally speaking people don't spend their time assessing the "creditworthiness" of the US federal government. The yield on US Treasuries are called the "risk-free rate" for a reason. The federal government has no limits on its ability to meet obligations denominated in its own currency. If you talk to any actual business owner in real life, most of them won't even be able to tell you how much debt outstanding there is ($30 trillion). Frankly, most of them probably won't be able to recite our nation's annual GDP! ($24 trillion). And that's among people who work in business. Does this guy actually think that non-business people spend time thinking about whether the US can "pay back" its debt? It's an utterly delusional assertion. The only people who talk about this stuff are economists and people in finance. Participants in the "real" economy don't actually know or care. Most people spend time thinking about how to pay their bills, feed their families, engage in extracurricular activities, and take care of their loved ones. The idea that consumers adjust the price they are willing to pay for goods and services based on their perception of the government's capacity to service its debt is absurd. I am embarrassed on the WSJ's behalf for publishing such drivel.

But that's not the only example of Cochrane conjuring fairytales in lieu of the real world. He likens the US Government's stimulus package to Milton Friedman's infamous "helicopter drop." I don't know about you, but I don't recall seeing bags of dollar bills being dropped from magic helicopters a year ago. In the real world, in the United States of America, on Planet Earth, money is created when either the US federal government spends more than it collects in taxes, or when banks create new loans. These new dollars are simultaneously assets and liabilities. Cochrane's analogy of a magic money helicopter is not only silly, it's also just the completely wrong. It implies that money appears out of nowhere, existing as a fixed stock of a scarce, commodity-like resource. It's as if cash exists only as an asset. In reality, we know that the cash in our pockets is our asset, and simultaneously a liability of the Federal Reserve. Cochrane, and those of his ilk, fail to understand this, and rather than engage in serious, useful discourse, instead resort to fantasies, fairytales, fables, and frauds.

Cochrane claims that when the government issues too much debt, people sell said debt to "buy other things," thus driving up the price of everything. This is just an asinine assertion. Cochrane doesn't seem to be much of a markets guy, so perhaps he doesn't understand that every sale has a purchaser. If "everyone" knows that the government has issued too much debt, and this has led the price of everything else to go up, why on earth would there be any buyers? It's just a ridiculous claim to make. It's also worth noting that people generally buy Treasury securities because it is a safe place to park one's savings. That is money that is put aside for future spending. Why would the government issuing additional debt compel people to all of a sudden spend away their savings? None of this makes any sense.

Let's pretend for a second that MMT is wrong, and that the US federal government does indeed need to "borrow" money from the private sector to fund its deficits. Even if this were true, it's noteworthy that, as Cochrane points out, the US national debt has increased by 30% since the beginning of the pandemic (> 30% since mid-2019). So, nearly 2.5 years after increasing its debt by > 30%, and inflation reaching 7.5%, logically one would expect the interest cost on such debt to be higher, right? As it turns out, the yield on the 10-year Treasury is almost exactly where it was back in mid-2019:

It's these types of thought experiments that compelled me to question conventional economic theory, and eventually embrace MMT. After all, if your theory can't explain and/or predict reality, then what good does it do? Nearly everyone on Wall Street laments how interest rates "should be" higher. This reflects the disconnect between how they think the economy and public finance works versus how it actually works. They stick to their dogma, rather than being open-minded and realizing that orthodox economics is wrong. They are modern-day flat-earthers, convinced their worldview is correct despite all evidence proving otherwise. 

Their ignorance creates our opportunities.

Before wrapping this post up, I wanted to share two data points which support assertions made in our previous post. Specifically, we wrote the following:

" far the most consensus trade for HFs has been “long growth, short value.” So, as reserves were transferred out of the banking system, margin lenders were forced to call in their loans, forcing HFs to de-gross their portfolios. By de-grossing, they sold their “growth” stock longs and covered their “value” stock shorts."

The folks over at Grant's Interest Rate Observer agree that, per FINRA, a substantial de-grossing has taken place as margin balances are falling off a cliff (emphasis added):

"As stocks rolled over to start the year, domestic margin debt collapsed by a record $85 billion in January vs. the previous month, data from the Financial Industry Regulatory Authority show.  Despite that downward lurch, the outstanding $830 billion figure at the end of January compares to $799 billion a year ago and sits far above the $562 billion in January 2020, before the bug barged in."  (source: Almost Daily Grant's

How they don't make the connection that the largest contraction on margin debt ever coincided with one of the largest treasury surplus months ever is beyond me.

And, per Goldman Sachs, hedge funds have generally performed terribly, because as stated, they have all piled into the same long growth/short value trades:

Friday, February 18, 2022

Unexpectedly Large Treasury Surplus in January Is Creating Stress In the Markets

Most people generally accept and understand that the Fed executes its monetary policy operations through the FOMC by purchasing or selling US Treasury securities and, in doing so, adding or removing reserves from the banking system. It isn’t controversial or insightful to say that an increase in the supply of reserves causes rates to come down, and vice versa when supply decreases. Per the Fed’s website:

“To raise the FFR, the Fed decreases the supply of reserves by selling U.S. Treasury securities in the open market. The decrease in reserves shifts the supply curve left, resulting in a higher FFR.

To lower the FFR, the Fed increases the supply of reserves by buying U.S. Treasury securities in the open market. The increase in reserves shifts the supply curve right, resulting in a lower FFR.”

However, what most people do not understand and/or acknowledge is that US budget deficits (i.e. Treasury cash outlays exceed inflows) are achieved by the Fed adding reserves to the banking system, and budget surpluses (i.e. Treasury cash inflows exceed outlays) are done by the Fed removing reserves. A 2018 paper released by the Chicago Fed makes this explicitly clear:

“When the U.S. government makes a payment, funds are withdrawn from the TGA [Treasury General Account] and sent to the bank accounts of individuals or businesses. These transfers increase the reserves of the commercial banks that hold the private accounts. Similarly, when the government receives a payment, the source of the payment is an individual or business account at a commercial bank and, ultimately, the reserves of the commercial bank.”

Orthodox economics tells us that a government which runs chronic budget deficits will eventually be forced by the bond market to pay higher interest rates as punishment for “profligate spending.” One of the critical insights of MMT is that, by looking at the order of operations of our monetary system, this “bond market vigilante” theory is complete nonsense. Per the above, budget deficits increase the supply of reserves in the banking system, and increasing the supply of reserves in the banking system leads to lower rates.

This is overwhelmingly supported by empirical evidence. Consider Japan. Like the US, the Japanese government issues debt in its own currency, and has been running large fiscal deficits for the last 30 years. Over that time, the interest rate on the 10yr JGB has gone from 5% to basically 0%:

Same goes in the US. Aside from a short period in the late 1990s/early 2000s, the US has been consistently running budget deficits for the last 30 years. As MMT would predict, rates have been falling over that same period:

Notice, too, how a recession followed shortly after fiscal year 2001 budget surplus. When the US government runs a budget surplus, that leads to the Fed removing reserves from the banking system. It is a de facto rate-hike, and takes away financial resources from the non-government sector. The weakened financial position increases the likelihood of a recession.

I bring this up because the BLS recently released the January budget figures, and it turns out the US government ran a budget surplus of $119 billion, the first since September 2019 ($83 billion), and an unusually high amount for the month of January. Market participants might recall the big Repo market blow-up that took place in September 2019, where stress in overnight funding markets caused the Secured Overnight Financing Rate to spike unexpectedly:

As the Fed explains, this was basically a timing issue: there was an insufficient supply of bank reserves due to higher-than-expected tax collections by the Treasury on September 16, which coincided with a $54 billion Treasury debt sale settlement, both of which caused a rapid $120 billion decline in bank reserves. This brought the aggregate level of reserves down to its lowest level since 2012. The lack of reserves increased bank borrowing needs, which spooked lenders (mainly Federal Home Loan Banks or FHLBs) and caused them to pull back on collateralized loan advances.

Let me repeat: insufficient reserves caused overnight rates to spike. That is precisely what MMT predicts! More reserves lead to lower rates, less reserves lead to higher rates. Given that fiscal deficits add reserves, that means that fiscal deficits lead to lower interest rates, and surpluses lead to higher rates. This stands in direct contrast to the mainstream view that fiscal deficits will (eventually) lead to higher rates. It’s all a gigantic lie/myth/fraud, perpetuated for decades by Wall Street, the media, policymakers, and academics.

So what happened in January 2022 when the Treasury ran a budget surplus, removing reserves from the banking system? Exactly what we would expect to happened: rates rose! This past January saw the largest fiscal surplus ever for the month of January. Lo and behold, the rates on US Treasury securities exploded. The secondary market rate on the 3 month US T-bill went up by 4x in a month, from 6bp to 24bp:

This unexpected event caused funding stress in money markets (as evidenced by the rapid rise in rates) which subsequently caused a decline in the stock market, as leveraged traders (read: HFs) had their margin loans called by banks and were forced to de-gross their portfolios. As a result, the NASDAQ had its second worst January performance ever (January 2008 was the worst) and the S&P 500 and Dow Jones Indices each had their worst overall monthly performances since the pandemic-induced panic in March 2020.

But not all stocks were treated equal over this period. “Growth” funds got absolutely slaughtered: Whale Rock Capital lost 15.9%, Tiger Global lost 14.8%, and Melvin Capital and Light Street Capital each lost 15%. Meanwhile, so-called “value” stocks performed exceptionally well. In fact, quant fund giant AQR’s value fund posted its best month ever this past January. The media has dubbed this the “great rotation” into value stocks. While I would love to see a secular rotation into value stocks, I am skeptical of this explanation. The more rational reason for this performance discrepancy is that for years, by far the most consensus trade for HFs has been “long growth, short value.” So, as reserves were transferred out of the banking system, margin lenders were forced to call in their loans, forcing HFs to de-gross their portfolios. By de-grossing, they sold their “growth” stock longs and covered their “value” stock shorts. And given that all these HFs have piled into the same names, there is very little liquidity from buyers. We are routinely seeing companies report earnings after hours and immediately go down by double-digits. As mentioned in a prior post, Meta Platforms (formerly Facebook) set a record for largest market cap loss in a single day.

This sequence of events is shockingly similar to what happened in September 2019. As mentioned before, September 2019 was the last month that the Treasury ran a budget surplus, causing stress in overnight funding markets. I distinctly remember that period because in the span of a few days, the portfolio of stocks I was helping manage at the time had the most ridiculous three-day stretch of performance I’ve ever seen, returning ~15%, including 7% on a single day. I remember chatting with friends in the industry who said many people’s portfolios were blown up from this, just like they are today. The move was so swift and severe that the media started writing about the beginning of a great “rotation” out of growth into value. You can’t make this stuff up. Rinse, cycle, repeat.

There are other examples of stress occurring in the markets today. We already wrote about the yield curve flattening/inverting, and how the mortgage market is expected to slow down dramatically compared to the last two years. Clearly, that is a sign that demand for mortgages is slowing. And yet, mortgage rates have experienced the largest monthly jump in 9 years. If mortgage rates are spiking, that is a sign that lenders are nervous about underwriting new loans. Think of a mortgage rate spike like the yield on a corporate bond: if yields explode, that is a sign of stress in the markets. Under healthy financial conditions, lenders feel confident and compete with each other, causing rates to go down. When they become nervous, they either pull back on their lending activities (leading to less competition) or demand higher rates to compensate for the perceived risks. High rates are an indication of fewer suppliers of credit, assuming demand is flat. But we know for a fact that demand is actually down, based on the outlook for mortgage originators like LDI. If demand was down but financial conditions were strong, lenders would be forced to lower their rates. The fact that demand is down and yet rates are spiking is a bad sign.

It is insane that nobody on Wall Street or the media connects the dots between the Treasury running a budget surplus causing stress in the markets. January 2022 and September 2019 share striking similarities. All the pundits insist the recent rapid rise in rates is because of the market’s perception that the Fed will adopt a more hawkish stance and hike rates multiple times in 2022 in order to “fight inflation” (I used quotation marks because, as argued previously, the notion that rate hikes slow inflation is questionable at best). And as a reminder, nobody updates their DCF model with a higher discount rate because the yield on the 10yr went from 1.5% to 1.8%. This is all just a narrative created by the media and Wall Street. In reality, the jump in yields is due to reserves being removed from the banking system thanks to the Treasury’s unexpectedly large budget surplus. Treasury flows affect real economic outcomes. Perhaps there is some marginal impact by speculative macro hedge funds laying on curve steepener trades. Indeed, after failed iterations of this trade in 2021 caused huge losses at big macro HFs, they have once again been piling on the steepeners in 2022:

And yet the results have been the same.

The fact that Wall Street and the media sticks to these false narratives just shows they have no idea what they’re talking about. When one understands the monetary operations of our financial system, it is easy to connect the dots between the Treasury running a budget surplus, removing reserves in the banking system, causing yields to spike, stress in funding markets, and forcing leveraged traders who have piled into the same trades to de-gross their portfolios. Using an MMT lens allows us to better see and understand this happening in real-time.

As for trade ideas to take advantage of these conditions, I have been adding the long-bond to my personal account. Treasuries have gotten hammered recently, so they offer higher yields. Their special legal status as HQLA means there will always be a bid for them when markets become stressed. Opportunities are created when changes in price are inconsistent with their fundamentals, which is exactly what’s happened. Additionally, the Treasury has gone back to running a deficit in February, and I expect that to continue until taxes are collected in April. Deficits add reserves, so we should expect rates to come down. Investors also might want to consider looking at Virtu Financial (VIRT), who is a specialist market-maker in equities and derivatives. When markets become stressed, volatility goes up and trading spreads widen, which are a benefit to VIRT’s bottom line. The VIX is up +72% YTD:

At 9x LTM P/E, VIRT looks reasonably priced (albeit not "pound-the-table-cheap") if the volatility continues.

Thursday, February 10, 2022

7s/10s Curve Is Inverted

Recession likely to come sooner than most think:

Of course, this shouldn't come as a surprise given what we wrote previously that the US government has been running a budget surplus in 2022. Indeed, this is the first time since April 2019 that the government ran a budget surplus:

And what happened in the months that followed that budget surplus? The yield curve inverted, and Google searches for "recession" hit their all-time highs:

And while HY spreads are unchanged from a year ago, they have been creeping up so far in 2022:

These are all ominous signs of an imminent recession and/or risk-off event. Prepare accordingly... 

Wednesday, February 9, 2022

Yield Curve Is (Still) Flattening, Liquidity Is Evaporating

There was a lot of excitement late last week about the BLS report showing US nonfarm payrolls added 467,000 jobs in January, and revising the prior period up by nearly 200,000, handily beating expectations.

While it's worth noting that there were some revisions to prior-reported data as part of its annual review, this is undoubtedly good news about the health of the economy and further supports the fiscal stimulus measures enacted by Congress in 2020 and 2021.

Per the WSJ, the report caused stocks to rise and bonds to fall.

(Side note - I have always been skeptical when I read or hear in the news about some presumed cause/effect relationship with regards to that day's news and the price action in financial markets. In the real world, investment decisions are frequently made days, weeks, even months in advance and are completely unrelated to what the mainstream media is reporting. Frustrating, but that is the world we live in.)

And while it's true that bonds largely sold off on Friday, what's more important is that the 2yr/10yr spread continued to fall, reaching its lowest level since October 2020. Per Bloomberg:

The fact that this is happening is an indication that monetary conditions are too tight. Interest rates are the price of credit money. Like any other commodity, money gets priced on a curve, at the intersection of supply and demand, over a period of time. New money supply is added through two channels: commercial bank loans and fiscal spending. As time passes, money is constantly being created and destroyed: money is created when banks make loans or the government injects new money, and it is destroyed as loans and taxes are paid off. Bank lending is primarily driven off of income: a loan is made if the lender believes the borrower has capacity to service its debt given their income. If long-term rates are falling relative to shorter term rates, that is an indication that demand for long-term borrowing is weak, forcing lenders to lower their rates. Perhaps people don't feel confident about their future income prospects, so they hold off on making long-term purchases like homes and autos. When this happens, banks are forced to lower rates (prices) in order to encourage people to borrow and spend.

Likewise, rising short-term rates indicate that current demand for money is on the rise, hence the price is going up. A flattening yield curve is therefore a signal that there are too few dollars in the economy: near-term demand for dollars is rising at the expense of future dollars. 

Without a surge in bank lending (which requires people to feel confident about their capacity to service debt with incomes earned) or fiscal spending (which requires cumbersome political processes), the supply of dollars across the time continuum is somewhat fixed. People need cash now, and they have limited access to cash in the future (for myriad reasons) so they borrow short-term, which leaves fewer dollars leftover for future spending. Given spending = income in aggregate, lower future spending means lower future income.

Per the aforementioned BLS report, the labor force participation rate (62.2%) and employment-population ratio (59.7%) remain below February 2020 levels, which were themselves unimpressive after declining for two decades. Fewer people working is a drag on the economy, limiting its full productive capacity and therefore suppressing incomes available for workers. Limited income for workers means fewer people feel comfortable taking out a long-term loan.

The government could fix this with a Job Guarantee. I also firmly believe that a student debt relief program would create new capacity for borrowers, and jumpstart the economy. Without these kinds of programs (or some other stimulus), however, I expect the curve to keep flattening as we head closer to recession.

There are already signs that economic growth is slowing. PayPal (PYPL) provided weak guidance on its earnings call last week, sending the stock down 24% in a day, citing a slowdown in consumer spending, particularly among low-income earners. They cited Omicron, inflation, and the lack of fiscal stimulus as contributing factors.

Likewise, mortgage loan servicer loanDepot (LDI) indicated on a recent earnings call that cash-out refi's were going to be much lower in 2022 than in 2020. Cash-out refi's are an important source of liquidity for consumers, and a slowdown there suggests that liquidity will tighten - consistent with earlier points about tighter monetary conditions. With fewer dollars to go around, sales and incomes should stagnate.

If there was ever a sign of tightening liquidity, consider that Meta Platforms (FB, formerly Facebook) recorded the largest market cap loss ever last week at $232 billion after a terrible earnings print. Meanwhile, Snap Inc. (SNAP) shot up nearly 60% after hours last week, adding around $23 billion to its market cap. The fact that megacap tech companies are suddenly trading like penny stocks is a sign of a lack of liquidity in the markets. Expect more volatility ahead.

And who can be expected to be a beneficiary of this volatility? I'll save that for a future post. Hint: It was one of the companies included in my Financials model portfolio posted on earlier this year.

Monday, February 7, 2022

MMT Has the Facts on Its Side and Is Starting to Win the Narrative

This weekend was a watershed moment for the MMT movement, as Dr. Stephanie Kelton graced the cover of NYT's business section with a title read: Time For a Victory Lap*.

This is a turning point because MMT is officially becoming mainstream (indeed, I may need to start writing about something else!).

I would encourage anyone to read it in its entirety, but the article was intentionally nuanced: author Jeanna Smialek gives credit to MMT for being correct that the US government didn't have a problem selling bonds to "fund" its large fiscal deficits, with the caveat that many mainstream economists have blamed the deficits for the elevated levels of inflation in 2021. This is obviously ridiculous considering we've been running deficits for two decades with mild inflation; the difference is this time, we had a global pandemic and supply chain disruptions to deal with, which stretched our real resources and caused inflation. Consider the below, which shows that consumer spending remains on trend with the last decade:

So if spending (i.e. demand) is the same and inflation is higher, that must mean the elevated inflation is due to supply side - bottlenecks and shortages thanks to the pandemic.

Joe Weisenthal, an editor at Bloomberg and co-host of the fantastic Odd Lots podcast, wrote it perfectly in this morning's "5 things to start your day" newsletter, which I recommend subscribing to (emphasis added):

"The story that a lot of people are telling right now is that "we tried MMT" got a lot of inflation, and so therefore it failed. But this is problematic on multiple levels. For one, it ignores the incredibly fast labor market recovery (or seems to imply that the labor market recovery was always inevitable, but that the inflation wasn't). But more importantly, a lot of the inflation we're seeing can be attributed to mediocre growth post-GFC. We're experiencing shortages for various parts of homes (garage doors, windows, lumber) in part because we let capacity for all of those things atrophy after the housing bust. A lot of lumber mills went bust after we let the economy collapse. The ideal MMT solution would be, in part, to never have had that horrible post-GFC growth in the first place, so that we didn't lose supply side capacity in those key areas. Now of course we can't go back in time to change policies. There's no time machine. But in some sense, we're now paying the price -- not for fiscal expansion in 2020 and 2021 -- but for fiscal timidity post-GFC that allowed the economy to be so languid for so long, such that we found ourselves with no capacity for a period of rapid growth."

This is incredibly well said. By deluding ourselves into creating imaginary financial deficits, we created real resource deficits that continue to create real consequences for real people.


Tuesday, February 1, 2022

Excerpts from "Monetary Economics" (Godley & Lavoie)

 From pgs. 48-52, these were just too good not to share (emphasis added):

"In the mainstream framework, money is sometimes said to fall from the sky, thrown out of an helicopter, as in the famous parable by Milton Friedman. In that mainstream framework, which is highly popular in mainstream intermediate macroeconomic textbooks, money is a given stock, which seems to appear from nowhere, and which has no counterpart in the rest of the economy. Despite changes in the real economy, and presumably in financial flows, the stock of money is assumed to remain at all time constant. The quadruple-entry system shows that such a conception of money is meaningless."

So well said, and the root of inspiration for "hard money" types, including goldbugs and Bitcoin HODLers. They fail, like most people do (including money managers), at grasping the concept of money and debt being one in the same.

"From a flow-of-funds standpoint, increased deposits are thus a source of funds while increased loans are a use of funds for the banks. For some, this terminology seems to reinforce the mainstream belief, associated with the loanable funds approach, that banks provide loans insofar as they have the financial resources to do so; in other words, banks make loans only when they have prior access to deposits...On the contrary, a key feature of the banking system is its ability to create deposits ex nihilo. More precisely, when agents in the economy are willing to increase their liabilities, banks can increase the size of both sides of their balance sheet, by granting loans and simultaneously creating deposits...It may be that, in flow-of-funds terminology, money deposits is the source of funds allowing the use of bank loans. But the cause of this increase in deposits and loans is the willingness to contract an additional liability and the desire of the borrower, here the production firm, to expand its expenditures."

Like I wrote about in an earlier piece, banks are the most misunderstood businesses in the world.

"Firms only draw on their lines of credit when they are required to make payments. In the second step of the circuit, the deposits of the firms are transferred by cheques or electronic payment to workers who provided their labour to the firms. The moment these funds are transferred, they constitute households' income. Before a single unit is spent on consumer goods, the entire amount of the bank deposits constitutes savings by households, and these are equal to the new loans granted to production firms."

At the risk of repeating myself: banks DO NOT use deposits to fund loans; LOANS CREATE DEPOSITS.

"The key factor is that, as households increase their consumption, their money balances fall and so do the outstanding amount of loans owed by the firms. Similarly, as households get rid of their money balances to purchase newly issued equities by firms, the latter are again able to reduce their outstanding loans. In other words, at the start of the circuit, the new loans required by the firms are exactly equal to the new deposits obtained by households. Then, as households decide to get rid of their money balances, the outstanding loans of firms diminish pari passu, as long as firms use the proceeds to pay back loans instead of using the proceeds to beef up their money balances or their other liquid financial assets. Although determined by apparently independent mechanisms, the supply of loans to firms and the holdings of deposits by households (and firms) cannot but be equal, as they are at the beginning of the circuit."

This is an important point, because many people who have been skeptical of the viability of Silicon Valley "tech unicorns" totally missed this. There are two ways for a firm to stay solvent (i.e. not default on its existing debt): funding obligations either using cash generated from internal operations/asset sales or raising new outside capital. Remember: US fiscal budget deficits create non-government surpluses, and the US government has run fiscal deficits every year since 2001. The budget deficits we ran over the last decade or so by themselves weren't a problem; the problems were in other public policy decisions that influenced where that newly created government money flowed to. If we had better design, and those newly created dollars actually flowed to people who spent their money on useful goods and services, that would have generated higher sales and profits for firms. With higher sales and profits, the firms could have paid higher wages to employees, who would in turn buy more goods and services, and perhaps have a stronger credit profile to borrow money to fund a mortgage or new car. This would have been especially helpful after the GFC.

Instead, many of these newly created dollars flowed towards, among other groups, VC funds. Recall that VC funds collect deposits from households and purchase equities of early-stage companies. These funds raised over half a trillion of capital in the 2010s. The new equity capital helps pay back old debts, keeping the companies solvent as they burn through cash. The funds raised were also largely put towards marketing rents paid to Google and Facebook. So, the money was trapped in this (un)virtuous cycle, whereby VC's would collude together and mark up each other's books, and all the money would flow to GOOG and FB, who's shareholders became rich and themselves launched careers as VC's, further continuing the cycle.

How could this happen? Lax regulations, particularly antitrust and corporate fraud enforcement, combined with powerful network effects associated with internet-based commerce, created a massive tailwind for Silicon Valley "tech" companies. These companies burned billions of cash, as they didn't have to be profitable thanks to their privileged access to the government's newly printed money. Take for example Uber Technologies (UBER), who as of its latest quarterly filing has an accumulated deficit of $23 billion in its shareholder equity account. That is an astonishingly terrible fundamental economic performance. And yet, UBER's current market cap is over 3x that accumulated deficit figure. It's hard to call this "capitalism" when it's just uber-rich, politically connected people lighting government money on fire and causing taxi shortages for the public to deal with.

"The mere holding of the money paid out as wages has a loan as its exact counterpart. When the household sector buys something from the production sector, this destroys money and loans by an equal amount. While the loan-granting activity created an efflux of money into the economy, the purchase of goods by households creates a reflux - the destruction of money. Thus, any series of transactions can be conceived as the creation, circulation, and destruction of money."

Circle of life. Money is created, circulates around, then dies upon return to its Creator (i.e. the government).

"These extra reserves do not mean however that a multiple of money deposits will be created, as the standard money multiplier has it. If banks do not find any credit-worthy borrower - and the fact that they now have additional reserves implies in no way that additional credit-worthy borrowers will be forthcoming - they always have the choice to purchase government bills...if the central bank is to keep the interest rate at its target level, the central bank must sell to the banks (and to households) the bills that they look for, and by so doing, the central bank will absorb the money balances that neither the banks nor the households wish to hold."

This is what most people got wrong with QE. I distinctly remember a portfolio manager at Tudor explaining to me that QE "deposited cash" into the banks so that they could be spent into the economy. Unfortunately, that's not how it works. Banks don't lend out deposits (or reserves). They create deposits when they make loans. Stuffing banks' balance sheets with reserves has no effect on lending activity, but it has other effects as discussed in a prior post. Public policy failures have resulted in fewer people with sufficient credit to get a loan from a bank. At the same time, banks need a source of income to fund interest expense on deposits, so they purchase Treasuries instead. Weak demand for credit further forces banks to lower their rates, creating a bid for Treasuries. 

On Inflation

[Note: I originally started writing this piece on December 23, 2022, then got held up with holiday festivities. More posts for the new year ...