This September marks the 225th anniversary of both the congressional authorization for the Department of the Treasury and the swearing in of its first Secretary, Alexander Hamilton. Throughout the department’s long and storied history, it has played an increasingly integral role in the issuance of national currency. This two-part series will provide a brief account of the evolution of our nation’s federally-issued currency, birthed during one of our nation’s most trying times – the Civil War.
The Civil War Era
The federal government began issuing its own currencies during the Civil War as it tried to meet funding and money circulation emergencies. In 1861, Secretary of the Treasury Salmon P. Chase directed the Treasury to issue Demand Notes to pay expenses. As the first national currency, Demand Notes earned their name from the fact that they were redeemable on demand for gold coin at the Treasury.
The government also created the United States Note, another currency designed as a temporary financing measure, with the passage of the Legal Tender Act of February 25, 1862. Almost bankrupt, the United States needed money to pay suppliers and troops during the Civil War. The plan was to print a limited supply of U.S. Notes to meet the crisis. However, U.S. Notes became popular and were issued for decades, coming to be known as Greenbacks.
The Civil War also brought about a shortage of coins. In response to this problem, Treasury issued currency notes in denominations of less than one dollar, ranging from three cents to fifty cents, in 1863. These small value notes are known as fractional currency. They were the first notes printed by the Bureau of Engraving and Printing, and were issued until 1876.
In an effort to get control over the chaos of the monetary system, Secretary Chase advocated the creation of a system of National Banks in 1863 that would issue a uniform, national currency. The National Bank Act of June 3, 1864, created National Bank Notes that were redeemable at any National Bank of the Treasury. The notes proved a success, and were issued well into the 20th century.
In the same year it authorized National Bank Notes, Congress also created another new form of currency, Gold Certificates. One could deposit gold at the Treasury and receive Gold Certificates in exchange. The first Gold Certificates were issued in November 1865, with a maximum denomination of $10,000.
The Late 19th Century
By 1878, U.S. Notes, National Bank Notes, and Gold Certificates co-circulated. That same year, Congress introduced the Silver Certificate. The act authorizing these notes allowed people to deposit silver coins in the Treasury in exchange for certificates, giving people an alternative to carrying numerous silver dollars. Silver Certificates became very popular and were a major form of currency for many years.
Twelve years later, the growth of silver mining in the United States led to another form of currency known as Treasury Coin Notes, which the Treasury Note Act of 1890 authorized. Until 1893, the law required the Treasury to purchase silver bullion and to pay for it with the new notes.
The close of the 19th century saw various forms of currency co-circulating in the nation’s economy, but money-related economic and banking crises continued. A central problem revolved around the inability of the supply of these currencies to expand or contract to meet economic conditions. Part two of this series, to be posted later this week, will explore the solution to this problem.
At the close of the 19th century there were five forms of currency making up the circulation of money in the U.S. economy: The United States Notes, National Bank Notes, Gold Certificates, Silver Certificates and the Treasury Coin Notes. Yet, despite the existence of all these currencies, the U.S. continued to experience money-related economic and banking crises, as the supply of these currencies could not expand or contract to meet economic conditions.
The Early 20th Century
The Federal Reserve was established as a possible solution. Created by the Federal Reserve Act of December 23, 1913, the Federal Reserve had the ability to change the money supply to meet changes in the economy and financial markets. In terms of currency, it did this primarily through the issuance of Federal Reserve Notes that were backed by gold held in Federal Reserve Bank vaults. Issuance of notes ranging in value from $1 to $10,000 began in 1914, and they co-circulated with the existing types of currency.
The next significant changes to the money supply occurred in the 1930’s. The Great Depression and the banking crisis of 1933 forced the U.S. off of the gold standard. The Gold Reserve Act of 1934 made it illegal for private citizens to hold Gold Certificates. Consequently, Gold Certificates were taken out of circulation but were allowed to be used by the Federal Reserve and the Treasury. This included the newly printed $100,000 denomination note. In 1935, the issuance of Bank Notes ended.
The Late 20th Century
By the second half of the 20th century, the amount of silver and silver dollar in the Treasury had declined, threatening the metallic backing of Silver Certificates. In 1963, Congress decided to end the issuance of the certificates. To compensate for the loss, issuance of the $1 denomination Federal Reserve Note was authorized. On July 14, 1969, the Treasury also stopped issuing Federal Reserve Notes with values over $100. In 1976, the $2 denomination was added.
By this time, U.S. Notes were of little importance in the nation’s money supply, though Congress still supported their continued circulation. In 1966, Congress recognized the reality of the situation and began to remove the notes from circulation. These last delivered notes were in 1971. Then, in 1994, Congress ended the issuance of U.S. Notes. This move made Federal Reserve notes the only form of currency available to the general public.
In 1996, the look of Federal Reserve Notes began to undergo major alterations as designers changed and enlarged the portraits on some denominations. These new currency designs also included various anti-counterfeiting devices such as security threads and micro-printing. In 2003, the next generation currency was introduced beginning with the $20 note. The Treasury added subtle background colors and other features to the redesigned bills to make them more secure and difficult to counterfeit. Next generation design reached its apex with the introduction of the new $100 in 2010.
Currency in circulation has become much simpler, consisting of one type for each denomination up to $100; however the actual notes themselves have become more sophisticated. With its various security features, this seemingly simple form of money has become a global currency and has become a measure of value around the world.
The Structure of the Global Monetary System
Rather than being a haphazard mess, international trade and exchange rates have a certain structure to them, built and enforced by the hegemonic powers that exist during a given era.
In other words, at any given time, an empire or set of powerful countries work together to enforce a rules-based global order on how international trade works, and how it is priced.
However, there is inherently an economic entropy within any system, as order gradually frays into disorder. Global monetary systems can be long-lasting, but not permanent. As the global center of power shifts over time, and as bottlenecks and imperfections in the system grow to unsustainable levels resulting in increasing levels of disorder, a system gradually or abruptly gets re-ordered into another system.
Ironically, it’s often not an external threat that brings down the existing order; it’s the flaws within the system that, left unchecked, eventually expand enough to bring it down and necessitate a re-ordering, either from the same ruling regime or from a new regime that displaces it.
Over the past century, for example, the world went from a gold standard system, to the Bretton Woods system, to the petrodollar system. Each system mostly unraveled from within rather than being brought down externally, and each time one system transitioned to another, a significant and widespread currency devaluation occurred.
Gold Standard (pre-1944)
For much of human existence, economies were based on trade. Furs for oysters, olive oil for spices, labor for bread, etc.
The mining of precious metals like gold and silver made that simpler, and these metals have been considered money for thousands of years. With precious metals, you could turn a specific commodity (like furs) into a universal commodity (like gold and silver, which are rare, long-lasting, and able to be broken into small measurable units), to buy whatever you want at a later date.
From there, paper currency and credit was added as a more convenient layer onto gold. Gold itself could be held securely in vaults, and paper slips representing a share of that gold could be used as mediums of exchange. Sometimes they were issued by private banks, and in modern times they were generally issued by sovereign governments. In this sense, governments would issue paper currency that is backed by gold held in central bank vaults.
From that point, we saw the rise of global reserve currencies, referring to either paper or precious metal currencies of trading or military empires that were recognized and accepted in many countries outside their own homeland. The Roman Empire was an ancient example. More recently, the Dutch Empire was a notable example, followed by the United Kingdom, and now the United States. In the 1800s and early 1900s, the United Kingdom had the mantle of the most globally recognized currency, although it existed within a system of many currencies being backed by gold.
During these centuries, the center of global power mostly rested within Europe with its precise epicenter shifting over time, and wars within Europe played a large role in its eventual replacement.
Under this gold standard system, exchange rates between currencies still shifted over time for various reasons, with the balance of payments being a key variable. My article 「Why Trade Deficits Matter」 goes into detail on why that is the case. The crux of it is that whenever a country began persistently importing more than it was exporting, it risked having gold flow out of the country and risked economic stagnation within the homeland. Ultimately, however, this state would usually be self-correcting because a recession would eventually devalue the currency, which would make their exports more competitive and imports more expensive, and thus re-align their export and import balance.
In the later stages of this system, all major nations devalued their currencies sharply and reset or suspended their gold pegs.
The winners of the world wars devalued their currencies less than the losers, but everyone devalued. This was partly from the wars, but also just as much from the end of the long-term debt cycle.
Bretton Woods System (1944-1971)
The most recent handover of global reserve currency status gradually began after World War I, and was finalized in the later stages of World War II. As a result of the wars and the rise of the American economy, the center of global power shifted from Europe (and particularly the United Kingdom) to the United States.
In the 1930’s, the United States government made gold ownership illegal and forced citizens to sell their gold to the government, which allowed the government to build up huge gold reserves. Then, in order to keep gold safe during the war, many countries shipped their gold to the United States. So, the United States had its own massive gold stockpile, and also served as the global gold custodian for many allies.
As World War II unfolded, while Europe and east Asia were devastated by the war, the United States homeland was barely touched, and the US became the world’s largest creditor nation in the process. At that point, the Bretton Woods system was established, whereby the United States backed its dollar by gold, and dozens of other countries pegged their currencies to the dollar, and thus also had a gold standard by association. Many countries held US Treasuries, as a form of reserve collateral that was 「good as gold」. The dollar was not redeemable to US citizens for gold, but it was redeemable to foreign governments for gold.
During this time, the United States also began laying the groundwork for its alliance with Saudi Arabia, which would come into play with the next system.
This period also saw the rise of the 「eurodollar market」, referring to the dollar market that exists between banks and other entities outside of the United States and outside of the Federal Reserve’s jurisdiction, primarily centered in Europe but extending throughout the world.
With the Bretton Woods system and the following petrodollar system, the United States obtained a near-global lock on the international money system. Previous empire currencies never obtained that complete of a financial lock on the world, and thus were never true 「global reserve」 currencies but instead were just 「widely recognized and dominant」 currencies. So the 1944-present status of the dollar as the global reserve currency is not perfectly comparable to pre-1944 periods of other global reserve currencies.
This period was rather unique, in other words. It was the first time technology allowed the entire world to be connected together enough for a truly global war to happen, and for a truly global monetary system to come in its wake.
However, after only a decade, the Bretton Woods system began to fray. The United States began running large fiscal deficits and experiencing mildly rising inflation levels, first for the late 1960s domestic programs, and then for the Vietnam War. The United States began to see its gold reserves shrink, as other countries began to doubt the backing of the dollar and therefore redeem dollars for gold instead of comfortably holding dollars.
In fact, the numbers show that from inception, it was already on an unstable path. The US began the system with more gold than foreign liabilities, but that gap quickly began closing within the first few years.
By the late-1950s, US external liabilities exceeded US gold reserves. By the mid-1960s, the subset of US external liabilities that were owed to foreign officials exceeded US gold reserves, which was the true crossover point where the system became troubled. And by 1971, the system broke down and was defaulted on by the United States.
The system had an underlying flaw that when left unaddressed brought the system down. It was never truly sustainable as designed. There was no way that the US could maintain enough gold to back all of its currency for domestic use, and simultaneously back enough currency for expanding global use as well (which was the part that was redeemable).
Some economists such as Robert Triffin, explicitly warned about this problem to Congress and the business world in what became known as the Triffin dilemma. It was a foreseeable problem, in other words. The same thing happened to the United Kingdom in the early 1900s, prior to World War I.
John Keynes saw the problem ahead of time too, and proposed an alternate system called the Bancor, where an international unit of account based on gold and a basket of major currencies would be used to settle balances of trade and would be held as a central bank reserve asset. This would be an inherently more balanced system, with a neutral settlement mechanism rather than centering everything on the currency of one country.
However, politics often wins out over math, at least at first, and the Bretton Woods system won over other ideas. Something like the Bancor idea was enacted on the side by the IMF as well, with units called SDRs that are a basket of major currencies and are still held by central banks, but it never had enough support to catch on in more than a limited way.
Eventually in 1971, math came back with a vengeance on the Bretton Woods system, and Richard Nixon ended the convertibility of dollars to gold, and thus ended the Bretton Woods system. The closing of gold convertibility was proposed to be temporary at the time, but it ultimately became permanent. Rather than shifting to another country, though, the United States was able to re-order the global monetary system with itself still in the center, in the next system.
Ultimately, all major currencies including the dollar devalued radically vs gold and other hard assets in the 1970’s. This continued the trend of major currency devaluations happening whenever the global monetary system gets re-ordered. Usually the same forces that break the system, also break the currency itself. When that happens, the quantity of broad money supply goes up significantly, and the purchasing power of existing debts gets partially inflated away.
Petrodollar System (1974-Present)
Beginning in 1971 after the breakdown of the Bretton Woods system, currencies around the world all became fiat currencies, and the global monetary system became less ordered. This was the first time in human history that this happened, where all currencies in the world at the same time were rendered into unbacked paper.
A 「fiat」 is an absolute decree from a person or institution in command.
Fiat currency is a monetary system whereby there is nothing of value in the currency itself; it’s just paper, cheap metal coins, or digital bits of information. It has value because the government declares it to have value and that it is legal tender to pay all things including taxes.
A country can enforce the usage of a fiat currency as a medium of exchange and unit of account within their country by making all taxes payable only in that currency, or by enacting other laws to add friction to, or in some cases outright ban, other mediums of exchange and units of account. If their currency has a big enough problem, though, as is the case for many emerging markets, a black market will develop for other mediums of exchange, such as foreign currency or hard assets.
A fiat currency can face particular problems when trying to be used outside of its home country. Why should businesses and governments in other countries accept pieces of paper, which can be printed endlessly by a foreign government and have no firm backing, as a form of payment for their valuable goods and services? Without a real backing, what is it worth? Why would you sell oil to foreigners for paper?
In the early 1970’s, there were a variety of geopolitical conflicts including the Yom Kippur War and the OPEC oil embargo. In 1974, however, the United States and Saudi Arabia reached an agreement, and from there, the world was set on the petrodollar system; a clever way to make a global fiat currency system work decently enough.
We think of this as normal now, but this five decade period of global fiat currency is unusual and unique in the historical sense. Imagine trying to architect a way to make an all-fiat currency system work on the global stage for the first time in human history. In doing so, you have to somehow convince or force the whole world to trade valuable things for foreign pieces of paper with no guarantee from the paper-issuing governments that those papers are worth anything in particular, in relation to an amount of gold or other hard assets.
With the petrodollar system, Saudi Arabia (and other countries in OPEC) sell their oil exclusively in dollars in exchange for US protection and cooperation. Even if France wants to buy oil from Saudi Arabia, for example, they do so in dollars. Any country that wants oil, needs to be able to get dollars to pay for it, either by earning them or exchanging their currency for them. So, non oil-producing countries also sell many of their exports in dollars, even though the dollar is completely fiat foreign paper, so that they can get dollars for which to buy oil from oil-producing countries. And, all of these countries store excess dollars as foreign-exchange reserves, which they mostly put into US Treasuries to earn some interest.
In return, the United States uses its unrivaled blue-water navy to protect global shipping lanes, and preserve the geopolitical status quo with military action or the threat thereof as needed. In addition, the United States basically has to run persistent trade deficits with the rest of the world, to get enough dollars out into the international system. Many of those dollars, however, get recycled into buying US Treasuries and stored as foreign-exchange reserves, meaning that a large portion of US federal deficits are financed by foreign governments compared to other developed nations that mostly rely on domestic financing. This article explains why foreign financing can feel great while it’s happening.
The petrodollar system is creative, because it was one of the few ways to make everyone in the world accept foreign paper for tangible goods and services. Oil producers get protection and order in exchange for pricing their oil in dollars and putting their reserves into Treasuries, and non-oil producers need oil, and thus need dollars so they can get that oil.
This leads to a disproportionate amount of global trade occurring in dollars relative to the size of the US economy, and in some ways, means that the dollar is backed by oil, without being explicitly pegged to oil at a defined ratio. The system gives the dollar a persistent global demand from around the world, while other fiat currencies are mostly just used internally in their own countries.
This chart is two years old, but things haven’t changed much since then. What it shows is that even though the United States represented only about 11% of global trade and 24% of global GDP in early 2018, the dollar’s share of global economic activity was far higher at 40-60% depending on what metric you look at, and this gap represents its status as the global reserve currency, and the key currency for global energy pricing.
The inherent flaw of the petrodollar system, much like the inherent flaw with the Bretton Woods system, is that as previously mentioned, the United States needs to run persistent trade deficits, and is another version of the Triffin dilemma again. This can work for decades but can’t work forever.
Instead of drawing down our gold reserves, however, we gradually draw down our domestic manufacturing base and it gets replaced piece-by-piece in foreign countries.
When most other countries run trade deficits, they eventually have a big enough currency devaluation so that their exports become more competitive and importing becomes more expensive, which usually prevents multi-decade extremes from building up. However, because the petrodollar system creates persistent international demand for the dollar, it means the US trade deficit never is allowed to correct and balance itself out. The trade deficit is held open persistently by the structure of the global monetary system, which creates a permanent imbalance, and is the flaw that eventually, after a long enough timeline, brings the system down.
The other flaw in the system is that it incentivizes mercantilism. This means it incentivizes various trade partners to maximize their exports and minimize their imports by manipulating their currencies to weak levels. Since currencies around the world are fiat with floating exchange rates, many countries try to keep their own currencies weak, so that they have a positive trade balance with the United States and other trading partners. They don’t want their own currencies to be so weak that their citizens can’t import things, but they want their currencies to be weak enough so that their exports are very competitive and the importing power is not very strong, so that they can run trade surpluses. This allows a country to rapidly build up industrial production, and accumulate dollars and reserves. As the global reserve currency, the United States is basically excluded from this option, so we’re the ones left holding the bag of persistent trade deficits.
Some of us, particularly near the top of the income ladder, directly or indirectly benefit from this system. Americans who work around finance, government, healthcare, and technology get many of the benefits of living in the hegemonic power, without the drawbacks. On the other hand, Americans who make physical products tend not to benefit, because they lost their jobs or had their incomes suppressed, and thus haven’t benefited from the gains. And outside of the United States, exporting countries benefit from the system, while countries that don’t like how the global monetary system is structured don’t have much recourse to do anything about it, unless they get big enough like Russia and China.
The Great Petrodollar Bull/Bear Cycle
Because exchange rates are free-floating since 1971 within the petrodollar system, the dollar can strengthen or weaken against other currencies significantly, and other currency pairs can strengthen or weaken relative to each other.
Whenever the dollar begins to take a dip, we get a host of superficial articles from financial media about the 「potential loss of the dollar’s global reserve status」, but that’s not how it works. Conversely, if an analyst such as myself brings up that the dollar may decrease markedly vs other major currencies, one of the comments or pushback they』ll get is 「but the US is the global reserve currency.」
We need to treat those concepts separately. The dollar indeed has had two huge bear market drawdowns of 40%+ vs a basket of other major currencies within this existing monetary system, without losing global reserve currency status. Being a dollar bear within the existing petrodollar system (and having no opinion about the petrodollar system ending), is not identical to someone who thinks the petrodollar system as currently structured is coming to an end.
This chart is the dollar index since the early 1970’s when the petrodollar system began. The chart compares the dollar vs a basket of major currencies, and shows the three major cycles it has gone through :
The dollar index broke below its 50-month moving average this year, and that 50-month moving average itself now has a slight downward tilt. Could it have another one of those dollar down-legs like it had after the previous two major cycle tops? Sure.
So, let’s separate being a dollar bear from being someone who thinks the global monetary system will change structurally. The two don’t necessarily go hand in hand, although they can. It’s important to treat those ideas independently, because even though I do hold both of those views over different timeframes, they aren’t the same view.
Similarly, the dollar being the world’s reserve currency doesn’t necessarily protect it from major swings relative to other currencies. In fact, the depth to which the dollar is plugged into the global financial system arguably gives it bigger swings than it otherwise would have, both to the upside and downside.
Causes for the Cycle
The dollar cycle is based on major shifts in monetary and fiscal policy, as well as the resulting capital flows for global money that wants to chase whatever area of the world is doing well. Underlying all of this is the global monetary system as currently structured, i.e. the petrodollar system.
As I discussed in my February 2020 article, 「The Global Dollar Short Squeeze」 and in my April 2020 article, 「The $40 Trillion Problem「, governments and companies outside of the United States have a lot of dollar-denominated debt ($13 trillion at a minimum according to the BIS), but also have even more dollar-denominated assets (around $42 trillion according to the IMF and US BEA). These debts and assets were built up over decades due to those countries running trade surpluses with the United States, and from the dollar being used for the majority of global financing deals, especially for emerging markets.
That dollar-denominated debt represents a consistent source of demand for dollars to service those debts. So, if recessions happen, or dollar-based global trade slows down, there can become a scramble for dollars which can be in short supply outside of the United States, causing an international dollar spike. This happened in March 2020 as the pandemic sharply diminished global trade, and oil prices collapsed.
In that sense, the petrodollar system reinforced itself over time. At first, countries needed dollars so that they could get oil. After decades of that, with so much international financing happening in dollars, now countries need dollars so they can service their dollar-denominated debts. So, the dollar is backed by both oil and dollar-denominated debts, and it’s a very strong self-reinforcing network effect. Importantly, most of those debts aren’t owed to the United States (despite being denominated in dollars), but rather are owed to other countries. For example, China makes many dollar-based loans to developing countries, as do Europe and Japan.
When the dollar strengthens relative to emerging market countries』 local currencies, it acts as a sort of quantitative tightening for those countries because their dollar-denominated debts go up in local currency terms relative to their assets and cash flows, which can be particularly brutal during recessions. That’s one of the key reasons why emerging market assets and economies are riskier and more volatile than developed market economies; their dollar-denominated borrowings.
On the other hand, a weakening dollar can be like quantitative easing for them, as it eases their debt load relative to their local-currency cash flows and assets.
Similarly, dollar-denominated assets, especially ones held by foreign governments and central banks (acquired from years of trade and current account surpluses), represent collateral with which those countries can defend their currencies, or represent assets that they can sell in order to get dollars to support their obligations if need be.
During a weak dollar period, there is often a global economic boom, and nations around the world including the United States have a period of growth and prosperity. If nations are smart, they start building up big foreign exchange reserves with their dollar inflows. Within this petrodollar system, that has meant buying US Treasury securities. Countries also often use that period to take out dollar-based loans, which comes back to bite them later.
During a strong dollar period, the global economy often slows, and nations get squeezed by dollar-denominated debts. They buy far fewer Treasuries, if any, and might even sell some to get dollars to service dollar-denominated debts or manage their currency.
As a result, we see a clear pattern between dollar strength and the percent of US federal debt held by the foreign sector. Whenever the dollar enters one of its big bull runs, foreigners start to get squeezed, global growth slows (including US growth, due to the interconnection of the global economy), and foreigners slow down or stop their purchases of US debt.
This chart shows the trade-weighted dollar index in blue (with a newer index in red spliced onto it, due to the fact that the longer-running index discontinued at the start of 2020), and the percent of US federal debt held by the foreign sector in green:
As the chart shows, each of the three major dollar index bull runs were accompanied by a sharp reduction in the percentage of US federal debt held by the foreign sector. The United States was still issuing debt, but foreigners weren’t buying much of it.
This lack of buying by foreigners forces the US to fund its own federal deficits, meaning either its private sector or increasingly the Federal Reserve itself had to buy Treasuries, and that eventually leads to a dovish shift in US monetary policy, which plays a role in weakening the dollar and starting the cycle anew.
For a second chart, we can compare the dollar index to US corporate profits, which shows that corporate profits go flat in dollar terms for a number of years every time there is one of the big dollar bull runs:
In other words, as we all know, the global economy is interconnected. The US usually runs into economic problems when the dollar strengthens, just like certain other parts of the world. In a strong dollar environment, US exports become less competitive, and the overall global trade environment becomes sluggish, resulting in domestic stagnation within the US as well.
The 1980s dollar spike occurred in an environment with less global debt, so it required deliberate intervention to reverse. The second and third dollar spikes occurred in environments with more debt in the US and elsewhere, and thus were more self-correcting without global coordination, by unilateral shifts in monetary policy by the US Federal Reserve to protect the US Treasury market and stimulate the domestic economy.
1980s Dollar Cycle
The dollar was weak in the 1970’s after going off the gold standard, and the United States and many other countries experienced rapid consumer price inflation. In the early 1980s, the new Fed chairman Paul Volcker jacked up interest rates to quell inflation. At the same time, Ronald Reagan ran large fiscal deficits by cutting taxes and increasing spending, which contributed to an economic boom. This combination of tight monetary policy and loose fiscal policy tends to be strong for a currency while it lasts.
The first half of the 1980s saw rapid strengthening in the dollar. This contributed to the Latin American debt crisis; emerging markets in Latin America were unable to pay dollar-denominated debts back, resulting in defaults, recessions, and currency crises.
Debts within the United States were very low, so interest rates could be kept high by Volcker for a long time, which added a lot of fuel to the dollar bull run. The dollar eventually reached an apex in 1985, when the United States and four other major countries (Germany, Japan, United Kingdom, and France) agreed to deliberately weaken the dollar in an event called the Plaza Accord so that American and European exports would be more competitive vs Japanese exports, which were dominating global trade at the time.
As the dollar fell in the late 1980s and the yen strengthened markedly, money flooded into Japan, which along with their overall strong economy, led to the massive well-known Japanese equity and real estate bubble.
1990s/2000s Dollar Cycle
The Soviet Union fell in 1991, leaving the United States as the world’s sole superpower, and led to a period of opening markets and rapid globalization. In the early 1990s, the United States had a recession, and saw a period of declining interest rates, and the dollar was weak overall. Emerging markets had a strong period until the mid-1990s.
At that point, the United States』 economy began to do well and raised interest rates, beginning the second dollar bull run. In addition, the US baby boom generation reached its peak working age, resulting in the highest level of labor participation in US history:
By the second half of the 1990s, the United States entered a tech boom/bubble period, and the dollar spiked. Several emerging markets encountered serious dollar-denominated debt problems, resulting in the 1997 Asian financial crisis and the 1998 Russian financial crisis. Emerging markets, as a whole, suffered. It mirrored the 1980s Latin American debt crisis, but with its epicenter in southeast Asia.
The reason that some emerging markets suffer more than others during a given cycle, has to do with the amount of dollar-denominated debt they have relative to the amount of foreign-exchange reserves they have. The most vulnerable nations for a financial crisis are the emerging markets that have high dollar-denominated debts and low foreign-exchange reserves, while those with the opposite situation of high reserves and low debts are well-fortified.
By 2000, the US dotcom equity bubble began to collapse, and the Fed cut interest rates. In the years that followed throughout the 2000s decade, the dollar weakened notably, and emerging markets had a massive boom period. The acronym 「BRIC」 became popular, referring to the idea that Brazil, Russia, India, and China, due to large populations and massive growth rates, would become increasingly important on the global economic stage.
2010s/2020s Dollar Cycle
The dollar remained weak for a while, although it had a brief spike around the 2008/2009 global financial crisis as oil prices fell and a global recession occurred. The Fed, in particular, did three major rounds of quantitative easing, but those ended in late 2014.
Between 2014 and 2015, as the Fed shifted to tighter monetary policy by putting an end to QE, the dollar quickly strengthened, resulting in the third major dollar bull run. Several emerging markets subsequently encountered a severe recession from 2014-2016.
In 2016, the dollar reached a peak, and there were talks of a secret Shanghai Accord to weaken the dollar, in reference to the well-known Plaza Accord of 1985. The dollar indeed weakened significantly throughout 2017, and the world encountered 「global synchronized growth」 as it was called, where the United States, Europe, Japan, and emerging markets all did quite well together.
In early 2018, the Fed began quantitative tightening (reducing the size of its balance sheet), and the dollar began re-strengthening. From peak to trough, the dollar only had a 12% drawdown from its peak, and never achieved one of those massive 40% dollar declines like the previous two cycles. By mid-2018, global growth began to slow in the US and the rest of the world. The dollar weakness was a fake-out, in other words. It was still a strong dollar period.
Argentina and Turkey in particular began experiencing currency crises. They were the vulnerable ones, with lots of dollar-denominated debt and little foreign-exchange reserves.
On the other hand, the countries that suffered in the late 1990s dollar bull run, such as Thailand, South Korea, Malaysia, and Russia, learned their lesson from last time around, and came into this cycle with a ton of foreign-exchange reserves and less dollar-denominated debt, which is the opposite of the situation they all had in the 1990s. They were fortified against a strong dollar this time around.
By summer 2019, the Fed began cutting interest rates in the face of slowing economic growth. In September 2019, the overnight lending rate in the US banking system spiked, leading the Fed to begin supplying repo liquidity, and then eventually to buying T-bills and expanding its balance sheet, which marked the end of quantitative tightening.
This was an example of the system correcting itself, or more specifically, forcing US policymakers to correct it. A strong dollar contributed to slowing global GDP growth, including in the United States, which led the Fed to cut rates. And, with foreigners not buying enough Treasuries for years due to the dollar being so strong, the US domestic balance sheets became increasingly stuffed with Treasuries and couldn’t keep buying more, so the Fed had to shift from quantitively tightening to quantitative easing to begin buying a ton of Treasuries, which floods the system with liquidity.
The dollar began weakening again from there, as expected.
However, the COVID-19 pandemic hit in early 2020, which halted global trade and contributed (along with a structural oil oversupply issue) to a collapse in oil prices. The dollar quickly spiked, foreigners began outright selling Treasuries and other US assets to get dollars, causing the Treasury market to become very illiquid and 「ceasing to function effectively」 as the Fed described it. In response to this, the Fed cut rates to zero and performed massive quantitative easing, and the US federal government performed massive fiscal stimulus.
The dollar began weakening again, and from there, it remains to be seen what the next chapter will be.
The Fraying of the Petrodollar System
As I explained before, each global monetary system begins to suffer from a form of entropy, where order falls into disorder as inherent flaws in the system manifest themselves over time.
For the Bretton Woods system, the flaw was the persistent reduction in US gold reserves against a growing amount of external liabilities, leading to an eventual inability to maintain the convertibility of dollars into gold.
For the petrodollar system, the flaw is the persistent trade deficits that the US has to run with the rest of the world in order to supply the world with dollars that they must use for energy pricing. The US ends up outsourcing large portions of its industrial base, and in the process builds up a massive deficit in its net international investment position as the foreign sector owns an increasing share of US assets.
In other words, the flaw in the Bretton Woods system was about the United States』 capital account, whereas the flaw in the petrodollar system is about the United States』 current account.
A detailed 2017 paper by the BIS called 「Triffin: dilemma or myth?」 examines the validity of Triffin’s dilemma from multiple angles, agrees with aspects and disagrees with other aspects, and re-states it and re-applies it in multiple scenarios. In that paper is a good summary of what this updated 「current account Triffin dilemma」 proposes:
The most common version of Triffin shifts his thesis from the capital account to the current account. It posits that the reserve currency country must run, or at least does run, persistent current account deficits to provide the rest of the world with reserves denominated in its currency (Zhou (2009), Camdessus and Icard (2011), Paul Volcker in Feldstein (2013), Prasad (2013)). 「In doing so, it becomes more indebted to foreigners until the risk-free asset ceases to be risk-free」 (Financial Times Lexicon (no date)).
As applied to the United States, the current account version of Triffin runs as follows. The global accumulation of dollar reserves requires the United States to run a current account deficit. Since desired reserves rise with world nominal GDP, which is growing faster than US nominal GDP, the growth of dollar reserves will raise US external indebtedness unsustainably. Either the United States will not run the current account deficits, leading to an insufficiency of global reserves. Or US indebtedness will rise without limit, undermining the value of the dollar and the reserves denominated in it.
Then in the end, the paper concludes:
While there is much to argue with Triffin and those who invoke his dilemma, there is no arguing the dilemmas posed by a national currency that is used globally as store of value, unit of account and means of payment. 「The reserve currency is a global public good, provided by a single country, the US on the basis of domestic needs」 (Campanella (2010)). Padoa-Schioppa emphasises the awkwardness of national control from a global perspective. But the global use of the dollar can pose dilemmas to the United States. How should the Federal Reserve respond to instability in the markets for $10.7 trillion in dollar debt of nonbanks outside the United States or in a like amount of forward contracts requiring dollar payments?The central bank ignores such instability at the peril of possible turmoil in US dollar markets that does not stop at the border – even if the floating rate index for dollar debts is brought back from London to New York. Yet the Federal Reserve responds to such instability at the peril of seeming to overreach its mandate.
Issues arising from one country’s supplying most of the world’s reserve currency are not going away.
A System Without a Purpose
For a while, the petrodollar system made a degree of sense, despite its trade-balance flaws. Unable to maintain gold backing in the previous system, policymakers managed to give order to an all-fiat system. The United States was the biggest economy in the world and the biggest importer of commodities, so our currency was the only one 「big enough」 to be used for the global oil trade.
In addition, as macro analyst Luke Gromen, who in recent years has specialized in analyzing the petrodollar system and the US fiscal situation, has pointed out that the first two decades of the petrodollar system overlapped with the Cold War. So, the system helped strengthen US hegemonic power in a divided world. Love it or hate it, the geopolitical intentions of the system architects were clear.
From the 1990s onwards after the Soviet Union fell, as Gromen and others have argued, the system has made less sense, and has resulted in more US military involvement than need be (to put it lightly) as the US indirectly seeks to defend its hegemonic role without a clear direction or identity.
In addition, China is now the world’s largest importer of commodities, rather than the United States. It’s challenging to maintain a system of all oil and most commodities being priced worldwide in US dollars if there is a bigger global trade partner and importer of oil and commodities than the United States. The United States still has an unrivaled military reach, but its other justifications for the existing system are diminishing.
Shrinking US Share of Global GDP
Despite all of this, China can’t replace the United States as the holder of the sole global reserve currency. Not even close. No single country can. And here’s why.
In the aftermath of World War II, the United States represented over 40% of global GDP. By the time the Bretton woods system ended and the petrodollar system began, the United States still represented 35% of global GDP. It has since fallen to only 20-25% of global GDP:
And that’s nominal GDP (i.e. priced in dollars), so it is tied in part to dollar strength. If the dollar does have another bear cycle, this would be down to maybe 20%. And based on purchasing power parity (which more closely tracks commodity consumption), the US represents only 15% of global GDP. That’s still pretty good for a country with 4% of the world’s population, but really not enough to maintain the petrodollar system indefinitely.
The global energy market, and more broadly international trade, is now too big to be priced primarily in the currency of a country that represents this small of a share of global GDP.
Imagine if the entire world tried to price energy exclusively in Swiss francs; there simply wouldn’t be enough of them out there for that to work. The petrodollar situation is not that extreme of course, since the United States is far larger than Switzerland, but the point is, as the US economy represents a smaller and smaller share of global GDP over time, it becomes increasingly unable to supply enough dollars for the world to price all energy in dollars.
There’s no country or currency group big enough to do that alone anymore. Not the United States, not China, not the European Union, and not Japan.
The United States was uniquely able to do it for decades in the aftermath of World War II as most other nations were decimated and the US share of global GDP became unusually high. However, as the world grows and becomes more multi-polar over time, with no individual country representing a domineering share of global GDP like the US used to, the global monetary system itself also requires more decentralization to work properly.
And we’re starting to see that happen.
Multi-Currency International Trade
As Bloomberg reported this year, exports from Russia to China have quickly de-dollarized over the past few years into a more diverse basket of currencies:
Six years ago, Russian exports to China were over 98% dollar based. As of early 2020, it’s only 33% dollar-based, 50% euro-based, and 17% with their own currencies. And importantly, Russia’s exports are significantly energy-based and commodity-based, which gets to the heart of the petrodollar system.
Similarly, the article shows that Russian exports to Europe have become increasingly euro-based as well. Six years ago, Russian exports to Europe were 69% dollar-based and 18% euro-based. Now they’re 44% dollar-based and 43% euro-based.
Plus, Bloomberg reported back in 2019 that Russia has been achieving similar results with India as well, with a remarkable drop from nearly 100% of exports to only 20% of exports being priced in dollars:
This isn’t the first time this sort of thing was attempted. Back in 2000, Saddam Hussein began selling oil priced in the newly-created euro. A couple years later, the United States invaded Iraq and removed Hussein from power based on allegations of Iraq possessing weapons of mass destruction. These allegations turned out to be untrue, and Iraq quickly went back to selling oil in dollars.
It is disputed to what extent Iraq’s decision to sell oil in euros factored into US decisions to enter the war, but what can be said is this. There is no shortage of malevolent dictators in the world, but that’s the one that we spent 4,500 American soldier lives and $2 trillion in US funds to take out, and that’s without getting into the destruction on the Iraqi side.
There is a detailed speech by then-Representative Ron Paul to Congress in 2006 about Iraq and the euro, and broader themes about the petrodollar system as it relates to US foreign policy, including policy towards Venezuela and Iran. Although he’s a controversial political figure, regardless of what side of the political spectrum someone is on, I think that’s a speech worth being familiar with on the historical record.
However, when major powers like China, Russia, and India begin pricing things outside of the dollar-based system and using their currencies for trade, including for energy in some cases, the US can’t realistically intervene militarily, and instead can only intervene with sanctions or trade disputes and other forms of geopolitical pressure.
The latest hot spot has been multiple rounds and threats of US sanctions for companies involved in the Nord Stream 2 pipeline from Russia to Germany, which if completed would strengthen Russia’s gas supply system to Europe. Both the United States executive branch and legislative branch have been quite fixated on that project. A number of US senators, for example, sent a letter warning of 「crushing and potentially fatal legal and economic sanctions」 against Germany’s port operator involved with the project. German officials have pushed back, saying such sanctions threaten European sovereignty.
Another hotspot has been the US sanctions against Iran. Europe, India, and China all have trade relations with Iran and want to trade with them, and all of them are major energy importers whereas Iran is an energy producer.
Europe created INSTEX in 2019, a special purpose vehicle to avoid US sanctions on Iran. The vehicle facilitates trade outside of the SWIFT system and outside of the dollar system more broadly. It has been successfully tested, but barely used. Similarly, India has long had constructive trade with Iran, despite religious/cultural differences that often cause issues between India and its neighbor Pakistan and territorial disputes in Kashmir, but the Iran-India trade partnership has been constrained in 2020 due to a combination of US sanctions and COVID-19. China has a number of strategic energy partnerships and trade agreements with Iran as well, but US sanctions along with COVID-19 also threw a curveball into their trade situation.
China is Subverting the Petrodollar System
For the past seven years, China has been using the petrodollar system against the United States. The petrodollar system encourages mercantilist nations to run trade surpluses with the United States and recycle those dollars into buying US Treasuries, but after a while of doing this, China started taking their dollar surpluses and investing in other foreign assets instead. This topic has been reported on by petrodollar experts like Luke Gromen and others for quite some time, but is not widely followed in the broad sense.
Early on in the days of the petrodollar system, Europe and the Middle East were the biggest trading partners and ran trade surpluses with the United States. They accumulated a lot of dollars, and reinvested those dollars into Treasuries. Then, Japan’s quick rise led them to become the next big trading partner and center of global growth. They took the baton and ran big trade surpluses with the United States, and again, reinvested those dollars into Treasuries. Then, with the stagnation of Japan and the rise of China, China became the biggest trading partner with the United States, ran big trade surpluses with the United States, and reinvested those dollars into Treasuries.
All was well, except for the Americans who wanted to make things, or any folks, American or foreign, who were on the wrong side of military adventurism. The wheels of the petrodollar system kept functioning.
But then, China broke the wheels. Back in 2013, China declared that it was no longer in their interest to keep accumulating Treasuries. They kept running huge trade surpluses with the United States, and had dollars still coming in, but they would no longer recycle those to fund US fiscal deficits by buying Treasuries. As per the linked Bloomberg article:
「It’s no longer in China’s favor to accumulate foreign-exchange reserves,」 Yi Gang, a deputy governor at the central bank, said in a speech organized by China Economists 50 Forum at Tsinghua University yesterday. The monetary authority will 「basically」 end normal intervention in the currency market and broaden the yuan’s daily trading range, Governor Zhou Xiaochuan wrote in an article in a guidebook explaining reforms outlined last week following a Communist Party meeting. Neither Yi nor Zhou gave a timeframe for any changes.
Indeed, China now holds fewer US Treasuries than they did seven years ago, even though they kept increasing their trade surplus with the United States through 2018.
Instead, they launched the Belt and Road initiative in 2013. China began aggressively lending dollar-based loans for infrastructure projects to developing countries in Asia, Africa, Latin America, and Eastern Europe, and providing their infrastructure-building capabilities as well, because infrastructure has long been one of China’s technical specialties.
Many of those foreign loans, if defaulted on, mean that China gains ownership of the infrastructure. So, whether the loans are successful or not, China gains access to commodity deals, trading partners, and hard assets around the world.
So, the US runs big trade deficits with the rest of the world (and especially China), but now rather than funneling those dollar trade surpluses back into financing US fiscal deficits, China uses its incoming dollars to finance hard asset projects around the world, and increase their global reach.
At this stage, instead of just blue-collar labor in America being hurt by the system, the geopolitical ambitions of United States hegemony are also subverted. As far as Americans were concerned, for 40+ years the petrodollar system used to work for the top half of the income spectrum but not really the bottom half, and now it neither particularly works for the top half nor the bottom half. It’s now a system without a purpose.
There’s an old quote from Charlie Munger that goes, 「show me the incentives and I』ll show you the outcome.」 As clever as the design of the petrodollar system was in the 1970s, China’s subversion of the fraying petrodollar system was just as clever. The flaws of the system basically ask for it to happen eventually, and it’s mathematics and Triffin’s dilemma coming home to roost.
From a geopolitical standpoint, we can see why China would want to do it. The western powers severely damaged China in the 1800s Opium Wars which contributed in part to the next 150 years of Chinese destabilization and stagnation, and now having regained a degree of organization and power, China isn’t playing nice with the global system as structured by those western powers.
Chinese officials have said on numerous occasions that their reliance on the dollar system is a security risk for them. Having surpassed the United States as the world’s largest trading partner and world’s biggest importer of commodities, China increasingly has an interest in being able to acquire commodities and perform global trade without dollars, which as we see with trading partners like Russia, or with China’s yuan-based oil futures contract, they’re increasingly able to do with small steps at a time.
At the same time, the United States faces increasing populism in its own country, as the persistent trade deficit becomes an increasingly political issue to fix. Plus, US officials have routinely pointed out the security risk of having so much critical supplies made outside of the country, which became even more apparent during COVID-19.
The trap solution is for US policymakers to try to narrow the trade deficit by getting other countries to buy more American goods, but that’s like putting a Band-Aid on a gunshot wound. The deeper problem is that the global monetary system as currently structured simply doesn’t work well with that goal; it’s inherently designed at its core to run with persistent trade deficits to get dollars out into the world and enforce dollar-only global energy pricing.
Back on March 2, 2018, President Trump tweeted that 「trade wars are good and easy to win」. Since then, the US trade deficit increased, rather than decreased. Trade wars are very difficult for the US to win within the petrodollar system as currently structured. The US can close its trade deficit over time, but not without changing the global monetary system from its current structure.
So on one hand, US policymakers do what they can with military action or sanctions against those that would sell energy in a currency other than dollars, and try to maintain the dollar lock on global energy markets wherever possible. On the other hand, the US wants to fix its deepening trade deficit, even though that trade deficit is what gets dollars out into the world for use by countries to sell oil in dollars or acquire dollars to buy oil. It’s an incoherent strategy, and it runs deep in US political culture, rather than tied to any one politician.
Meanwhile, the entropy of trade deficits chips away at the existing system from within, China uses the system against the system’s owner, populism rises in the US and elsewhere, and countries throughout Eurasia gradually build non-dollar payment channels.
Eating Our Own Cooking
As of this year, the US Federal Reserve (blue line) now owns more Treasuries than all foreign central banks combined (orange line):
That’s not exactly how the 「global reserve」 currency is supposed to work. It’s like a restaurant chef eating her own cooking more than her customers do. This is what other non-global-reserve countries look like. Within one year, the Fed went from owning half as much Treasuries as foreign central banks combined, to more than them combined.
As previously described, countries can only keep buying Treasuries if global dollar liquidity conditions are good. A strong dollar halts foreign accumulation of Treasuries. In addition, any impact to trade, such as a pandemic and associated economic shutdowns that crater oil demand and import/export volumes, threatens that whole system. And China isn’t recycling dollars into Treasuries for aforementioned strategic reasons.
As it relates to the Treasury market, in addition to not buying much Treasuries over the past five years of this strong dollar environment, some countries began rapidly selling Treasuries in March and April of this year at the height of the global shutdown and liquidity crisis. Leading into the pandemic, long-duration Treasuries rallied as investors flocked into them and drove their yields down, but at the worst point in the liquidity crisis as the dollar index spiked to 103, even Treasuries sharply sold off.
The Fed described the problem in their emergency March meeting and their subsequent April meeting.
Here’s March:
In the Treasury market, following several consecutive days of deteriorating conditions, market participants reported an acute decline in market liquidity. A number of primary dealers found it especially difficult to make markets in off-the-run Treasury securities and reported that this segment of the market had ceased to function effectively. This disruption in intermediation was attributed, in part, to sales of off-the-run Treasury securities and flight-to-quality flows into the most liquid, on-the-run Treasury securities.
–March 2020 FOMC Meeting Minutes
And here are two snippets from April:
Treasury markets experienced extreme volatility in mid-March, and market liquidity became substantially impaired as investors sold large volumes of medium- and long-term Treasury securities. Following a period of extraordinarily rapid purchases of Treasury securities and agency MBS by the Federal Reserve, Treasury market liquidity gradually improved through the remainder of the intermeeting period, and Treasury yields became less volatile. Although market depth remained exceptionally low and bid-ask spreads for off-the-run securities and long-term on-the-run securities remained elevated, bid-ask spreads for short-term on-the-run securities fell close to levels seen earlier in the year.
Several participants remarked that a program of ongoing Treasury securities purchases could be used in the future to keep longer-term yields low. A few participants also noted that the balance sheet could be used to reinforce the Committee’s forward guidance regarding the path of the federal funds rate through Federal Reserve purchases of Treasury securities on a scale necessary to keep Treasury yields at short- to medium-term maturities capped at specified levels for a period of time.
–April 2020 FOMC Meeting Minutes
And here’s what they did. The red line is 10-year Treasury yields. The blue line is the weekly rate of Treasury security purchases by the Fed.
More importantly than the yield spike itself in March was the fact that the Treasury market became illiquid, with wide bid/ask spreads. It wasn’t functioning properly, let alone yields going up.
Since then, the Fed has gradually tapered their Treasury security buying program from those extreme $75 billion-per-day highs, although they are still buying at a rate that rivals previous instances of QE, at $80 billion worth of Treasuries per month. The Fed remains the biggest buyer of US fiscal deficits, in other words. The dollar weakened from its March highs, but is still at a relatively strong part in the historic cycle, and as such, the foreign sector isn’t recycling many of their dollars into accumulating Treasuries.
That’s what happens when there is $13 trillion in dollar-denominated debt in the world, and plenty of dollar-funding needs, while dollars simply aren’t being supplied in sufficient quantity to the world. Foreigners begin selling some of their $42 trillion in dollar-denominated assets to get dollars, and that crashes US markets along with everything else, which forces the Fed to step in, print dollars to buy what they sell, and open dollar swap lines to foreign central banks, until sufficient global dollar liquidity is restored.
Triffin’s Dilemma Unfolds
Ultimately, this gets back to the question of whether the United States should even want to try to maintain the petrodollar system, if it could.
As previously shown, the US trade balance is a mess:
The US net international investment position has absolutely collapsed, with the US having gone from being the world’s largest creditor nation to the world’s largest debtor nation:
The net international investment position of a country measures how much foreign assets they own, minus how much of their assets that foreigners own, and the chart above shows it as a percentage of GDP. As of this year, the United States owns $29 trillion in foreign assets, while foreigners own $42 trillion in US assets, including US government bonds, corporate bonds, stocks, and real estate.
This is a result of accumulated US trade deficits (and on the other side, accumulated trade surpluses by the foreign sector), and now puts the US at one of the weakest positions in the world in terms of this metric. This was as of 2019, and it has gotten worse since then:
Wealth concentration in the US is now higher than just about any other developed nation:
The top 1% have as much as the bottom 90%, which is a lot more concentration than 30-40 years ago:
The United States is ranked #27 in the world for social mobility, which puts it at the bottom range of developed countries. For Americans, their family of birth dictates their lifetime economic potential more-so than other advanced peers. With a few exceptions, we have to go down into emerging/developing markets to find lower social mobility scores than the United States has.
Median American wages decoupled from productivity since the 1970’s, and that gap was arbitraged by those at the top thanks to offshoring/automation:
Now, the median American male has trouble affording the expenses for a family that he could easily afford decades ago. Either an above-median income is required, or two incomes are required, because the median income just doesn’t support a family like it used to:
Meanwhile, there has been a rapid increase in CEO pay over the past four decades. CEOs used to make 20x as much as the average worker in 1965, and that ratio moved up to 59x by 1989, 122x by 1995, and in recent decades has been well over 200x as much as the average worker.
According to the 2019 Credit Suisse Wealth Report, although the United States is wealthy per capita, because that wealth is so concentrated, the median American net worth (which represents the 50th percentile- the middle person on the spectrum) is actually lower than the median net worth of most other advanced countries. We squeezed our middle and working classes harder than most other countries:
It’s no wonder that populism is on the rise, both from the right and the left. Folks sense something isn’t working but differ on what they think the causes and solutions are.
Basically, the petrodollar system and the associated fiscal policy is fraying under its own inherent flaws over decades, which again gets back to the Triffin dilemma that to maintain a global reserve currency, you need to export an increasing amount of your valuable assets like gold reserves or your industrial base. That cost inherently makes these sorts of systems long-lasting but not permanent.
At first, having the global reserve currency is an exorbitant privilege, because the benefits of hegemonic power outweigh the costs of maintaining the system. Over time, however, the upside benefits stay relatively static, while the costs keep compounding over time, until the costs outweigh the benefits.
And from there, the value of the system depends on who you ask. Folks who are often on the higher end of the income spectrum who worked in finance, government, healthcare, or technology benefitted from this system, since they obtained many of the benefits of globalization and none of the drawbacks. Folks who are often on the lower end of the income spectrum, specifically those that make physical things, are the ones that benefitted least and gave the most up, since their jobs were outsourced and automated at a faster rate than other developed countries. But now with China also undermining the structure of the system, even the geopolitical/hegemonic benefits for the political class are subverted as well.
As the system frays, it’s easy to point to external nations as the cause of this fraying. When they begin pricing things outside of the dollar-based system, or employing mercantilist currency policies, or building pipelines, or deciding to do something with their dollar surpluses other than reinvest them in US Treasuries, it can seem as though they are undermining an otherwise sound system.
In reality, those external actions are a symptom of the more underlying flaws in the system: the fact that the United States is no longer big enough as a share of global GDP to supply enough dollars to fund global energy markets and global trade, the fact that the United States has to run persistent trade deficits to get dollars out into the system, and the fact that an all-fiat global currency system incentivizes mercantilist currency manipulation by many countries to generate trade surpluses against the US wherever possible.
The Intermediate-Term Outlook
Whether there are major changes to the system or not, I think probabilities lead to a weakening dollar in the years ahead.
In other words, another down leg on this dollar chart, even if the overall system structure doesn’t change much:
The Dollar vs Other Currencies
Some people ask why would the US dollar weaken more than other major currencies if all of them are printing a lot of money. What causes these big bear markets in the dollar?
In other words, just because the US Federal Reserve turns dovish, doing plenty of QE and keeping interest rates at zero, why would the dollar be weak vs the euro, yen, pound, or other countries that are acting similarly dovish? It’s easy to argue that it should weaken against hard assets (and indeed, that’s probably the easier long-term trade), but why should it weaken vs other fiat?
The first answer to that question has to do with magnitude. All major countries are acting similarly, but not at the same magnitude. US fiscal deficits as a percentage of GDP were larger than most advanced peers before the pandemic hit, and are larger than most advanced peers during this pandemic as well.
Here’s a chart I had in my November 2020 newsletter about the US federal deficit, showing that it’s the first time in modern history where the United States had a rising deficit (both in absolute terms and as a percentage of GDP) during the later years of an economic expansion:
In addition, while Japan and Europe and China have positive trade balances and current accounts, the US has the aforementioned Triffin dilemma issue of structural trade and current account deficits. Here’s a chart I put together in 2019 using data from late 2018, showing that pre-pandemic, the US had the biggest twin deficit among major developed nations:
So, when US monetary policy also turns dovish as it did in 2019, the dollar has plenty of room to decline.
The second answer to that question has to do with valuation. Suppose a value stock had a price/earnings ratio of 10x, and you expect 5% earnings growth this year. And suppose a growth stock had a price/earnings ratio of 30x, and you expect 15% earnings growth this year. What happens if, despite expectations, the value stock only grows earnings by 4%, and the growth stock only grows earnings by 7%? Due to high valuation and the bigger relative gap vs what was priced in, the overvalued growth stock has a lot further to fall in that scenario than the value stock.
The dollar is specifically propped up in a bullish cycle due to tons of offshore dollar-denominated debts, structural scarcity for dollars outside of the United States to service those debts, and a decade of capital inflows to the United States. Now, in an environment where all countries including the US create massive liquidity and create more currency units, the currency that was specifically overvalued due to scarcity relative to required demand (the dollar) is the one that has the furthest to fall, because that specific scarcity/liquidity problem that was propping it up gets addressed.
Trade deficits imply an overvalued currency (too much importing power, uncompetitive export pricing), and trade surpluses imply an undervalued currency (too little importing power, and overly competitive export pricing). Mercantilist countries can manipulate their currency to keep those trade surpluses open for a while, and the global reserve currency can go decades with trade deficits, but when monetary policy stops pushing against these inherent trade forces, exchange rates have a tendency to push back towards the direction of balanced trade.
When the US is in a strong dollar cycle, has a big trade deficit, and then cuts interest rates and shifts from quantitative tightening to quantitative easing, the dollar has plenty of room to weaken compared to currencies of developed nations that already have trade surpluses (i.e. undervalued currencies), even though the dollar is the global reserve currency. We saw that happen this year, so the question is whether it will continue.
Plus, US stocks are more expensive than many other nations, even when adjusting for sector differences. So, if US equity indices can’t continue their period of outperformance, capital could start flowing elsewhere, which also weakens the currency.
Usually, due to equity valuations and shifts in policy, whatever equity region outperformed in one decade tends not to be the same one that outperforms in the next decade.
Risks to this view:
Within a multi-year outlook, there will likely be occasional counter-rallies where the dollar outperforms other currencies, or even outperforms gold, despite being within a declining trend. So, maintaining a clarity of time horizon is important.
Similar to how the pandemic was a 6-month curveball towards my view of a weaker dollar in the first half of 2020, there are other tail risks that could temporarily derail the outlook as well. An economic slowdown this winter, before the vaccines achieved widespread penetration and change consumer behavior? A sovereign debt or banking crisis in Europe, centered on southern European countries? A famine in China? A currency crisis in a big emerging market like Brazil? Some sort of unexpected military engagement between major powers?
Any of those outcomes could cause a temporary spike in the dollar, similar to the spike that occurred in March. An outlook can be firm for structural reasons, but still needs to adapt as data change. That’s why I write newsletters and research reports regularly; things change.
In terms of inevitability, the eventual issue with southern European sovereign debt is one that should cause investors a lot of concern in the long run. The euro has structural issues of its own, with a monetary union but no fiscal union, although that’s a subject for another article. The euro has a lot of problems, but being overvalued isn’t one of them. In this strong dollar period, Europe has run persistent trade and current account surpluses:
A weaker dollar vs the euro, if it happens, could indeed reduce Europe’s trade surplus with the United States. But the corresponding emerging market boom that would likely come along with a weaker dollar, would open up other trading avenues for them as well.
The Long-Term Outlook
The further we look out, the more we can think about a structural shift away from the petrodollar system itself rather than just another dollar cycle within the system.
The Slow Restructuring Option
A structural change could happen gradually, as it already is happening. If an increasing share of global trade, particularly within Eurasia and particularly regarding energy and commodities, keeps shifting towards euros, yuan, and rubles and away from the dollar, then the system can become more decentralized over time.
In fact, we could argue that the petrodollar system peaked in 2000, has been in a steady-state for the past 20 years since then, and is now potentially facing decline. This chart shows currencies held as a share of total central bank reserves:
Another way of looking at it is that it peaked in 2013 when foreigners owned a record high percentage of US debt, and China declared that it was no longer in their interest to keep accumulating Treasuries. Since then, the percent of Treasuries owned by the foreign sector has diminished.
As a base case, I expect this gradual outcome to continue happening, whether the United States participates or not, as various major powers continue to increase their usage of non-dollar payment systems over time, and an increasing percentage of US federal debt becomes owned by the Federal reserve and the US commercial banking system.
The new RCEP trade agreement between many Asia Pacific nations, which creates the largest trade bloc in history, could further accelerate that trend, and new technologies including blockchains and domestic government-issued digital currencies, open up novel opportunities for new payment networks as well.
The Fast Restructuring Option
On the other hand, a structural change could happen with a shock and stepwise change, like the end of the Bretton Woods system. This can happen in a few ways, but becomes more probable if the United States decides to actively promote a change rather than defend the status quo.
On the legislative side, the United States could reverse some policies that I described in 「The Big Tax Shift」 which would make onshore labor more competitive. This would include things like cutting payroll taxes or performing similar measures, and re-arranging other spending and taxing priorities, to emphasize some degree of industrial onshoring.
On the Treasury/Fed side, the easiest way would be through foreign-exchange reserves.
Countries manage their currencies primarily with their foreign-exchange reserves, which consist of foreign currencies in the form of sovereign bonds, and gold. In some cases they also own foreign equities and other assets. These foreign-exchange reserves held by central banks around the world have multiple purposes:
They act as savings; a way for a central bank to be able to pay external obligations if necessary.
If a country’s own currency weakens (which makes imports more expensive, and in crisis situations can lead to major devaluation), their central bank can sell some of its foreign-exchange reserves and buy its own currency. This reduces supply and increases demand for their own currency, strengthening it. The bigger the reserves compared to the country’s monetary supply or GDP, the more 「ammunition」 they have to defend the value of their currency if needed.
If a country’s own currency strengthens too much (which can be bad for export-driven countries), their central bank can print units of their own currency and use it to buy foreign-exchange reserves. This weakens their currency and increases their reserves for later.
Because the dollar is the axiom of the current global monetary system, Treasuries are the biggest component of most countries』 foreign-exchange reserves. The US itself doesn’t have much foreign exchange reserves. Emerging markets often have the biggest reserves, since they need them the most, but a handful of developed nations also have huge reserves as well, and just about every country has more reserves as a percentage of GDP than the United States.
This chart shows foreign-exchange reserves as a percentage of GDP for dozens of countries, as of spring of this year when I assembled it. In terms of comparative magnitude for most countries, it hasn’t changed much since then:
For the United States, this number includes our official gold reserves at this year’s gold prices, and gold indeed represents the vast majority of US reserves.
For Eurozone countries, the European Central bank also has another layer of reserves as well in addition to the individual country reserves on the chart, so the numbers on the chart for Eurozone countries mildly understate the total direct and indirect reserves relative to GDP for the euro.
The US could devalue the dollar any time it wants by printing dollars to buy foreign assets or gold, and build more sizable foreign-exchange reserves in the process, which would be in line with other peer nations. With a nominal GDP of over $20 trillion, for each 5% of foreign exchange reserves as a % of GDP they want to have, the United States would need to print and spend over $1 trillion. So, adding a 10%-of-GDP reserve would cost over $2 trillion, especially as the dollar devalues in the process of building that reserve.
That’s one of the potential endgame scenarios for how the United States could choose to abruptly end this system as currently structured. It could decide to cease being the axiom of the global monetary system and simply move to being the biggest individual player in the system by acquiring foreign-exchange reserves, devaluing its currency in the process, adopt various fiscal changes to promote on-shoring, and begin promoting rather than fighting the trend of energy and other commodities being sold in a handful of major currencies around the world rather than just the dollar.
In doing so, it would sacrifice some of its international hegemony in favor of more industrial competitiveness and higher domestic economic vibrancy. The dollar would still be 「a」 reserve currency, and still the largest individual one, but wouldn’t be 「the」 reserve currency like it is now.
Risks to this view:
Big macro shifts have a tendency to take longer to play out than logic would suggest. These sorts of things don’t change easily, so predicting a sharp change to the global monetary system just around the corner is always going to be improbable, even if one day, one of those improbable things happens.
I’m focusing on monitoring the slow option: the continued progress or setbacks of non-dollar exports/imports between major powers, particularly regarding energy and other commodities.
I prefer 「win/win」 bets for long time horizons. Scarce assets, particularly industrial commodities, are historically cheap. Plenty of high-quality equities inside and outside of the United States are reasonably-priced. Alternatives like Bitcoin also offer asymmetric outcomes even with small allocations.
At this stage in the long-term debt cycle, currency devaluation of some kind or another is likely in the 2020’s decade, both for the dollar and other currencies, so having exposure to scarce assets could do well, regardless of what the global monetary system looks like at any given time based on the decisions of policymakers.
What the Next System Looks Like
What the next system will look like is an open question. I』ve seen multiple proposals.
Whatever form it takes, it』ll be decentralized in the sense that it won’t be completely tied to any one country’s currency, since no country is big enough for that anymore. It』ll be based around neutral reserve assets, and/or a more regional-reserve model based on a handful of key country currencies, with an expanded variety of payment channels.
Decentralized Energy Pricing
At the heart of all of these systems would be the fact that the dollar would no longer be the world’s only currency for energy pricing. The euro, yuan, and perhaps a few others, or a neutral reserve currency, could be used in trade agreements to buy oil, gas, and various commodities, which unlocks the prospect for more global trade and reserve holdings in those currencies.
Even without a major structural change or the formal adoption of a new system, this is already gradually emerging throughout Eurasia, as shown earlier in this article as other large currencies are increasingly used between trading partners including for energy. And as I previously described, the United States, if it felt the current system was no longer in its best interest, could accelerate this shift at any time by building foreign-exchange reserves and/or supporting other non-dollar payment systems for energy and commodities rather than opposing them.
In this sense, the world moves from a 「global reserve currency」 to a handful of 「regional reserve currencies」. It doesn’t require new technology or new neutral currency units to do this, but it does require the continued development and usage of non-dollar payment systems. In addition, central banks can hold more gold as a reserve asset (which they already have been doing over the past five years) in this scenario, since it’s a neutral currency.
Alongside this trend, countries are increasingly launching or researching digital versions of their own fiat currencies, called central bank digital currencies 「CBDCs」.
In addition to this base outlook, there are some additional layers that could be added on top, described in the following sections.
Digital Global Bancor
A number of policymakers have resurrected the idea of the Bancor as a neutral reserve currency for international trade, which already exists in diminished fashion as the IMF SDR.
Mark Carney, who was Governor of the Bank of England at the time, made headlines in 2019 when he said at the annual Jackson Hole Symposium (in the United States right in front of US Federal Reserve officials) that the dollar is too dominant, and that a new digital currency could be used for international trade to fix some of the problems in the existing system. Coming from the head of the central bank of one of the United States』 closest allies, this was interesting.
The dollar’s influence on global financial conditions could similarly decline if a financial architecture developed around the new [digital currency] and it displaced the dollar’s dominance in credit markets. By reducing the influence of the US on the global financial cycle, this would help reduce the volatility of capital flows to emerging market economies.
-Mark Carney, Former Governor of BOE, 2019
Carney also mentioned the Libra in more positive tones than many other policymakers have. Facebook made headlines earlier that year with the proposal of the Libra; a digital currency that would consist of a basket of multiple currencies. The idea of the Libra is basically a stablecoin Bancor issued by a massive private corporation rather than a supra-government entity.
It would ironically be a form of centralized decentralization. In other words, it’s a centralized agreement to create and use a unit of trade that is neutral and not tied to any one country’s currency.
The problem with this proposal for a global digital Bancor, like a supra-government version of the Libra rather than a privately-issued one, is that it requires a lot of international cooperation and agreement to use it, something like a new Bretton Woods agreement. So, while certainly possible, something like that appears unlikely in such a fractured geopolitical system.
Digital Regional Bancors
A less ambitious form of a global digital Bancor idea is one or a set of regional Bancors.
In other words, suppose that the 15 nations of Asia Pacific’s new RCEP trade agreement agree to create and use some neutral digital currency between themselves. They’re already in a trading bloc, so organizing something like that is potentially more realistic than organizing something on a global scale.
And then maybe a few other nations like Russia would be willing to accept that trading bloc’s Bancor as payment for oil and gas and other commodities like they do for the euro? Russia’s biggest commercial bank, Sberbank, has already experimented with blockchain technology and is an avid investor in tech companies.
Blockchain technology creates new options for decentralized international payments, linked to a specific fiat currency or basket of fiat currencies weighted by a specific metric. This is the application of software to the relatively outdated global banking system; potentially a much more liquid medium for trade.
This year, the largest commodity companies in the world, BHP, Vale, and Rio Tinto, all completed blockchain sales of iron ore to Chinese firms. Singapore banks were involved with the transactions as well. Singapore also hosted the counterparties that tested blockchain transactions with Sberbank of Russia. Technology can lead to all sorts of new payment channels.
Referring to the recent exponential usage of existing private stablecoins on crypto exchanges, Nic Carter, the first crypto analyst at Fidelity, co-founder of blockchain analytics firm Coin Metrics, and who works at a blockchain venture fund, had this to say about stablecoin efficiency:
Lastly, capital existing in tokenized fiat format tends to enter the crypto industry but not leave. This is because crypto rails are fundamentally more convenient, more globalized, and less encumbered than traditional payment and settlement rails.
-Nic Carter
Adding governments to the mix to create regional multi-currency stablecoins i.e. regional Bancors for the purpose of international trade, could potentially make use of similar technology on a larger scale.
Gold Standard
Some gold investors believe that countries will return to a similar system as existed pre-1944, with central banks storing large amounts of gold and backing their currencies with it.
While no country would willingly go on a gold standard at this point (since it limits their ability to run big deficits and grow the money supply, and goes against the current incentive of having weak currencies to be competitive in global trade and generate trade surpluses), some countries could turn to it in a time of crisis to stabilize a currency during a period of inflation, if something breaks down.
Last year, the Dutch central bank stated that gold could be used to collateralize a collapsed financial system and start over.
Shares, bonds and other securities: there is a risk to everything. If things go wrong, prices can fall. But, crisis or not, a bar of gold always holds value. Central banks such as DNB have therefore traditionally had a lot of gold in stock. After all, gold is the ultimate nest egg: the trust anchor for the financial system. If the entire system collapses, the gold supply will provide collateral to start over. Gold gives confidence in the strength of the central bank’s balance sheet. That gives a safe feeling.
-DNB, 2019, translated to English
In a more benign way, a few years ago India’s central bank began issuing sovereign gold bonds on behalf of the government of India. These are government securities denominated in grams of gold. They pay lower interest rates than normal Indian sovereign bonds, because they eliminate currency risk. The government’s benefit is that they get to borrow at a lower yield. The investors』 benefit is that they get a more conservative investment, tied to gold prices instead of India’s currency, and can earn positive yield on gold exposure.
Whether currencies are ever backed by gold in a broad sense again, central banks can hold gold as a reserve asset within any sort of global monetary system, such as the above-mentioned decentralized energy pricing system, or alongside digital currency baskets.
Bitcoin as a Reserve Asset
Dismissed by many, there is a fervent group of proponents for the idea that Bitcoin’s network effect is too strong to stop, and that it will continue to expand exponentially until it eats the global financial system, i.e. hyper-bitcoinization.
As a decentralized and open source project, adopted by many programmers and proponents around the world, many intelligent people have dedicated their careers to Bitcoin. It’s hard to find a more voracious group of people than those in the Bitcoin community, and increasingly over time, Wall Street money has poured in as well.
So far, Bitcoin has defied most expectations, growing from zero into a $350+ billion market cap digital asset in a little over a decade in an algorithmic price pattern that has rivaled the speed of even the most successful tech companies:
Plus, there are countless businesses such as exchanges, lenders, custodians, security solutions, and more that exist in the ecosystem around it. Additional technologies have wrapped Bitcoin in other blockchain layers for use as collateral in other digital asset protocols and decentralized finance applications as well, or to increase Bitcoin’s scaling potential.
To use a Game of Thrones analogy, as the leaders of the Seven Kingdoms feud among themselves in order to control the Iron Throne and subsequently rule all of Westeros, a small but exponentially growing threat of inhuman White Walkers quietly builds from Beyond the Wall, far outside of the luxurious castles, seeking to supplant the established system and render their petty human squabbles over the throne moot.
Back to the present, Bitcoin’s adoption as a store of value has indeed spread worldwide in a niche sense. Consumers in many developing countries with currency weakness have used it as a store of value, and people in many developed countries have used it as a speculative growth asset. Lately, publicly-traded companies on major exchanges have bought it, Square’s Cash App lets users buy it, Paypal lets users buy it, and successful investors like Cathie Woods, Bill Miller, Paul Tudor Jones, and Stanley Druckenmiller are bullish on it. Fidelity began researching it in 2014, began mining it in 2015, and continues to build out their institutional-grade custody and trade execution solutions.
There are also some emerging state-based uses for Bitcoin. In 2019 and increasingly in 2020, Iran has turned to Bitcoin as a potential tool for performing international trade despite its sanctioned isolation. Bitcoin is verifiable, provable, requires no trust or cooperation other than agreement between parties to use it, and works well for large irreversible international transactions. Iran can subsidize Iranian Bitcoin miners with electricity resources, buy the bitcoins they generate, and use those bitcoins for international trade.
Even if it never reaches the scale that some Bitcoin proponents believe it might, it could still be used as part of a global monetary system, either as an additional neutral reserve asset, or by smaller isolated countries that make use of some of its features with relatively little way for other nations to stop them from doing so, as Iran seems to be doing.
In terms of seeing where this goes, we just have to see whether it keeps adding zeros to its market capitalization, or if it eventually fails to gain market value during one of its halving cycles and hits a saturation point somewhere.
Meanwhile, the Bitcoin community has different views of what the asset means; there is no unified vision within the community, but rather a set of different views for the long-term potential of the protocol. Some view it as the world’s future money, while others view it as digital gold, a store of value, or a bank in cyberspace that will exist alongside sovereign-issued currencies.
For example, Michael Saylor, the billionaire founder and first CEO of a public company on a major exchange to invest corporate funds in Bitcoin as its treasury reserve asset (to the tune of hundreds of millions of dollars), has stated that he doesn’t view Bitcoin as a currency, but rather as a digital savings bank:
Bitcoin is not a currency, nor is it a payment network. It is a bank in cyberspace, run by incorruptible software, offering a global, affordable, simple, & secure savings account to billions of people that don’t have the option or desire to run their own hedge fund.
-Michael Saylor, 11/12/2020
This is why Bitcoin should be neither a currency, nor a payment network. The principles of humility & harmony dictate that we should allow technology partners to provide for payments, & defer to governments on matters of currency. BTC is a purely engineered Store of Value.
-Michael Saylor, 11/19/2020
The world goes through periods of geopolitical order and disorder, and with that, comes the construction and subsequent fraying of the global monetary system each time.
More troublesome, the inherent flaw of having the global reserve currency, in a theme that goes back to economist Robert Triffin from over half a century ago, is that in order to maintain the global reserve currency, the country must supply the world with its currency via structural deficits in one form or another.
At first, the hegemonic benefits of being the reserve currency nation outweigh the costs, but as the benefits stay relatively static and the costs compound over time, eventually the costs outweigh the benefits and the system becomes unsustainable.
In addition, a system constructed around the US dollar decades ago when the US was 35% of global GDP, doesn’t work as well when the US is only, say, 20% of global GDP. It’s not about how big the US military is to keep its hegemonic status; it’s about whether the global monetary system as currently structured is still mathematically viable, and whether it even still supports the interests of the United States.
Put simply, there is a natural economic entropy to global reserve currency status, because inherent flaws in the system continue compound until they reach a breaking point. The challenge, of course, is identifying ahead of time where that breaking point is. A change in the global monetary system doesn’t necessarily mean bad things for the United States (indeed, the United Kingdom had an economic boom in the post-war years after it lost reserve currency status), but it does mean making a trade-off between international interests and domestic interests, and re-aligning trade as needed to obtain the desired balance.
My base case is that going forward over the next several years, the global economy will, more likely than not, encounter the third dollar bear cycle of this current petrodollar system. If so, assets such as global equities, quality residential real estate, precious metals, industrial commodities, and alternatives such as Bitcoin, are likely to do well.
From there, the global monetary system is gradually becoming more decentralized, in the sense that alternate payment systems and alternate currency settlements among trading partners are growing in use. This is indeed a more structural shift towards a new system. It could happen slowly, as it already is, or it could accelerate if the US itself also shifts out of the fraying system.
Banks, QE, and Money-Printing
Lately, it has become fashionable to debate what is, or is not, 「money-printing」 by central banks.
This debate is natural, due to the extreme policy nature of 2020, with massive fiscal expenditures, huge increases in central bank balance sheets, and changes in central bank inflation targets. It’s important to know what is inflationary, and what isn’t, and to what extent.
Because people have very different understandings of how central bank policy and fiscal policy work, there have been analyst calls this year ranging from hyperinflation to deep deflation, and everything in between.
The outcome has of course been somewhere in the middle as measured by CPI or PCE, with inflation that rebounded from March lows in response to policy, but neither much of an overshoot or undershoot, and still generally below long-term central bank inflation targets.
Many inflation categories for the most essential and non-outsourced goods and services, however, have risen faster than the overall basket this year, and in recent years.
The crux of this article is that quantitative easing on its own, and quantitative easing combined with massive fiscal deficits, are two very different situations to consider when it comes to analyzing the possibilities between inflation and deflation, and what constitutes 「money printing」.
The Deflationary Backdrop
Before diving into the mechanisms of money-printing, it helps to set the stage. Context is key.
Historically speaking, we’re coming down from the apex of, and currently within the lengthy resolution process of, a long-term debt cycle, which refers to a multi-decade peak in public and private debts relative to the size of the economy and money supply. This occurs in the aftermath of when interest rates hit zero.
We』ve been in this resolution process for the past 12 years, and the previous time before that was the two-decade period of the 1930’s and 1940’s where we hit the previous apex of a long-term debt cycle.
High private debt levels are deflationary, since it makes consumers and businesses financially restrained and risk-adverse.
Slowing population growth and aging demographics are deflationary, since resource demand slows.
Technology is deflationary, since it makes some things cheaper and better.
Wealth concentration into fewer hands is deflationary, since money coalesces rather than circulates.
Commodity oversupply is deflationary, since it cheapens the building blocks we use for everything else.
Outsourcing is deflationary, since it lowers labor costs of goods and puts downward pressure on domestic wages.
In a low-debt system, structural deflation for some of the positive reasons, such as technological improvement, would be a good thing. It means your money’s purchasing power grows over time, as higher productivity from technological enhancements lowers the cost of goods or improves their quality, so you get more value for your dollar.
However, in an extraordinarily high-debt system (which requires a lot of central policy intervention in the first place to be able to get up that high), deflation breaks things and results in widespread defaults, because the cost of servicing debts goes up relative to cash flows.
So, fiscal and monetary policymakers deliberately push back on deflationary forces with inflationary policy, especially when it gets to those extremes. And there are a few definitions or types of inflation that we can identify.
Monetary inflation refers to the growth of the broad money supply, which can be calculated in a few ways but is pretty straightforward.
Asset price inflation refers to bubble-like increases in the prices of financial assets, like stocks, bonds, gold, private equity, fine art, and so forth. This is a bit more subjective because valuations on assets can vary, but there are various ratios to keep track of it in a broad sense.
Consumer price inflation refers to a broad rise in the prices of everyday goods and services, and people debate about how it should be measured. The government uses CPI and PCE calculations on a basket of goods, but those use various substitutions. There are alternative calculations that don’t use substitutes, which generally lead to higher figures.
Each household has their own unique basket of consumer goods and services that they buy. For research purposes, I calculated that my personal household consumer price inflation rate averaged about 3% per year over the past two years, taking into account our total purchases of non-investment goods and services.
QE Alone = Bank Recapitalization
Going into the 2008 crisis, U.S. banks were extremely leveraged, with very low bank reserves.Large bank cash levels equaled just 3% of their assets (blue line below; cash as a percentage of total assets), and large bank holdings of Treasuries as a percentage of assets were pretty low historically as well.
So, leading into the financial crisis, only about 13% of their assets consisted of cash (3%) and Treasury securities (10%). The rest of their assets were invested in loans and riskier securities. This was also at a time when household debt to GDP reached a record high, as consumers were caught up in the housing bubble.
That over-leveraged bank situation hit a climax into the 2008/2009 crisis, coinciding with record high debt-to-GDP among households, and was the apex of the long-term private (non-federal) debt cycle. When banks are that leveraged with very little cash reserves, even a 3% loss in assets results in insolvency. And that’s what happened; the banking system as a whole hit a peak total loan charge-off rate of over 3%, and it resulted in a widespread banking crisis.
However, banks were bailed out via QE and the Troubled Asset Relief Program. It was a top-down, anti-deflationary bank industry bailout, but not a bottom-up, pro-inflationary real economy bailout. TARP boosted bank solvency, and QE boosted bank liquidity.
As the crisis played out and some banks failed and others were bailed out, regulators wanted to increase bank reserve requirements and capital requirements, requiring banks to hold a greater percent of their assets in cash reserves and other safe assets. The problem with that, however, is that banks can’t just magically boost up their reserves; they would have to sell other assets to get cash, but if every bank in the system sells assets to get cash, who do they sell to, and where would so much cash come from to buy what they sell?
In other words, while it’s possible for an individual bank to boost its reserves by selling assets to raise capital, it’s mechanically impossible for the entire banking industry to collectively raise its reserves industry-wide.
So, in the role of lender/buyer of last resort, the Federal Reserve created new cash reserves out of thin air, gave them to the banks, and took some of their Treasuries and mortgage-backed securities in return, aka quantitative easing or QE. Along with TARP, this recapitalized banks, bringing them from 3% cash as a percentage of assets at the start of 2008, to 8% by the end of 2008. The Fed did further rounds of QE through 2014 that brought banks collectively up to 15% cash levels, which brought them up to frothy levels of excess reserves.
This, however, didn’t result in more money chasing fewer goods and services, and therefore wasn’t particularly inflationary for every prices. The money remained mostly internal to the banking system, at higher reserve levels. Broad money supply didn’t increase rapidly.
Many analysts that were worried about inflation missed the fact that the transmission mechanism from QE to the real economy was small, so this was mostly just a bank-recapitalization process. Banks and their executives got a nice assist from the Fed and Treasury, but the broad public did not. Banks didn’t lend much of the money out (nor was there a ton of creditworthy demand for them to do so), and fiscal spending didn’t go around the banking channel very much either.
A similar version of this played out in the 1930’s, which was the previous time that interest rates hit the zero bound at the apex of a long-term private debt cycle. The banking system collapsed back then too, so policymakers devalued the dollar vs the gold peg, expanded the monetary base, and recapitalized banks during a banking holiday. This was enough to offset the deep deflation that was happening in the early 1930’s, and turn it back into a reflationary trend in the mid-1930’s, but not enough to cause rapid broad consumer price inflation. It was anti-deflationary, in other words, but not outright inflationary.
The Inflation Fake-Out
All told, the Fed expanded their balance sheet by about $3.5 trillion from mid-2008 to the end of 2014. They created new bank reserves to buy Treasuries and mortgage-backed securities.
Many folks thought this would be hyperinflationary, Weimar Republic style. So, they bid up the price of gold rather high. I’m glad they felt that way, because I sold my gold to them in 2011, during a period of very high sentiment. It’s the only time I sold physical bullion. I wanted to load up on historically cheap stocks instead.
Of course, this QE ended up not being outright inflationary for consumer prices, for reasons described before. It was anti-deflationary, rather than outright inflationary. Along with low rates, it was somewhat inflationary for asset prices, but not most consumer prices. That’s how it worked in the 1930’s, too.
We can put some broad numbers on it. From 2007 to 2009, there was a $11 trillion decline in U.S. household net worth, as it fell from $71 trillion to $60 trillion, due to a decline in stock and house prices. It then took about five years for U.S. household net worth to recover to previous highs. This was $11 trillion in deflationary wealth destruction (plus technology improvements, and commodity oversupply, tightened credit for home equity loans, and other deflationary forces), up against the response of $3.5 trillion in Fed bank reserve creation or QE. Of course it wouldn’t be hyperinflationary.
Morally hazardous? Sure. Hyperinflationary? No.
Moreover, as previously-described, most of the $3.5 trillion never entered the broad money supply because there was no major fiscal transfer mechanism, so it mostly just stayed in bank reserves. It offset a deflationary shock and bank collapse by recapitalizing the banking system with higher levels of solvency and liquidity (and thus was anti-deflationary), but it was not outright inflationary.
Bank Reserve Example
Banks, in practice, are limited in how much leverage and risk they can take by their regulatory capital requirements. In this model, there are some very low-risk assets (like bank reserves, Treasury securities, and gold) that don’t count against the bank’s risk level, and there are higher-risk assets (like personal loans, or corporate bonds) that do count against a bank’s overall risk level. Banks need to maintain an appropriate balance of assets to avoid being considered too risk-heavy.
In some regulation regimes, banks can also be constrained by reserve requirements, meaning that banks are required to have a certain percentage of deposits stored as cash reserves.
Suppose that there is a regulatory rule which says that all banks must have an amount of cash equal to 5% of their customer bank deposits (which are liabilities for banks; owed to their customers) held in reserve at the Federal Reserve. So, if a bank has $100 billion in customer bank deposits held with them (which are liabilities for the bank), and $110 billion in assets (and so they have $10 billion more assets than liabilities), they can put up to $105 billion of their assets into various forms (making loans, buying securities, etc), but must hold at least $5 billion in cash reserves at their account with the Fed.
Here is a reserve-constrained bank example. A bank has $100 billion in deposits (liabilities), and $110 billion in assets. Of their assets, $5 billion is in cash reserves, $20 billion is in Treasuries, $10 billion is in mortgage-backed securities, and $75 billion is in other assets (personal loans, mortgage loans, corporate loans, and/or whatever else). This bank can’t lend anymore, until either it collects more deposits which would also boost reserves, or sells some existing assets. It is therefore reserve-constrained. It might want to lend, and has good client demand to lend money to, but it simply can’t leverage itself anymore. If the Fed were to create $5 billion in brand new reserves (aka QE) and buy $5 billion of their Treasuries or mortgage-backed securities, it would alleviate their reserve-constrained status, and the bank could use that $5 billion to lend more, or buy more securities. This would be economically stimulative if the bank wants to lend money, because now the bank can go ahead and lend that money, and thus create deposits somewhere in the system and increase the broad money supply.
Here is a non-reserve-constrained example. A bank has $100 billion in deposits (liabilities) and $110 billion in total assets. Of their assets, $15 billion is in cash reserves, $20 billion is in Treasuries, $10 billion is in mortgage-backed securities, and $65 billion is in other assets. This bank has $10 billion in excess reserves above the $5 billion requirement; extra money it can lend. Maybe it doesn’t want to lend right now; it doesn’t see any good risk-adjusted loans to make. Or maybe there isn’t a lot of demand from its clients to borrow money. So, it’s just holding that extra $10 billion as excess reserves, in addition to their $5 billion required reserves. If the Fed were to do QE and buy $5 billion of their Treasuries, and bring the bank up to $20 billion in reserves, it won’t affect how much they lend, because they weren’t reserve-constrained to begin with. This would not be stimulative and would not increase the broad money supply, since it doesn’t coerce the bank to make any more loans.
That is why QE alone isn’t inflationary. Increasing bank reserves does not necessarily increase the broad money supply. A rapidly increasing broad money supply along with constraints on the supply of goods and services, is what can lead to inflation.
There are two ways to increase broad money supply. Either banks need to lend, or the federal government can go around them and run big fiscal deficits. At the apex of a long-term debt cycle, the latter tends to happen.
QE + Fiscal Stimulus = Money Printing
Now in 2020, in the next recession twelve years after the 2008 banking crisis, we’re back at it and bigger than before, but with a twist.
This time, going into the crisis, the banking system was already well-capitalized. The percent of bank assets that consist of cash and Treasuries was already historically high. So, unlike 2008, banks weren’t over-leveraged. However, the broader economy was over-leveraged, and the pandemic hit the broader economy.
Millions of people became unemployed, and countless businesses faced insolvency risk as their cash flows collapsed. For the Fed to simply buy Treasuries and MBS from banks wouldn’t do almost anything for this, because it’s not a bank recapitalization issue, and there would be no transmission mechanism to the public. Banks were already well-capitalized, and so the banks weren’t reserve-constrained.
Instead, this time, fiscal authorities (Congress and the President) spent trillions of dollars into the real non-bank economy, sending folks stimulus checks, boosting unemployment benefits by an extra $600/week (which is $2,400/month for several months for folks who received it), financing banks to give small businesses PPP loans that mostly turn into grants, and partially bailing out some of the hardest-hit corporate industries with fresh capital injections. It was a much larger stimulus than anything from 2008/2009.
The way that the government’s accounting works in the current legal structure, is that they have to issue a lot of Treasury securities to fund that expenditure. However, the foreign sector was not really buying Treasuries, and in fact were selling some Treasuries early this year. So, who would be available to buy $3 trillion in extra Treasury securities this year?
Enter the Fed again. When the Treasury market became illiquid in March from foreigners and hedge funds selling Treasuries against a backdrop of insufficient buyers, the Fed stepped in, and created $1 trillion in brand new bank reserves out of thin air to buy $1 trillion in Treasuries over a 3-week period. This was the most rapid asset-purchase program the Fed has ever done. And then they tapered that rate but kept buying Treasuries for months to soak up the massive 2020 Treasury issuance that funded all the stimulus, and are still buying tens of billions of dollars of Treasuries monthly with newly-created bank reserves to this day.
So, the Fed once again increased its balance sheet (this time by nearly $3 trillion in just three months) to buy a large chunk of Treasuries, plus some other assets like mortgage-backed securities and a handful of corporate bonds. About $2 trillion, or 2/3rds of this 2020 balance sheet expansion so far, consisted of buying Treasuries. But what made this one different, was that it didn’t just stay in the banking system to recapitalize banks. It flowed through banks to the U.S. Treasury Department, which injected that money directly into the economy as authorized by Congress』 CARES Act.
That chart is critical to see why 2020 and 2008 were quite different, and why the policy response acted so much quicker and more powerfully on financial markets and personal income this time. Personal income and net worth on a nationwide scale went up, rather than down, in 2020 so far.
In 2008-2014, there was a lot of QE (red line going up), but those dollars didn’t get out into public bank deposits (which is what mostly makes up the broad money supply). This was because there was little or no fiscal transmission mechanism; the government wasn’t sending huge checks to people. So, the green line (year-over-year change in government transfer payments) and blue line (year-over-year change in bank deposits) remained low. The QE process in 2008 mostly just recapitalized banks.
However, 2020 was a very different story. The government sent out tons of money directly into the economy, and financed it by issuing Treasury bonds that the Federal Reserve created new bank reserves to buy. For legal reasons, the Fed buys those securities on the secondary market, but that doesn’t make much of a difference in practice; it’s where they end up and remain that matters. The banks that buy them from the Treasury and sell them to the Fed just act as pass-through entities in this case.
So, the blue, green, and red lines all went vertical in 2020, unlike the 2008-2014 period. The government sent money to people and businesses (green line), that money showed up in their bank deposits (blue line) and thus in the broad money supply, and the Fed created new bank reserves to buy a lot of the Treasury securities issued to fund that program (red line).
Or, put simply, the broad money supply went up a lot in 2020, but didn’t budge nearly as much in 2008/2009 (in either absolute or percent terms), because QE alone to recapitalize banks, and QE-financed fiscal stimulus into the real economy, are two very different situations.
Many people who saw the inflationary non-event from 2008-2014, are suggesting that QE is inherently deflationary, and that it won’t cause inflation this time either.
I’m glad many people feel that way, because I’m happy to buy their gold from them on dips. I bought plenty of precious metals back in 2018 and have cooled my purchases since then due to the notable uptick in price, but am still happy to dollar-cost average into them at these prices, or buy on dips. I also like cheap natural resources more broadly, as well as high-quality equities, real estate, Bitcoin, and other scarce assets for a diverse mix, with a long-term view.
In my view, the 「QE is deflationary; it only increases bank reserves!」 position is from not taking into account the fiscal element; the transmission mechanism that gets QE into the hands of the public rather than stuck in the banking system. QE alone is not inflationary and mostly stays in bank reserves, but QE combined with massive fiscal deficits, is inflationary, and gets the funds out into the broad money supply, out into commercial bank deposits of the public.
Basically, massive fiscal spending combined with the central bank buying lots of sovereign bonds to fund it, is a modern monetary theory 「MMT」 program in practice, for the first time since the 1940’s when the equivalent of 「wartime MMT」 was used.
Now, bear in mind that this is still up against large deflationary forces: technology, demographics, debt, and shifting consumer behavior around the pandemic. So, even a one-time pro-inflationary $3 trillion injection into the real economy is merely enough to cause a quick rebound in inflation and a sharp recovery in asset prices, as we saw in 2020 from the March lows. Combined with certain supply limitations, it also helped cause non-discretionary prices to rise: grocery price inflation in particular was rather significant this year.
However, a one-time $3 trillion injection is not enough to cause a persistent trend change in inflation. Those deflationary forces outweigh it. There is not yet a situation of too much money chasing too few goods and services, except in niche areas. The stimulus delayed an insolvency crisis for several months and got consumers through the worst 3-4 month period of the economic shutdowns.
If we look over the past century, we can see that the two inflationary decades (the 1940’s and 1970’s) occurred when broad money rose rapidly. This chart shows the 5-year rolling cumulative percent increase in the consumer price index and in broad money supply per capita.
Therefore, the big question for investors in multiple asset classes, is whether the fiscal authorities will keep repeating that on a notable scale, or whether they will cool off. Without the massive fiscal+QE 「MMT」 combo, the economy remains in the grip of structural disinflation, and a renewed cyclical disinflationary trend. However, with another round of massive fiscal+QE 「MMT」 combo, the outcome would likely be more of what we saw in spring/summer of 2020: rebounding inflation and asset prices, and likely eventually pushing too far.
Ultimately, with so much debt in the system and the weight of private debt, policymakers are likely to be forced to do more rounds of fiscal stimulus (either from civil unrest or political donors), but the timing for that is something that investors need to work around when it comes to assessing the inflationary or disinflationary outlook for the next couple quarters ahead.
Right now, with money velocity so low and the pandemic still raging, and plenty of commodity oversupply particularly in regards to oil, it may seem like there is a limitless sink for broad money creation without leading to sustained consumer price inflation. However, that can change a couple years down the line, as the world fully emerges from pandemic effects, after years of not putting much capital into resource development.
It’s also worth noting that 「fiscal stimulus」 in this sense refers to both spending and taxation. In other words, federal deficits. A fiscal stimulus could include giving everyone a $1,200 check, or could include giving everyone a $1,200 payroll tax cut, for example. The differences between those two mechanisms matter around the margins (particularly for the unemployed, who wouldn’t benefit from a payroll tax cut), but for large chunks of the 150 million working population, a stimulus check and a payroll tax cut are functionally similar throughout the course of a year, and result in more cash in the hands of most people. These policies increase the amount of broad money, not just bank reserves.
When it comes to fiscal stimulus, regardless of whether it takes the form of taxation or spending changes, its stimulatory impact and inflation outcomes are mostly a question of magnitude, as well as who it primarily targets (unemployed, working class, middle class, wealthy, or rich). It’s inflationary, against the deflationary backdrop, and so whether the outcome shifts to inflation or remains disinflationary becomes a question of scale and persistence, and whether it increases productive capacity or not.
Rules Are Meant to Be… Broken? Bent?
In my view, focusing on some of the mechanics of the Fed’s QE combined with fiscal injections is like focusing on the trees and missing the forest.
This is because at the end of a long-term debt cycle, policymakers do whatever they need to in order to avoid a deflationary collapse and get towards some degree of reflation and devalued debt levels.
The Federal Reserve Act doesn’t allow the Fed to buy corporate bonds. And yet, the Fed bought corporate bonds this year.
How did the Fed do that? They worked with the Treasury and Congress, set up a Special Purpose Vehicle, and bought corporate bonds through that vehicle, with any defaults on those bonds funded by the Treasury so the Fed doesn’t face the risk of nominal losses.
People saying this violates the Federal Reserve Act are, unfortunately, falling on deaf ears.
Nobody Cares Meme
Policymakers went around the spirit of the Federal Reserve Act, but perhaps not the letter of the law due to the structure involved. It’s perhaps not surprising that the heads of the world’s two biggest central banks, the Fed and the ECB, are both lawyers rather than economists.
I personally think that the Fed buying corporate bonds was not a good part of the overall policy response, and sets a bad precedent and moral hazard. But, it happened nonetheless, and it is during the apexes of long-term debt cycles that these sorts of 「exceptions」 tend to happen.
The Fed has legal limitations on its own, which is good. However, when the Fed works closely with the Treasury Department and Congress to combine fiscal and monetary policy, all bets are off. They worked together closely in 1940’s decade to fund World War II in the second half of the previous long-term debt cycle apex, and they did so again here in the new 2020’s decade.
Love it or hate it, that Treasury+Fed combo is extremely powerful and bypasses just about any limitation that the Fed alone has. The Fed can lend but can’t spend. The Treasury can spend, but if it spends a ton and issues more sovereign debt than there is demand for, it needs the Fed to buy some of its sovereign debt issuance (using primary dealer banks as pass-through entities). The Fed can’t buy certain securities, particularly those that could lead to nominal losses, but with a special purpose vehicle and a financial backstop by the Treasury, they can. Together, they can create new money, and inject it to whoever they want.
Many people think that the broad money supply is only able to increase when banks lend money and create deposits. However, ironically, the biggest increases in the broad money supply historically happen when things are terrible and so banks *aren’t* lending much, and thus when the money multiplier (broad money divided by base money) is low.
At those times, the federal government runs massive fiscal deficits, and goes around the bank lending channel to either tax less from the economy or inject more money into the economy (historically they choose the latter), and finances its massive deficits by having the Federal Reserve create new bank reserves to buy a large chunk of its Treasury debt issuance.
However, when it comes to investment timing, sometimes focusing on the mechanics is helpful. So, let’s dive into some of those mechanics.
Bank Reserve Accounting
Bank reserves, referring to the accounts that commercial banks have with the Federal Reserve, are strange beasts because of how unintuitive they are.
In fact, even the very definition of 「money」 is subject to debate. There are multiple ways to define 「money」 in the modern banking system.
The monetary base, and the broad money supply, are the two most important definitions, so let’s quantify them for context.
Base Money
The monetary base is the foundation, and consists of physical currency in circulation (currently around $2 trillion) and cash reserve deposits that the commercial banking system has with the Fed (currently around $2.8 trillion).
Although not part of the original definition, because the Treasury’s general account 「TGA」 with the Fed has grown in size and importance in recent years (currently $1.7 trillion), we functionally should include that as well, since it’s another cash deposit with the Fed. Those three buckets combined are $6.5 trillion in 「base money」.
All three of these buckets of base money (currency in circulation, bank reserves with the Fed, and the Treasury’s general account with the Fed) are the Fed’s biggest liabilities. On the other side of the Fed’s ledger, Treasuries and mortgage-backed securities represent most of the Fed’s assets.
If we look at these major Fed liabilities separately, with the TGA in blue, bank reserves in red, and currency in circulation in green, it looks pretty random.
However, there’s a method to the madness, and the Fed controls the total sum.This next chart shows the sum of those three lines, meaning currency in circulation, commercial bank reserves with the Fed, and the Treasury’s general account with the Fed (which are collectively the main liabilities of the Fed) in blue, and shows the Fed’s total assets in red (which mostly consists of Treasuries and mortgage-backed securities).
Bank cash reserves at the Fed are fungible with each other. As folks like you and I use various payment systems to transact with each other, our banks use reserves to settle with each other behind the scenes.
Bank reserves are also fungible to some extent with currency in circulation. In fact, that’s one of the initial reasons for banks to have reserves in the first place: in case tons of people want to withdraw money at once. In theory, if we all wanted to go and take out some of our bank cash at once, it would come from bank reserves. However, in practice, the amount of minted physical currency is limited (mostly on purpose), so if there was a bank run, consumers would quickly find themselves limited in how much cash they would physically be allowed to withdraw, as the bank runs out of vault cash. But basically, physical currency and bank reserves are fungible.
Bank reserves are fungible with the Treasury general account as well. When the Treasury issues a lot of bonds and pulls capital into its account, it sucks it out of bank reserves. When it eventually spends down its account, those funds wind up back in bank reserves.
Broad money
The broad money supply, on the other hand, is currently $18.8 trillion, which is far larger than the base money amount. This broad money calculation consists of currency in circulation, but then also includes the massive amounts of checking deposits, savings deposits, and various functional cash-equivalents that consumers and businesses hold at commercial banks. This is the broader set of money that we consumers actually use to transact with each other and store our capital and define as our 「money」.
When the Fed does QE alone, it increases bank reserves in the system, but doesn’t necessarily increase the broad money supply. The broad money supply only increases when either a) banks create more money by making loans or b) the federal government runs big fiscal deficits to inject money to people and businesses in the system. Many people miss that second one; they assume that money supply can only increase if banks lend, which isn’t correct.
Conservation of Reserves + Currency + TGA (Base Money)
For the most part, only the Fed can determine the sum of commercial bank reserves + currency in circulation + the Treasury’s general account, hereby referred to as 「base money」.
Think of these three forms of base money as buckets of water. The total amount of water can move around between the three buckets if we pour one into another, but is conserved within the total three-bucket system. Only the Fed can increase or decrease the total amount of water in the total three-bucket system.
The purpose of modern banks is to 「multiply」 base money into broad money, and make a profit along the way. We can call this the 「money multiplier」, defined as the broad money supply divided by the base money supply.
When a bank makes a loan to someone, it becomes another bank’s deposit, and the loaning bank sends the reserve amount to the depositing bank, and increases the total amount of commercial bank deposits and broad money in the system. So, when they 「loan reserves」, banks collectively don’t actually reduce total bank reserves in the banking system; they just lever those reserves up with a higher money multiplier, and change the location/ownership of those reserves.
Any individual bank can leverage itself (up to a limiting point where it still meets capital and reserve requirements) by lending money or buying securities, and thus reducing its excess cash reserves at the Fed. However, when they make these loans or buy those assets, they create deposits somewhere else in the financial system, and those deposits become reserves of other banks. Similarly, a bank could sell assets and increases its cash reserves, but in doing so, some other bank deposits would be drained to buy those assets, which would reduce reserves somewhere else in the system.
Therefore, the banking system as a whole can’t decide to collectively increase or decrease the system-wide amount of bank reserves, even though any individual bank can alter its own level of reserves. They can collectively increase the money multiplier (the broad money supply divided by base money) by making more loans or buying more securities, but they can’t change the total system-wide bank reserves. They can just move them around, and leverage them up, or deleverage them.
Similarly, the U.S. Treasury can determine the size of its general account at the Fed. To increase it, they can issue Treasuries, bring in a lot of cash, and then hold the cash in that account at the Fed for a while before spending it. This sucks bank reserves out of the system, on a 1:1 basis with the general account increase. When they eventually reduce the general account by spending more than they take in, that money goes into peoples』 and companies』 bank accounts and thus winds up back in bank reserves.
The public can theoretically pull money out of excess bank reserves into physical currency, or deposit physical currency into banks which would wind up as more reserves, like water flowing back and forth between those two buckets of base money. In practice, however, physical currency is limited on purpose, so if the public collectively tries to pull bank reserves out into physical currency, they get told by the bank teller that they can’t, because there’s a nationwide shortage of physical currency.
The Fed, however, can create new base money, and thus add more total water to the three-bucket system analogy, by performing quantitative easing or 「QE」. To do this, they create new bank reserves out of thin air, and then buy existing assets, like Treasuries or mortgage-backed securities with those new reserves. After this asset swap, the reserves become owned by a commercial bank (and thus become the Fed’s liabilities), and the securities become owned by the Fed (and thus become the Fed’s assets). In this process, the Fed increases their total assets (the securities they are buying) and increases their liabilities (the new reserves they are creating) by the same amount.
The Fed can also decrease base money, or destroy water in the three-bucket system analogy, by performing quantitative tightening 「QT」. To do this, they sell or let some of their Treasuries or mortgage-backed securities mature and get their principle back. They then retire that cash. In this process, both the Fed’s assets and liabilities decrease.
In a vacuum, neither QE nor QT alone directly affects the broad money supply; it just affects the base money amount.
However, if the federal government is running very large fiscal deficits and the Fed is creating new bank reserves to buy the Treasury issuance to fund those deficits, it directly creates new broad money (and thus goes around the bank lending channel).
On the other hand, if the federal government were to run big fiscal surpluses on a sustained basis (i.e. tax more than they spend by a lot), at a time when banks aren’t lending much either, they can theoretically decrease the total amount of broad money. This would be very rare, if ever, to occur. Additionally, widespread bank collapses without any bailout or FDIC insurance can also theoretically reduce broad money, which happened in the early 1930’s.
Bank Reserve Accounting Examples
This section gets gritty. I』ll work through six examples of bank lending, QE, and fiscal deficits, to help show which types of actions by banks, the Fed, and the government, can influence the amount and location of bank reserves and broad money supply in the system.
For each example, I have two people, Mary and Sara, the two banks they do business with, the Fed, and the U.S. Treasury. Each of these six entities has a column that represent each of their assets and liabilities 「A | L」.
Each example is a small closed-loop financial system. Each block in an entity’s asset or liability column represents $1,000 of value.
「D」 represents a $1,000 customer bank deposit.
「R」 represents a $1,000 cash reserve allocation that a bank has at the Fed.
「T」 represents a $1,000 U.S. Treasury note; U.S. federal government debt.
Other assets, like a $1,000 used car 「C」 or a $1,000 car loan 「L」 are sometimes used as well.
A deposit block 「D」 is an asset for a consumer, and is simultaneously a liability for their commercial bank, since the bank holds it on behalf of the consumer and owes it to them on demand.
Similarly, a reserve block 「R」 is an asset for a commercial bank, and they keep it at the Fed. The Fed lists it as a liability, owed to the bank who deposited it with them.
Likewise, a Treasury note 「T」 is an asset for whoever holds it, whether a consumer, or a commercial bank, or the Fed, and is a liability of the U.S. Treasury.
A bank loan block 「L」 or mortgage block 「M」 is an asset for the bank that lent it, and is a liability for the consumer who borrowed it from their bank.
Example 1) A Bank Loans Money
This is the simplest example to show how banks create deposits and broad money without reducing the amount of reserves in the system. It involves Mary buying a used car from Sara.
Mary begins with 「D」 in assets, meaning a $1,000 deposit in her bank, and no liabilities. Her bank (which is very unlevered) starts with her deposit 「D」 as a $1,000 liability, and then has two reserve block assets 「R」, representing $2,000 held at the Fed.
Sara begins with 「DDDC」 in assets, meaning $3,000 in bank deposits at her bank 「DDD」, and a $1,000 used car 「C」, and no liabilities. Her bank starts with her deposit 「DDD」 as liabilities, and has its assets primarily invested in Treasuries 「TTT」 and one reserve block at the Fed 「R」.
The Federal Reserve holds the three blocks of reserves from the two banks as its liabilities, and has three blocks of Treasuries as its assets. The banks use the Federal Reserve as their bank, in a similar way that Mary and Sara use their banks. In other words, the two banks store their extra cash reserve assets in their accounts at the Fed, which are the Fed’s liabilities.
The U.S. Treasury Department, representing the financial arm of the overall U.S. Federal Government, has 6 blocks of Treasuries outstanding as its liabilities. For the sake of simplicity it doesn’t have any assets listed, but in reality, its assets would consist of working capital, various federal buildings and lands and military assets, and its ability to tax citizens. Its 6 Treasury liabilities are owned by the Fed and Sara’s bank.
Between Mary and Sara’s cash, there are 4 deposit 「D」 blocks in the total system, which are assets for them and liabilities for their banks. Likewise, there are 3 reserve 「R」 blocks in the system, which are assets for their banks and liabilities for the Fed.
Intermediate State
Now, for the intermediate state, Mary and Sara enter into negotiations, and Sara agrees to sell her car to Mary for $1,000. Mary, however, only has $1,000 in deposits, and although she needs the car, she doesn’t want to be completely cash-less. So, she goes to her bank, and takes out a $1,000 car loan 「L」. Mary’s bank creates a $1,000 deposit 「D」 for Mary, and creates a $1,000 loan liability 「L」 for her as well. For the bank itself, Mary’s new deposit asset is its new liability, and Mary’s new loan liability is its new asset. No reserves moved, but a new deposit was created.
Mary’s net worth is unchanged at $1,000 in total, but she now has $2,000 in deposits and $1,000 in loan liabilities ,and thus is a bit more leveraged. Mary’s bank’s net worth is unchanged as well, but it also leveraged itself up a bit, by creating a new asset and a new liability, since it expects that Mary will be able to pay the loan back with interest.
Neither the Fed nor the U.S. Treasury are involved yet.
There are now 5 deposit 「D」 blocks in the system rather than 4, because Mary’s bank is more levered with an additional asset and liability. It created new broad money by loaning a new deposit into existence. However, there are still 3 reserve 「R」 blocks in the system.
Ending State
For the ending state, Mary writes Sara a $1,000 check for the car, and therefore gives her the new deposit 「D」 that she just received from her bank loan. Sara receives the check and deposits it in her bank account, and her bank credits this by giving her an extra $1,000 deposit asset 「D」, which becomes a new liability for her bank. Behind the scenes, Mary’s bank sends a $1,000 reserve block 「R」 to Sara’s bank to honor the check. So, Sara’s bank now has a new liability 「D」 in the form of Sara’s new deposit, but also has a new reserve block 「R」 as its new asset. Sara’s bank doesn’t have any creditworthy clients asking for loans at the moment, so it keeps its new reserve block at its Fed account for now.
The Fed’s ending state is unchanged on net, except that it updated its book-keeping for its two client banks when Mary’s bank sent Sara’s bank a $1,000 reserve block 「R」. The Fed used to attribute 「RR」 to Mary’s bank and 「R」 to Sara’s bank, but now it attributes 「R」 to Mary’s bank and 「RR」 to Sara’s bank. These reserve blocks are liabilities for the Fed, but assets for its client banks.
The U.S. Treasury’s ending state is also unchanged, and unlike the Fed, it wasn’t even aware of the transaction at all.
In the final ending state, just like the intermediate state, there are still three reserve blocks 「R」 in the system, and there are 5 deposit blocks 「D」, which is one extra deposit block compared to the beginning state, created by Mary’s bank loan.
The point of this example is to show how, when a bank uses its reserves to lend money, the reserves aren’t destroyed. The money shows up in another bank, and the reserve amount is sent there. The overall amount of reserves or base money in the system is unchanged, but the system becomes slightly more levered, and has more consumer deposits and therefore more broad money. In other words, the money multiplier ratio (D-to-R, broad money to base money) increased from 4-to-3 to 5-to-3.
Any bank can increase or decrease its own amount of reserves by buying or selling assets, or making loans. However, those reserves get moved around to or from other banks rather than created or destroyed. Banks can, however, create or reduce the amount of deposits leveraged on those reserves, depending on how much risk it wants to take on and how many creditworthy opportunities it has to lend money for.
Example 2) The Fed Performs QE from Banks
This next example is a bit more realistic, with a more levered banking system. It involves the Fed performing quantitative easing on the banking system, meaning it creates new reserves to buy existing assets from the banks.
Sara and Mary are identical to each other in this example. For assets, they each have a House 「H」, a car 「C」, and $4,000 in cash deposits 「DDDD」 at their banks. For liabilities, they also have a car loan 「L」 and a mortgage loan 「M」 owed to their respective banks.
The banks are also identical to each other in this example. They each have their $4,000 customer deposits 「DDDD」 as liabilities owed to Mary and Sara respectively. For assets, they each have 「RTTML」, meaning one reserve block, two Treasury blocks, one mortgage loan block, and one car loan block. The banks are rather highly levered, with lots of assets and liabilities relative to their sole reserve block.
The Fed is small, with just 「RR」 in liabilities for their member bank reserve accounts, one for each, and 「TT」 in assets.
The U.S. Treasury has 「TTTTTT」 in liabilities, which are owned by the banks and the Fed.
There are 8 deposit blocks 「D」 in the system, and 2 reserve blocks 「R」. So, the system money multiplier is levered 8-to-2, aka 4-to-1.
Ending State
In this example, the Federal Reserve realizes that both Mary’s bank and Sara’s bank have just one reserve block each. Assuming the banks are each required by regulations to have at least one reserve block, this means they can’t really lend any more, and can’t create more broad money. The Fed wants banks to be able to lend. So, the Fed decides to recapitalize the banking system by giving them plenty of excess reserve blocks. It can’t, however, legally just give free money to banks; it has to take something in return.
The Fed creates four new reserve blocks out of thin air, and gives two to Mary’s bank and two to Sara’s bank. These new reserve blocks become liabilities of the Fed, and become assets for the banks. In return, the Fed takes one mortgage block and one Treasury block from each bank. The Fed therefore adds 「TTMM」 to its assets and 「RRRR」 to its liabilities.
The banks are now much-better capitalized, with plenty of excess reserves as assets, and fewer Treasuries and mortgages. If they want to loan money or buy more securities, they now have plenty of excess reserves to do so with. However, they haven’t lent any more money yet, so the amount of deposits or broad money in the system remains unchanged. Underneath the surface, the banks are just less-leveraged, with plenty of reserves relative to deposit liabilities and overall assets.
Mary and Sara didn’t notice anything from beginning to end in this example. They have the same assets and liabilities that they started with. They weren’t even aware this happened.
The Fed is more leveraged now, with more assets and liabilities than it started with.
The U.S. Treasury didn’t change on net, except that it now attributes ownership of 2 of its Treasury note liabilities to the Fed instead of to the private banks, since the banks each sold a Treasury note 「T」 to the Fed.
There are still 8 deposit blocks 「D」 in the system, but the number of reserve blocks 「R」 increased from 2 to 6. So, the money multiplier in the system is now 8-to-6, aka 1.33-to-1. The amount of broad money hasn’t changed, but the amount of base money grew, due to the Fed’s decision to buy bank assets with new reserves. The banking system has been recapitalized, and has a lot more lending power now.
This is why, although many people think QE by itself is inflationary on consumer prices, it generally isn’t. The money isn’t getting out to consumers like Mary and Sara yet; it’s just internal to the banking system. This QE process sets the long-term stage for inflation as an early foundation, by recapitalizing banks and therefore being 「anti-deflationary」 by preventing a bank collapse and ensuring they have plenty of lending capacity, but it’s not inflationary yet.
Inflation would come if Mary and Sara have a lot more deposit money chasing the same amount of goods and services, but neither Mary nor Sara have more deposit money than they started with, and there’s no reason for anything to be inflationary. The amount of consumer deposits in the system hasn’t changed.
Example 3) The Fed Performs QE from Non-Banks
This third example starts with a simpler system again, very similar to Example 1. However, instead of having a car as an extra asset that she had in the first example, Sara has a Treasury note.
Sara decides to sell her Treasury note, but there aren’t many buyers for it at the moment. So, the Federal Reserve steps in and performs QE to buy it from her. The result ends up slightly differently compared to the Fed buying a Treasury note from the banking system.
Beginning State
Everything begins similarly to Example 1, except Sara has a Treasury note instead of a car. There are 4 「D」 deposits in the total system, and 3 「R」 reserves to start.
Sara decides to sell her Treasury note, but neither Mary nor either bank particularly want to buy it.
So, the Fed decides to buy it. The Fed creates a new bank reserve 「R」 out of thin air and gives it to Sara’s bank, and tells the bank to buy Sara’s Treasury note with a new deposit, and then to give the Fed the Treasury 「T」.
The Fed, therefore, bought Sara’s Treasury note with a brand new reserve block, using the bank as the intermediary (so Sara and the Fed never talked to each other; Sara sold the Treasury note to her bank for a deposit block 「D」, and her bank sold that Treasury note to the Fed, who bought it with a new reserve block 「R」).
Ending State
After the bank completes this task, Sara has the same net worth as she started the example with, but replaced her Treasury 「T」 with an extra deposit 「D」. Her bank also has the same net worth as it started the example with, but grew a bit bigger, with an extra reserve block asset 「R」 and an extra deposit block liability to Sara 「D」.
The Fed grew a bit more leveraged as well, with an additional Treasury asset 「T」 and an additional reserve liability 「R」, which it lists as an asset of Sara’s bank.
The U.S. Treasury didn’t change on net, except that it now recognizes Sara’s initial Treasury 「T」 as owned by the Fed instead of Sara now, since the Fed bought it.
Whether this is stimulatory for the economy or not depends on what Sara wants to do with her extra cash. She had 「DDDT」 and now she has 「DDDD」 as her assets. It’s still $4,000 but it’s a bit more liquid now. If the reason for her selling the Treasury was to raise more cash to do something big, like start a business or lend money to her friend to start a business, then it might be simulative. However, if she merely holds the money in an extra 「D」 deposit rather than the Treasury 「T」, then she’s not using the money any differently. It then becomes a question of what her bank does.
Sara’s bank now has an extra reserve asset block and an extra deposit block liability compared to the beginning state, meaning it’s a bit bigger and has more lending power. It could finance a corporate loan, or a consumer loan, which would be stimulative. Or, if it thinks the economy is too risky, or if none of its creditworthy corporate or consumer clients are asking for a loan, it might just sit on its safe 「RRTTT」 assets and do nothing. In that case, this example wouldn’t be stimulative.
There are now 5 「D」 deposits in the system compared to the beginning state that only had 4. In addition, there are 4 「R」 reserve blocks in the system compared to the beginning state that only had 3.
So, there’s more liquidity in the system, with an increase in both base money and broad money. However, none of that broad money moved yet, and is just sitting there with Sara and her bank. Broad money velocity is low, in other words. There is more inflationary potential in the system, due to there being more broad money and reserves, but no consumer price inflation yet. Sara isn’t any richer; just slightly more liquid.
In this example, the Fed directly increased the amount of broad money in the system without banks doing any private lending, and without the federal government doing any spending, but it remains unclear if it will be impactful or not (subject to what Sara and/or her bank do with their extra liquidity). And even if it was impactful, the Fed wouldn’t be able to repeat it a second time, because neither Mary nor Sara (the two private non-bank entities) have any more Treasury notes to sell to the Fed.
If anything, it’s likely to be somewhat inflationary on asset prices, because Sara is flush with cash, and perhaps more willing to buy stocks, or buy more Treasuries, etc. She’s a saver and this might not make her spend more, but it might shift how she invests, with her extra liquidity.
Example 4) Nonbank-Financed Helicopter Money
The first three example were separate cases, each meant to illustrate a different scenario.
These final three examples, Example 4, Example 5, and Example 6, however, build on top of it each other to show what happens when the U.S. Treasury gets involved with deficit spending, with differences depending on who finances that spending by buying the Treasury debt.
Example 4 begins with a relatively unlevered system. However, the economy is in a recession, and Mary just lost her job and only has a little bit of money in her bank account and is making her frustration known, so Congress authorizes the U.S. Treasury to send everyone $1,000 in stimulus checks, right to their bank accounts. This is known in economics as 「helicopter money」, referring to a thought experiment of dropping money out of helicopters on consumers. The Treasury finances this by issuing Treasury bonds, which Sara, who has plenty of money and hasn’t lost her job, buys.
Beginning State
Mary has a car 「C」 and a deposit 「D」 as assets, and a car loan 「L」 as a liability. Mary’s bank has a reserve block 「R」 and Mary’s car loan 「L」 as assets, and has Mary’s deposit 「D」 as its liability.
Sara has three blocks of deposits 「DDD」 as her assets, and no liabilities. Sara’s bank has a blend of excess reserves and some Treasuries as assets 「RRTT」, and has Sara’s three deposit blocks 「DDD」 as its liabilities.
The Fed holds the banks』 3 total system reserve blocks as its liabilities, and holds 3 Treasuries as its assets.
The U.S. Treasury has 5 Treasury notes outstanding as liabilities, which are owned by the Fed and Sara’s bank.
Total system deposits are 4D = $4,000, and total system reserves are 3R = $3,000.
Intermediate State (not shown)
Although it is the originator of currency, the U.S. Federal Government legally has to finance its spending by receiving taxes or issuing Treasury debt to settle its account.
So, the U.S. Treasury sends a $1,000 deposit 「D」 block each to both Mary and Sara, deposited in their bank accounts. Both Mary and Sara are happy, because their net worth goes up by $1,000 each. Their banks get money deposited into them, and haven’t loaned any out yet, so they just keep this new cash at their Fed account as new reserves.
However, this is just a brief intermediate state. The Treasury now issues new Treasury note liabilities 「TT」 to pay for the expenditures it just made. Sara then decides to use two of her deposit blocks 「DD」 to buy those two Treasury securities 「TT」, since they are yielding slightly higher rates than her bank deposit account yields.
If we imagine it happening simultaneously, what happened is that the U.S. Treasury extracted two deposit blocks from Sara (and therefore extracted two reserve blocks from Sara’s bank, as Sara’s bank settled the transfer with the U.S. Treasury), and the U.S. Treasury gave Sara two Treasury note blocks as assets in return. At the same time, the U.S. Treasury gave both Mary and Sara one deposit block each, and therefore gives one reserve block to Mary’s bank, and one reserve block to Sara’s bank, to settle the transfers.
Ending State
By the end of the transfers, both Mary and Sara are $1,000 richer than they started. Mary’s assets simply went from 「CD」 to 「CDD」 as she gained a deposit block. Sara’s assets went from 「DDD」 to 「DDTT」, because she gained a deposit block but used two deposit blocks to buy two Treasury notes.
Mary’s bank is slightly bigger than it began, because Mary received a deposit block 「D」 and her bank was credited with a reserve block 「R」 to settle it (but also owes an extra liability 「D」 owed to Mary), and Mary hasn’t spent it yet. So, Mary’s bank has the same net worth (both its assets and liabilities increased by the same amount), but it’s overall combined assets and liabilities are bigger, and it has more lending power now because of that.
Sara’s bank is slightly smaller than it began, because although Sara and her bank received a deposit and reserve block respectively, Sara sent two deposit blocks to the Treasury to receive the Treasury notes, and therefore Sara’s bank sent two reserve blocks to the Treasury, which were then given back out, one to Mary’s bank and one back to Sara’s bank. Sara’s bank has the same net worth, but is simply smaller, as both assets and liabilities decreased, and its lending power is decreased.
The Fed is unchanged, except that it updated its book-keeping to attribute one of the reserve blocks 「R」 originally attributed to Sara’s bank, to being attributed to Mary’s bank instead. Its overall amount of Treasury note assets and reserve liabilities remains unchanged.
The U.S. Treasury is more leveraged, with an extra 「TT」 in debt liabilities outstanding, owed to Sara.
Total system deposits are 4D = $4,000, and total system reserves are 3R = $3,000, meaning that neither the total amount of deposits or reserves changed in the system from the beginning state to the end state. Deposits and reserves were just moved around a bit within the system.
Example 5) Fed-Financed Helicopter Money
Example 5 starts exactly where Example 4 left off, and builds from there.
Both Mary and Sara are happy because they got some extra money in the previous example. However, Sara is just prudently saving her money due to uncertainty about the economy, and Mary still doesn’t have a job so she is also just saving her money, and their favorite restaurants and vacation spots are closed due a virus pandemic anyway.
Some politicians want to give $1,000 to everyone every month for the next year, due to so many displaced workers like Mary having so little money and with no jobs. Other politicians say, 「no, that’s too much federal debt, let the economy try to heal itself.」 The politicians argue for a couple months and then eventually compromise and decide to send everyone $1,000 one more time, to see if that helps. So, Congress authorizes the U.S. Treasury to send out another $1,000 to everyone.
This time, instead of Sara buying the new Treasury liabilities with her existing deposits, the Fed buys the new Treasury liabilities with new reserves.
Beginning State
Sara already owns a lot of Treasury notes and sees that the U.S. Treasury will become even more indebted after it sends out all this money without raising taxes, so she doesn’t want to buy any more Treasury notes. So, how will the U.S. Treasury finance this second round of helicopter money?
Well, because there is a lot of new Treasury note issuance but nobody desiring to buy it at current prices, the Treasury note market suddenly becomes illiquid, and prices start to fall (meaning yields start to rise). Sara and her bank both get nervous, because they own a lot of Treasury notes.
The Treasury note market briefly looks like it did in March 2020: totally illiquid, with yields extremely volatile.
However, this problem doesn’t last long, because the Fed says, 「It’s fine everyone! We』ll buy the extra Treasury note issuance. Relax.」
So, the Fed creates two new bank reserve blocks 「RR」, and gives them to the Treasury in exchange for the new Treasury debt liabilities, 「TT」, which become the Fed’s assets. Technically, the Fed can’t legally buy directly from the Treasury, so they agree to transfer the securities through one of the banks as a brief pass-through entity.
The U.S. Treasury then sends a $1,000 deposit 「D」 each to Mary and Sara, and settles this by sending a reserve block 「R」 to each of Mary’s and Sara’s banks.
Ending State
Mary and Sara are both $1,000 richer, again. They each have a new $1,000 deposit 「D」.
Mary and Sara’s banks are both bigger, although their net worth didn’t change. They each have an extra $1,000 reserve block 「R」, but also each have a new $1,000 liability block to their customer deposits 「D」.
The Fed is bigger and more levered, with $2,000 more assets in the form of Treasuries 「TT」, and $2,000 more liabilities in the form of reserves 「RR」 that they hold for the banks.
The U.S. Treasury is bigger and more levered, with $2,000 「TT」 in more debt liabilities outstanding.
System-wide deposits (broad money) increased over the beginning state, from 4D = $4,000 to 6D = $6,000. System-wide reserves (base money) also increased over the beginning state, from 3R = $3,000 to 5R = $5,000.
This was outright money-printing. The amount of broad money and base money in the system went up by a lot. Mary and Sara are richer, and their banks are bigger. Money was injected into the system, without being extracted anywhere from the system, because the deficit spending was financed by the Fed creating new bank reserves to buy the Treasury notes.
The Treasury and Fed can perform this repeatedly if they want, any number of times, although they both know that if they do it too much, it could cause consumer price inflation.
Whether it is inflationary for consumer prices or not, however, depends on whether Mary and Sara still have confidence in the value of their deposits, and whether they go and spend them or not. It’s also potentially inflationary for asset prices; Sara in particular is flush with assets and more likely to put some money to work in stocks other gold or other assets than she was before.
Example 6) Bank-Financed Helicopter Money
Example 6 starts exactly where Example 5 left off. Both Mary and Sara are happy because they got some extra money in the previous example, again.
The pandemic eased a bit, and Mary got a new job, but realizes she needs to keep more cash on hand in case she loses her job again in the future. She learned a lesson about saving, in other words.
Sara was already a saver, and hasn’t been spending extra money yet either. Sara, however, is considering going on a vacation or buying a car, now that she’s feeling a bit more confident with so much cash. She’s also not sure about the value of her money, as she watches the broad money supply expanding so rapidly due to these helicopter checks that everyone is receiving. Car prices are starting to go up, probably due to so many people receiving stimulus checks, so there seems little reason to wait.
However, because the economy is still sluggish, with many people saving more than they used to, Congress decides to do yet another round of $1,000 helicopter checks to everyone, and issue $2,000 in new Treasury note liabilities 「TT」 to pay for it. This is it, the final stimulus round!
Fortunately for the U.S. Treasury, the banking system has tons of excess reserves due to their previous round of helicopter spending that the Fed bought with new reserves, and so this time, the banks each agree to buy one Treasury note 「T」 with one of their excess reserve blocks. (In fact, the banks don’t have much of a choice, because as primary dealers they 「have」 to buy Treasury notes at auction if they have enough liquidity to do so, and if neither Mary nor Sara nor the Fed agree to buy the Treasury notes from them, they get stuck holding the Treasury notes.)
Beginning State
System-wide deposits are 6D = $6,000. System-wide reserves are 5R = $5,000.
Here’s what happens if we imagine the process happening simultaneously. The U.S. Treasury sends Mary and Sara each a $1,000 deposit 「D」 block, and sends their banks each a $1,000 reserve 「R」 block to settle it. The U.S. Treasury then issues two new Treasury note liabilities 「TT」 to pay for it. The banks each send a reserve block 「R」 to the U.S. Treasury in exchange for one of those Treasury notes 「T」.
Ending State
Mary and Sara are, yet again, $1,000 richer. They each have yet another deposit block 「D」 added to their assets.
Their banks have the same amount of reserves they started with, because they each received a reserve block 「R」 from the U.S. Treasury’s helicopter deposits to their customers, but since each bank also sent a reserve block 「R」 back to the U.S. Treasury to pay for the stimulus, they each ultimately received a Treasury note 「T」 as an asset instead. They still have the same amount of reserve blocks that they started with, but they each have an extra asset 「T」, and they each have an extra deposit liability 「D」 for their customers. So, they are a bit more levered overall.
The Fed didn’t change at all from the beginning of this example, although it did some book-keeping for the reserves moving around and ending back in the same place.
The U.S. Treasury is $2,000 or 「TT」 more in debt than it started the example with.
System-wide deposits increased by $2,000 or 「DD」 from 6D = $6,000 to 8D = $8,000. System-wide reserves are still 5R = $5,000. So, the money multiplier increased a bit, from 6-to-5 to 8-to-5. Broad money increased, but base money remained the same.
Will it be inflationary? It depends on what Mary and Sara do from here, but most likely at this point, yes. Sara now has tons of cash and is concerned about the value of that cash, so she decides to spend money on a vacation and buy that new car, or buy stocks or gold or real estate, or something. Even Mary decides to eat out at restaurants more, now that she has more cash than usual. Other people seem to be doing the same; prices of things are inching up each month.
There is now $8,000 in total deposits (broad money) in the system, compared to the start of Example 4 where there was only $4,000 in deposits. However, the amount of goods and service in the economy have not doubled. So, if Mary and Sara and others decide to start spending their money, it could indeed result in a lot of money chasing a limited supply of goods and services, and therefore could push up consumer prices and be inflationary.
In response to high inflation, the Fed’s normal tool would be to raise interest rates. However, with U.S. Treasury debt so high at that point, the Fed’s ability to raise interest rates would be limited, since it would result in an acute fiscal crisis as rising Treasury debt interest eats up a large part of the fiscal budget. So, either the Fed would have to let inflation run hot and inflate away part of the debt and keep creating Reserve blocks to buy new Treasury notes as needed to keep Treasury security yields low (which they did back in the 1940’s), or the U.S. Treasury would have to restructure/default on the central bank portion of U.S. Treasury debt.
So, the Treasury+Fed combo has all the power to boost the broad money supply enough to cause a rising trend shift in inflation, but when they do with such a highly-leveraged U.S. Treasury, they face some consequences in their ability to constrain it.
Example Summaries and Findings
If we analyze all of the examples, we see a few observations:
-Banks can create new deposits and increase the the amount of deposits (broad money) in the system by lending. Lending creates deposits. This lending doesn’t change the amount of base money (reserves) in the system, but it moves those reserves around from one bank to another, and levers those reserves up. This is the money multiplier ratio, the ratio of broad money to reserves in these simplified examples. Although the banks can create new deposits and increase broad money by lending, it is not 「money printing」 because the banks are simply making decisions regarding how much to lever themselves up relative to their cash reserve assets, and they are constrained by various regulatory standards for how much leverage they can have.
-The Fed alone has the power to create new bank reserves, and to therefore increase the amount of bank reserves in the system (base money) or more broadly, the total amount of water in the three-bucket system analogy. However, if it buys assets from banks, it doesn’t directly lead to more deposits (broad money) being in the system. It de-levers banks and gives them more capacity to lend and create new deposits (broad money), but whether they will or not is up to them. On the other hand, if it buys assets from non-bank entities like Sara (using the banking system as its intermediary), it can slightly increase deposits (broad money) in the system, but only to a limited extent, based on limited amounts of non-bank entities holdings』 of Treasuries that they can sell. It is, in this sense, very limited 「money printing」.
-On behalf of Congress, the U.S. Treasury can give more deposits to somewhere in the system, but deposits also get extracted back out of the system when non-bank entities like Sara buy the Treasuries that are used to fund this expenditure. So, it doesn’t necessarily create new deposits or new reserves. This is what deflationists often refer to as the 「crowding out effect」, meaning that the U.S. Treasury can extract capital from somewhere in the economy and inject it somewhere else in the economy, if it runs large deficits and builds up federal debt, and it displaces nonbank capital that could have been used for something else. This is not 「money printing」 since it just moves things around and levers up the Treasury.
-However, if the Treasury and Fed work together, they can rapidly increase both the deposits (broad money), and bank reserves in the system (base money), without extracting deposits from anywhere in the system. In this process, the Treasury injects money into the economy by spending, which creates new deposits, but instead of that money being extracted from deposits somewhere else in the economy, the Fed finances those new Treasuries with newly-created bank reserves out of thin air, and thus levers itself with additional assets (the new Treasuries) and additional liabilities (the new reserves attributed to the banking system). It doesn’t matter if banks lend or not; the Treasury+Fed combo goes around the bank lending channel by just giving people and businesses more deposits (broad money). This outright increases the net worth of Mary and Sara in the examples, and increases the size of their banks including broad money supply and bank reserves (but the banks』 net worth remains unchanged), and levers up both the Fed and the U.S. Treasury. There is no limit to the amount they can do this, other than the fact that it would eventually be inflationary if done too much and too rapidly relative to the amount of goods and services and productive capacity in the economy. This is outright 「money printing」, although there are some checks and balances since fiscal changes have to be passed by Congress and signed into law, rather than done unilaterally by the Fed.
-Additionally, if the U.S. Treasury injects money into the economy with large deficits and the Treasuries to finance it are bought by a well-capitalized banking system (usually as a result of the Fed already having capitalized banks by creating excess reserves in the recent past), it also increases the deposits (broad money) and levers up the money multiplier. This can be done quite a bit if banks start with excess reserves, because every time the federal government injects more money into the system, it creates more bank deposits, which replenishes the reserves that the bank spent buying Treasuries, and thus gives the banks more ability to buy additional Treasuries. This is mostly 「money printing」, although to maintain leverage ratios, the banks need to start with plenty of excess reserves.
-If there is a lot of broad money added to the system, with both Mary and Sara confident to spend, it could very well be inflationary. Plus, now that Mary and Sara are richer than they started, they might feel more confident to take out a mortgage loan or business loan from their bank to buy a house or start a business, and their banks are more willing to lend it now because Mary and Sara both have plenty of net worth and creditworthiness. This could very well be inflationary.
-There are proposals for central bank digital currencies, which if enacted may allow the Fed to inject money to consumer deposits without going through Congress. This would likely require an overhaul of the Federal Reserve Act, and would substantially change the nature of the system. Some folks argue that this would be necessary for inflation to happen, but inflation can already happen within the existing framework through the combination of fiscal deficits and QE monetization of those deficits. The current framework requires Congress to go along with it rather than performed unilaterally by the Fed, and thus has checks and balances in the system.
Implications: Focus on Broad Money
It’s fashionable to debate lately whether QE is inflationary or not, and whether central banks have run amok.
However, for more fruitful results as it relates to analyzing inflation vs deflation and the associated impacts on various asset classes, investors should focus on fiscal spending, especially when it is combined with monetary financing to pay for it. Are major fiscal deficits happening or no? How big are the deficits, relative to the deflationary backdrop? Who are the deficits targeting? Who is financing the deficits by accumulating the Treasury securities?
And then specifically, look at what the broad money supply is doing. Is it going up, or no? At what rate?
Banks are already well-capitalized. The big non-fiscal QE for bank recapitalization was done back in 2008-2014. Now, with massive Treasury debt in the system and interest rates at zero, fiscal authorities find themselves spending more, and running larger deficits, with the Fed and banking system buying the majority of their Treasury note issuance.
We have division of fiscal and monetary powers, and only when the powers combine (like in the 1940’s and again in 2020, where the Treasury runs massive deficits and those Treasury notes are accumulated by the Fed and banking system), does it become outright money-printing. It doesn’t require any change to existing laws for them to do that; they use banks as pass-through entities and other structures as needed to do what they do.
QE alone, where the Fed buys existing assets mostly from banks, is simply anti-deflationary, to recapitalize a banking system and fill it up with excess reserves. It’s not outright inflationary because it doesn’t directly increase the broad money supply. If the Fed buys existing assets from non-banks, it only increases broad money a bit, around the margins.
Meanwhile, large fiscal deficits funded by QE (the central banks monetizing deficit spending by buying any of the excess Treasuries over the real demand for them), actually is pro-inflationary, because it gets money directly into the economy, into the broad money supply, and can be done with no limit except for inflation that it would eventually cause when done to excess.
Whether it takes the role of unfunded tax cuts or unfunded fiscal spending, if fiscal spending combined with monetary financing results in higher personal income for consumers like Mary and Sara, and more broad money in the system, it’s an inflationary force. It then becomes a question of how big it is, how persistent it is, and what portion of the income spectrum it is targeting.
Given how highly-leveraged the system still is, and how reluctant banks are to lend, for the next several years as we head deeper into the 2020’s and eventually move past the pandemic, navigating the 「inflation vs deflation」 debate is going to mostly be a matter of watching how large or small the federal deficits are, and observing who funds those deficits (i.e. the Fed and banking system), and to see if the broad money supply goes up more quickly than the deflationary forces that exist.