“Large government deficits exist and will almost certainly increase substantially, which will require huge amounts of more debt to be sold by governments — amounts that cannot naturally be absorbed without driving up interest rates at a time when an interest rate rise would be devastating for markets and economies because the world is so leveraged long."
- Ray Dalio (2019), founder of Bridgewater Associates, a hedge fund, and author of Principles: Life and Work
“It is a sobering fact that the prominence of central banks in this century has coincided with a general tendency towards more inflation, not less. [I]f the overriding objective is price stability, we did better with the nineteenth-century gold standard and passive central banks, with currency boards, or even with 'free banking.' The truly unique power of a central bank, after all, is the power to create money, and ultimately the power to create is the power to destroy.”
— Paul Volcker (1994)
Our future will be determined by five transformative forces: The Five FATEsGraphic by Dez Cesarini
From the New York Times on October 16: “The federal budget deficit soared to a record $3.1 trillion in the 2020 fiscal year…The federal government spent $6.55 trillion in 2020, while tax receipts and other revenue trailed at $3.42 trillion. Much of the spending came from the $2.2 trillion economic relief package that Congress passed in March…The deficit — the gap between what the U.S. spends and what it earns through tax receipts and other revenue — was $2 trillion more than what the White House’s budget forecast in February. It was also three times as large as the 2019 deficit of $984 billion.
Here's a quiz question: do you really understand how the U.S. Government can spend so much more than it receives? If so, no need to read further.
For those of us willing to admit that we don’t really understand how the U.S. Government can continue to fund its deficit spending…for the first time U.S. debt is now about equal to GDP (Gross Domestic Product), like the sound barrier we once thought if we hit it we might explode…this column will try to explain.
Our trusted guide is not an academic economist, who tend to be….academic. Ian Shepherd, a fellow classmate from Stanford Graduate School of Business (1978) is an Australian, although a knowledgeable and caring United States “outsider.” Ian is principally an inventor of new systems in financial markets, an activity that resulted in him appearing before the United States Supreme Court in its ground-breaking 2014 “patent eligibility” case, Alice Corporation v. CLS Bank International. Ian has a deep understanding of financial markets; he worked in international banking, was a partner at McKinsey & Company and has been an advisor to the Australian Treasury and the Australian Office of Financial Management. Ian has a particular professional interest in monetary policy design.
What’s different this time? The U.S. has had large deficits in the past. And we endured the 2008 financial crisis much better than many predicted.
“There were specific villains in the 2008 Financial Crisis; take your pick: Lehman Bros, AIG, Countrywide, Goldman Sachs, and so on. In mid-March 2020, there was a run on liquidity in financial markets worldwide. Yes, most companies in America then had a dependency on debt. But, to market outsiders, the financial markets functioned as well as they do usually. Still, the March liquidity run involved no (obvious) specific villains.
“The extraordinary demand for market liquidity in the United States in mid-March principally manifested itself as non-Government sales of U.S. Treasury securities (treasuries). It quickly became clear to the Federal Reserve (the Fed) that its Primary Dealer banks (large global banks) lacked the balance sheet capacity to buy (and then sell to others) these securities quickly; the Fed needed to immediately become the principal buyer of treasuries. Had the Fed not done this, the price of treasuries would have fallen, possibly precipitously, and their yield or interest rate would have risen just as dramatically; this would have then put upward pressure on the Government’s borrowing costs…and then, likely inflation and higher interest rates for everybody.
WASHINGTON, D.C. - October 27: A general view of the Federal Reserve Building in Washington, United ... [+] States on October 27, 2014. (Photo by Samuel Corum/Anadolu Agency/Getty Images)Getty Images
“The Fed soon began purchasing treasuries at a scale never seen before; it became a buyer of all treasuries its banks wished to sell. These sales saw the Fed rapidly increase its balance sheet assets and, correspondingly, increase the “excess reserve” liabilities of its banks. Looked at from the perspective of the Fed’s banks individually, these “excess reserves” simultaneously became their new assets, replacing their sold treasuries.
“Soon after this, the Fed began purchasing any and all other assets that its banks wished to sell, at prices that held before the mid-March liquidity crisis, allowing banks to escape taking losses. Meanwhile, the Fed, because it is, well, the Fed, didn’t need to account for the assets it purchased as losses.
“In short, the Fed’s “excess reserves” became new and high-quality assets of the banks. The popular term for what the Fed is doing is “printing money,” and at a rate rarely seen before; in fact, most of this printing is by the banks.
“This process repeats itself; every time this happens the banks are able to purchase the unwanted assets of other market participants, using their money creation powers to do so, backed by their ‘excess reserves” with the Fed. In turn, the Fed purchases these assets in return for providing further increased “excess reserves” to its banks.
“The effect of the Fed’s actions has been to keep interest rates lower than they would have been, benefiting all borrowers, including the Government, in the process.
WASHINGTON, DC - SEPTEMBER 24: Federal Reserve Board Chairman Jerome Powell testifies during a ... [+] Senate Banking Committee hearing on Capitol Hill on September 24, 2020 in Washington, DC.Getty Images
“A feature of the Fed’s asset purchases by “printing money” is that Wall Street firms and their large corporate clients have been the primary beneficiaries of its actions. The Fed has contributed to programs to directly support Main Street too, although nowhere near as much, or as effectively, as its Wall Street programs. The net effect of this strategy has been to increase societal inequity within the United States; it has also exposed the average U.S. citizen to future inflation risks.
“With the Covid-19 pandemic appearing likely to persist for longer than we had hoped and the economy showing few signs of improving, the Fed’s actions will likely continue. With interest rates now close to zero, there is really nothing else the Fed can do. The Fed’s balance sheet will continue to grow, possibly to tens of trillions of dollars. Financial asset prices could be expected to continue increasing too, particularly in the equities market, if it continues to be stable, supported by technology companies, led by FAANG (Facebook, Apple, Amazon, Netflix, Alphabet/Google).
“But we are on a collision course with another force, as we see further increasing Main Street insolvencies, unemployment and the weakening of the finances of ordinary households and businesses. If the Fed were to ease up “printing money,” we might see significant deflation, like Japan in the 1990s. Worst still, we might see rapidly increasing inflation. This would produce the secular stagflation former Treasury Secretary Larry Summers has spoken of—remember President Jimmy Carter?”
Why can the U.S. confidently “print money”, but other countries cannot (necessarily) do the same?
“The short answer is because the U.S. dollar is the global reserve currency. In other words, most countries and companies from other countries usually need to transact business in U.S. dollars, making them exposed to the value of their currency relative to U.S. dollars. The United States and the Fed in particular, doesn’t face this “currency risk.
“Some contend that the United States is at risk to other countries, particularly China, not buying treasuries, or even aggressively selling the treasuries they already hold. At least in the short-medium term, the Fed could directly purchase all of the treasuries the Government issues. Under worse case scenarios, the banking industry would contract.
Freshly printed 100 dollar bills from the Federal Reservegetty
“Nevertheless, the United States should be in a position to fund itself for a very long time. All other things being equal, the U.S. dollar status as the global reserve currency could be expected to progressively decline. But the United States global position need not decline relative to most other countries. If, in particular, China were not a variable in this equation all this might be a reasonable bet for the United States to take; however, China is a variable in the equation.”
How could China’s emerging new monetary policy threaten the sustainability of the United States’ current approach?
“The notion of central bank digital currency (CBDC)-based new monetary policy rests on the radical idea of every individual and business in a country having a bank account with its central bank (the equivalent of the Fed) rather than with a commercial bank. Interest on balances in these accounts could be at positive, zero or negative rates. By way of such an account, entities would be able to electronically transact with others, typically using their phones, Paypal, WeChat Pay, credit or debit cards – effectively, a government-underwritten type of bitcoin, on steroids. The government could credit payments, including money its central bank simply “prints”, and debit payments, like for taxes.
“Monetary policy based on such an account system would allow a government to by-pass having to issue bonds to raise debt in order to spend the bond’s proceeds as they do now. Any government would simply “print money” and use it to buy the goods and services it needs or make payments to individuals or businesses. In such a world, all the actions we described the U.S. Fed doing above become outdated.
“A distinctive aspect of CBDC-based new monetary policy is that the money it “prints” is no longer “fungible,” meaning one US dollar or Euro isn’t necessarily equiuvalent to another. Rather, every unit of CBDC-type money that is issued by a country can have specific rules electronically attached to it. These rules can include: how quickly the money must be spent; on what goods and services it can be spent; which individuals or businesses it can be spent with.
“CBDC-based monetary policy would be completely different to current monetary policy, in which the U.S. dollar’s status as “reserve currency” allows the Fed to do all the things we described above. A risk any government faces from simply “printing money” is, of course, inflation. However, this could be mitigated by a government, reducing the CBDC units available or limiting their use. Similarly, faced with the risk of deflation, a government could increase the CBDC units it makes available or limit the period of time within which these units must be spent.
“If a CBDC-based monetary policy was implemented by China, Japan and/or the Eurozone, it could reduce their exposure to the U.S. dollar and weaken its unique role as the global reserve currency. And, the U.S., as the dominant even monopoly player may be slow to react to the “attacker’s advantage”. Ironically, the U.S. might also be constrained by hundreds of existing U.S. patents, many of which owned by inventors/assignees that are not U.S. entities.”
The Great Wall of ChinaArtyom Ivanov/TASS
With hopes that our trusted guide has led you this far, one must ask: how real is this threat? Consider this:
October 13, 2020: China news outlet Xinhua reports that China's central bank and the municipal government of the southern tech hub Shenzhen have finished handing out "digital yuan red packets" totalling RMB 10 million (USD 1.49 million) in what is seen as the first public test of the country’s official digital currency.
In simplest terms, as Modern Monetary Theory economists assert, perhaps the Fed can “print money” forever. Well, unless China can demonstrate it has the technological know-how, political will and economic strength to threaten the U.S. dollar as the global reserve currency, of course.