WBD359 Audio Transcription
Central Banking, Bonds & Inflation with William Elman & Greg Mercer
Interview date: Friday 11th June
Note: the following is a transcription of my interview with William Elman & Greg Mercer. I have reviewed the transcription but if you find any mistakes, please feel free to email me. You can listen to the original recording here.
In this interview, I talk to William Elman and Greg Mercer. We discuss bond yields and what they signal, the pros and cons of market intervention and the ever-increasing government debt.
“A lot of the tools that we’re using today to combat this coronavirus crisis were cooked up in 2008 during the great financial crisis, but now they’re on steroids; they’ve completely blown up to magnitudes that are unprecedented.”
— Greg Mercer
Interview Transcription
Peter McCormack: William, how are you doing mate?
William Elman: Doing good; how are you, Peter?
Peter McCormack: I'm good, thank you. Greg, are you well?
Greg Mercer: Doing great, thanks for having us on.
Peter McCormack: Well, first let's do the confession that I'm a horrible host and like two, three times I've put this back, I'm so sorry. Do you know what, one of the good things about it, I'm glad now it's coming after my interview with Eric Weinstein, because I think it's going to be mildly relevant to the conversation I had with him, especially with regards to CPI, but I'm glad to do it. William, do you want to just introduce yourself and give people the background to why we're talking.
William Elman: Sure thing. So, I'm a law student at the George Washington University in Washington DC. I'm studying business and finance law and my foray into Bitcoin, well I should say both Greg and I heard about Bitcoin probably in 2011 or 2012. We have a mutual friend who's quite eclectic and wanted to get us mining and I had no idea what he was talking about and just shelved the idea; and I periodically saw Bitcoin in the news and didn't really think much of it. Then COVID rolls around, it's maybe May or June of 2020, there is a global health pandemic, US Government has just passed a fiscal stimulus package of $3 trillion, and the world no longer makes sense to me.
This Bitcoin thing has just not gone away, it just keeps coming back; and so I decided to educate myself about it and now I'm pretty deep in the world of Bitcoin. I think it's a fascinating way to see the world through and earlier this year, there was a lot of talk around the bond markets and bond yields and I kind of followed it, but I'll admit it, I didn't totally get it and so I thought I'd educate myself and write an article about it. I did, I shared that with Peter, I suppose we can link the article in the show notes.
Peter McCormack: Definitely.
William Elman: And Peter invited me on the show to chat more about bonds and central banking in the context of Bitcoin.
Peter McCormack: But, you said we need to bring this other guy, Greg, on.
William Elman: Yeah, so Greg Mercer is a good friend of mine, became friends ironically in Econ 101 in college where I earned a middling grade and did not continue any further, but Greg has really taken the path professionally. Greg, do you want to introduce yourself and tell us a little bit more about what you do?
Greg Mercer: Sure, yeah. I'm Greg Mercer. Thanks again, Peter, for having us on the show, really been looking forward to speaking with you. I am a Deputy Director of a small think tank in Washington DC that really works on international economic co-operation, global development and global trade. One of the unique things that this position has provided me is kind of a direct line into mainstream economic thinking and policy making circles.
William, earlier this year, had dragged me into the Bitcoin world and one of the things that's been fascinating for me is having the opportunity to have a foot in both camps, so to speak, and seeing where there's disagreement, seeing where there's opportunities for agreement; so that's where I'm coming from. Yeah, I'm looking forward to getting into some of these issues and hopefully sharing some of the prospective that I've developed over my career here in DC.
Peter McCormack: So, Greg, big important question, how fucked are we?
Greg Mercer: William and I were talking about this before coming on the show, it's a crazy time right now.
Peter McCormack: Dude, yeah.
Greg Mercer: We were listing the number of ways in which traditional macro-economic thinking has been thrown out the window in the last ten months, so it's a crazy time and it's a hard time to predict what's going to happen. There's a lot of variables so, yeah, I don't know that I have any answers here.
William Elman: I will add that when I'm in my doomsday mode and thinking that the global financial system is on the verge of collapse, I go to Greg for reassurance, and he usually calms me down.
Peter McCormack: Well, it's good that you have him; I've got both of you here. I recently did an interview with Eric Weinstein and quite a large section of that interview was discussing inflation and CPI rates and his ideas that we need to challenge these people. A lot of stuff in there I didn't understand; I failed at what my normal duty is, which is to get a smart person to explain things that I can understand it, then everyone can understand it; and I failed that time.
I did have one question from that; you will be able to certainly answer this Greg, I don't know if William wants to take it, but he kept referring to neoclassical economics. I was sat in the interview going, "What the hell is that?" So, what it is neoclassical economics?
Greg Mercer: Yeah, I'm happy to take a first crack at it and, William, jump in as well. In my view, neoclassical economics is essentially the economics that you learn in Econ 101. So, this is the class that William and I sat in together in college and it's based fundamentally on a series of models. The simplest of those models is supply and demand, that a price is reached in a marketplace based on fluctuations in supply and fluctuations in demand. I think that's the most simple example of one of those models.
But the real challenge with neoclassical economics is that it's taught in the schools; if you've taken one course in economics, that's what you learn. Then when you get out into the real world, start digging into the data and start seeing how things actually work, you find that a lot of these models don't hold up in practice. There's endless examples of that and it is a shame that the introduction that most people have to economics is in that fashion and is in a way that doesn't necessarily help you understand the world any better.
Peter McCormack: I did economics at A Level at school, but we're talking, Jesus I'm such an old man now, 24 years ago I finished my A Levels, I got a C in economics, and I probably should have got a D, but I cheated in one of the tests, so I think I raised my mark up a bit. But I studied it, we had a micro class, a microeconomics and macroeconomics class, and the one thing that I remember from it, from speaking to bitcoiners is that we studied Keynesian economics which now apparently all needs throwing out the window, it's all bullshit.
I don't remember a lot of it but when you talk about supply and demands and Econ 101, it makes me think of the Ray Dalio video, How Markets Work, which I thought is an excellent video. But I've also since listened to the audiobook of Economics in One Lesson, so one of the things I am trying to understand with neoclassical economics: is this free market economics or is this the kind of economics where we have interference from the state; because it feels to me like the biggest problem we have with economics now is state interference?
Greg Mercer: Yeah, I think, and William, fell free to jump in here as well, but if I'm understanding neoclassical economics correctly, that's really the economics of the free market. It's not until later in the economics profession that the role of the state in managing economic cycles in propping up aggregate demand in cases of a recession, it is not until later in the history of economics that that comes in. So, yeah, when you talk about neoclassic economics, those models often don't assume a role for government.
William Elman: Yeah, that's right. Neoclassical economics, as Greg mentioned, those are kind of the nuts and bolts, so to speak, of how an economy in theory would work; basic concepts like supply and demand. When the Great Depression happened, the governmental response under the Hoover Administration was largely based in neoclassical thinking and was roundly criticised for being inadequate, and that was really the moment where Keynesian economics stepped in and shined.
I think mainstream economic thinking is that Keynesian economics, which prescribes an active role for the state, that was responsible in a large part, that and World War II, for pulling the US out of the Great Depression, and specifically, the government acting as a stimulant or stimulator of economic activity through spending.
Peter McCormack: Bitcoiners who I talk to regularly criticise Keynesian economics because the state interference makes markets less efficient and it creates this artificial boom and bust and we seem to be in this scenario where we are not allowing a bust to happen and in doing so, we are kicking the can down the road and eventually going to see an almighty crash, an almighty depression. Where are you with that?
William Elman: I'll take a first stab at that. What you're describing is very much the antifragile argument, this is the Talebian antifragile argument, that if you don't let the small wildfires run and clear out the underbrush, that when it finally happens it's going to be far worse. I do think there is some truth to that; the problem is we're not going to know until we know.
I mean it's like, I want to say it was Caitlin Long said something to the effect of, "The Austrian's are wrong until they're right", and I think that's the challenge is that, I think that bitcoiners maybe tend to underestimate the power and dexterity of the tools that the Federal Reserve has at its disposal. I would argue that its response has been largely successful, but the question is at the expense of what? Are we borrowing from the future? Are we borrowing from decades forward to prevent short-term pain? There is no answer, and this is the debate. Greg, do you have any thoughts on that?
Greg Mercer: No, I think that's right on. We're living through a moment where government intervention into the business cycle, into the economic cycle, is larger than it's ever been in history. A lot of the tools that we're using today to combat this coronavirus crisis were cooked up in 2008 during the Great Financial Crisis, but now they're on steroids; they've completely blown up to magnitudes that are unprecedented.
Is this going to come back to haunt us in the long-term? It's certainly possible. In the short-term though, I think that the application of these tools has helped a lot of people. So, we might be trading the reduction of pain in the short-term for more pain in the future, but I think that there is no doubt that using some of the emergency tools that we have used this crisis has really helped a lot of people.
Peter McCormack: See this is where it gets confusing, because whilst these tools may have helped a lot of people, have they also harmed a lot of people? Are these new tools sticking plasters for the damage that these people have also caused; and who really has benefitted? Looking at the wealth gap, and the cost of living, love that beautiful website my producer Ben Prentice is co-contributor, wtfhappenedin1971.com, sometimes I just get confused with it all.
Certainly stimulus packages during the coronavirus in the UK, they've helped businesses stay afloat whilst we've been in lockdowns, and we'll avoid the argument of whether lockdowns are right or wrong at the moment, let's just talk about the economic response; but again, are they just sticking plasters over problems that they've created themselves? Should markets ultimately be completely free without interference from the state?
William Elman: So, there are competing visions here. The free market vision is that absent the state, markets just work. It's this Adam and Eve utopia, if you will, where markets are self-regulating, they're self-correcting and at the source of economic crisis is government intervention. The Keynesians would say, "No, there is inherent volatility to free markets and when you let markets run wild without regulation, you get things like the depression, and that actually necessitates government intervention".
I certainly don't have a definitive answer to your question, but the reality is that government intervention has costs, nothing is free and the immense amount of fiscal stimulus that's been injected into the economy has propped up certain asset classes and that benefits certain groups of people, for sure. It might be keeping poor people afloat, just hanging on, but it also might be disproportionately, helping people who already have assets, namely stocks and real estate.
So, yeah, I personally do think that there is a strong case to be made that the fiscal response has contributed to inequality, even while it's helped throw a lifeline to some of the most vulnerable people.
Peter McCormack: Yeah, I mean I've heard it referred to as like a drug addiction. We keep feeding the addiction, but every time we feed it, we need more of the drug because our tolerance is increasing and eventually, and as somebody who was an addict I understand this analogy, but at some point we are putting off a crash. You cannot keep printing money continuously, trillions and trillions of dollars, without either leading to some form of mass or hyperinflation, or just creating a massive wealth gap and making life unaffordable for people. I mean the cost of living in the US now compared to the average salary is getting ridiculous. People in the middle classes have been hugely squeezed, so I struggle with it all.
Okay, well listen, let's talk about CPI, because actually this came up in an argument the other day. I was at the Logan Paul/Mayweather fight, some dude never met him before was in the suite we were in, and we started debating Bitcoin with him and one of the good reasons is prevention against inflation. This dude was like, "Look, there is hardly any inflation, check out the CPI numbers, it's relatively low". I was like, "Well, are the CPI figures a fair reflection on inflation or are they a suitable measure of inflation for the government to justify money printing, because I know certain things are getting more expensive, although they are above the, say 2%, the rising energy prices?"
I know part of that can be blamed as a supply shock following coming out of the Coronavirus situation but also house prices, if you go to Austin, they're up 30% in a year. Is the CPI measure fair and can you ever get to a truly fair measure of inflation, because everything's relative? You might be in a certain place, a certain state, where rents haven't gone up or house prices haven't gone up and in other places, they've gone up massively. Can you even get a fair measure of inflation?
Greg Mercer: I would respond to that in a couple of ways. The first is that I think you're right and I should preface this by saying I'm no expert in CPI. If you want to talk to the economists at the Bureau of Labor Statistics, they can give you the full breakdown on what's in there and what's not, but that's not me; but I would say that I think you're right that it's a relatively blunt instrument, right. It's trying to capture the purchases that an average consumer is making across a country that's enormously diverse.
Trying to boil all of that data, all of that information down to one measurement probably is a blunt tool, but I don't think that makes it without value. It gives you a snapshot of where inflation and where prices are going, and even if that's not a perfect snapshot, at least it communicates something. That would be one thing that I would say.
The other is that, and maybe this is where we can take the conversation from here perhaps, but the causes of inflation are diverse. You mentioned the supply stuff, you mentioned money printing or monetary expansion, but those aren't the only causes; there are other causes and it's about the interplay of those different causes that really leads to where inflation is going. So, it's a complicated issue and I think to some degree you're right, that boiling it down to one number in CPI is probably oversimplifying things.
William Elman: If I might add to that, I mean just to start when you say "inflation", there are different kinds and, Peter, you already narrowed it to CPI, which is an attempt to capture consumer goods and that doesn't speak to inflation we might see in the stock market for example, or just the inflation in the money supply itself.
I think it's particularly difficult to capture some kind of average person in 2021, because we live in an increasingly diverse society. For example, Greg ad I live in the same city, we're a similar age, similar life circumstances; he shops at a different grocery store than I do. How do you capture the increase in the price of meat at his grocery store versus mine? 50 years ago, people may have bought shoes at the same shoe store, but now I go online and I seek out shoes that retail for $100 and I buy them for $30 on discount. How does CPI capture that? I don't know.
What I do strongly reject is the bad faith argument. I am aware that in the Bitcoin circles, there is a thread that says that CPI is fudged, or it's manipulated by the government to justify its own ends, and I mean I've dug into the CPI reports and that's actually included in the slide deck that we shared with you, Peter, at the end there, and I mean they lay it all out there, all the data is there; and I don't think there is some black box where they're cooking up the numbers, I really don't.
I think we can have honest arguments about the choices they make in coming up with that methodologically, but I think the government is way too complicated, dysfunctional and decentralised to organise that level of conspiratorial economic planning.
Peter McCormack: Right, okay. I think some bitcoiners will disagree with you there; I think they'll be like, "No, full of shit".
William Elman: I'd love any evidence; I'd be interested in seeing it.
Peter McCormack: Greg, talk to me about these other forms of inflation you highlighted?
Greg Mercer: Other forms of inflation?
Peter McCormack: Well causes.
Greg Mercer: Yeah, this might be a bit of a textbook answer, but in my view it's right on. There's really three big buckets. So, one of which, and I know you've talked to folks on the show about this in the past, is supply issues. It's the fact that all the sawmills' shutdown is a direct contributor to the increase in lumber prices, so those supply bottlenecks are essential to understand.
The housing example that William mentioned is a key example of this. Strict regulations about building homes in the United States, strict zoning laws that prevent construction, directly contribute to supply bottlenecks that lead to increased prices. Washington DC, where I live, is a great example of this. There's very strict rules about where you can build residential housing, how high you can build residential buildings, and as a result we have seen prices go through the roof here in DC. So, supply is definitely one critical factor.
Peter McCormack: The thing we should say there is because, for example, there was the big jump in lumber prices this year, but that wasn't to do with an increase in the money supply, that was to do with sawmills closing down and there being a supply bottleneck. But as bitcoiners, I don't want to say "we", some bitcoiners may tweet out, "lumber pricing: there is no inflation", and lumber's up 400%, but it's a supply bottleneck and it actually hasn't got anything to do with an increase in the M2 money supply.
Greg Mercer: Yeah, exactly right and I think that it's really important that we all recognise the unique circumstances we're in. We just, for the first time in history, turned a modern developed economy off for a year, and then tried to turn it back on, and that's going to come with some really strange implications, some of which are going to be supply bottlenecks; so, that's a very real consideration when we're looking at these CPI numbers.
The other important factor that isn't included in the money printing discussion is inflation expectations. I think there's a very strong argument that at the end of the day inflation is fundamentally a social and psychological phenomenon and not one that has to do with mechanical relationships between an increase in M2 and a rise in inflation.
One good piece of data that came out recently, the University of Michigan did a study where they surveyed consumers and then looked at market-based determinations of future inflation and they saw that both on the consumer survey side as well as on the market base side, both of those groups were seeing less than 3% inflation on average over the following five years. To me that suggests really importantly that inflation expectations haven't become dislodged, despite what we're seeing in CPI, despite the massive fiscal stimulus; it's not as if consumers and others in the economy are predicting runaway inflation.
So long as businesses aren't predicting runaway inflation, they are probably not going to raise prices, so those expectations and those psychological factors are really, really essential.
Peter McCormack: We are though seeing a lot of people highlight increases in costs. One of my good friends, I've mentioned this on the show a couple of times, he's a plumber and he said he's having to raise his prices because his raw material prices are going up; I'm not sure how much that is a supply bottleneck. It seems to me that there is also this wave that's hitting now where everything is going up in price. It does feel like that, but there isn't this wave of increase in salaries. Can we identify where this is coming from?
Greg Mercer: Yeah, it's going to be interesting to see. I mean here in the United States there's obviously a massive debate going on right now about what exactly is happening in the labour market and particularly, what the impact of the unemployment insurance programmes has had on the labour market. I think the traditional republican or conservative response to this question, would be that generous unemployment benefits that were offered by the states and subsidised by the Federal Government are keeping people out of the labour force, and I think there might be some truth to that.
At the same time, it seems quite clear to me that these low quality, low wage jobs are going to have to raise their wages to attract workers, at least in the short term and it will be interesting to see. If wages start going up, it'll be interesting to see how that feeds on down the line into price inflation and consumer goods.
William Elman: Yes, so the most recent round of economic data did show a strong wage growth over the last few months, but is that a sign that the labour market's totally healed? No, it's much more likely that there's still millions of people who are sitting on the sidelines, because they're taking care of kids who cannot go to school because they're all shut down; they might still have some lingering concerns about safety with COVID; and we have an artificially restricted labour market because so many people are sitting on the sidelines, but eventually they're going to come back in.
So, is that wage growth that we've seen over the last few months a secular sign of some kind of structural change; or is it just us working out the kinks as we adapt, as we transition to some degree of normalcy? I think it's probably the latter.
Peter McCormack: We're half an hour in and we haven't actually touched on the subject that we originally were going to talk about, which is really interesting. Okay, so we originally were going to talk about bond yields and yield curves because that was a subject that came up for me a couple of times. Greg Foss, I discussed it with him, and Lyn Alden; and I think people who listen to the show can see my brain ticking and trying to figure it out and trying to understand this. Because, when it was first explained to me, that yield rates going up was a bad sign, I was like, "That doesn't make sense, surely this is a good sign. Yields are going to be paying a better return, this is awesome".
What I didn't understand I what that meant for the repricing of bonds in the market, because it's a constant liquid market. I know I've touched this before, and I've had it explained before and I've done my best, but there will be some people who missed those shows or are new to the shows. I think it's a really interesting topic to get into, so we're going to go basics. William, do you want to just start with explaining what a treasury bond is; how it works; how the market trades these?
William Elman: Absolutely. So, let's just start with what a bond is, before we even get into the treasury bond. So, a bond is a loan; it's an IOU. If you have some extra money sitting around, you can own by purchasing stock in a company, or you can loan by lending that money to a borrower. So, a bond is a fixed loan, it's what we think of when we think of a loan; there's a principle amount; there's a maturity date, let's say ten years from now, when the bond will be repaid; and there's annual interest.
A treasury bond is that issued by the US Department of the Treasury. That is the government agency that is responsible for managing the US Government's finances. It is not the bank; it is not the Federal Reserve; and it's very important to keep those two institutions distinct. The US Treasury is the money manager, so when you pay your taxes, like the IRS is a wing of the US Treasury; when you get your stimulus checks in the mail from the government, that's from the US Treasury.
The US Government issues bonds to fund government spending, whether it's Medicare, military, you name it, the government essentially continually runs a deficit and so it needs to borrow money. It cannot just totally create that money out of thin air, and so it issues bonds. Those bonds are issued on what's called the primary auction market and they can be purchased by private actors like institutions, they can be purchased by individuals, they can even be purchased by other governments. So actually, in preparation for this show, I actually bought a US Treasury directly.
Peter McCormack: You did?
William Elman: Yeah, I'm showing it on video here, but it's just a printout, because it's not a real thing. But if you go treasurydirect.gov or treasurydirect.com, just google it, you can actually create an account and buy a US Treasury bond; so I bought one, it was like $100.
Peter McCormack: That is cool, I didn't know any of us could just go and do that.
William Elman: You can buy a bond, and I'm looking for it here and I can't find the details.
Peter McCormack: Over what year; what period? Is it a ten-year bond?
William Elman: I bought a ten-year bond and at that time, I think it was about 1.6%.
Peter McCormack: So, you will get $101.67 back in ten years?
William Elman: I will get a $1.60 per year, that's the interest.
Peter McCormack: Per year.
William Elman: So, I will get $1.60 per year and then at the end of ten years I will get my $100 principal back in full.
Peter McCormack: So, you're going to get about $111, $112.
William Elman: Give or take, yeah.
Peter McCormack: Right, interesting. What will be interesting is if you get the same purchasing power for $111.60 in ten years as you get for $100 now. I have a feeling you won't; I think you will get less coffee at Starbucks, I think you will get less cheeseburgers at McDonald's, you certainly can buy less of a house. It seems like a shit deal.
William Elman: I would agree with you that in real terms, I'm going to lose money with that investment, because inflation in goods and services will outpace that 1.6% annual interest; I'm fairly confident of that. However, bonds are extremely safe. So, if you are a bank or a large institution and you have hundreds of millions of dollars to allocate and you don't want to put it into Tesla or Bitcoin, you could purchase US Treasury Bonds. US Treasury Bonds are called, Peter, you've probably heard this term going around, the risk-free rate of return.
Peter McCormack: Yeah.
William Elman: The reason it's called the risk-free rate of return is because the US Government is considered essentially the perfect creditor. They're never going to go bankrupt; they've never defaulted; it's the largest economy in the world, or at least I think it still is; the global superpower; and those bonds are "backed by the full faith and credit of the US Government". So, yeah, you're only earning maybe 1% or 2% annual interest on a bond, but there's virtually no risk, at least today.
Peter McCormack: And, the rate is going to be better than the interest you get in a bank, so your options are leave it in a bank and make less money, take out the treasury bond and have a guaranteed nominal rate over ten years. Do you get that interest every year, or do you get it as one lump sum at the end?
William Elman: It's typically paid semi-annually, every six months, that's just kind of the standard.
Peter McCormack: You're going to be about 80 cents every six months.
William Elman: Correct.
Peter McCormack: Dude, dinner's on you!
William Elman: I think it might be helpful to actually just walk through another example here with some numbers, because I know we did want to talk about yields. What is a bond yield; what is bond yield going up and down; what does that actually mean? Peter, would you be open to just kind of doing a walkthrough of an example here where I have a bond that I'm interested in selling you?
Peter McCormack: Yeah, let's do it.
William Elman: Okay, so let's say I purchase a bond for $100; that's called the principal or Par value. I give the US Treasury, the US Government, $100; they give this piece of paper, this bond in return. Let's just say nice round number, it's yielding 2% per year, so $2 interest I'm earning; and it's a 20-year bond, so at the end of the 20 years, I'll get my principal of $100 back. All good so far?
So, now let's say a year or two goes by and the new Treasury Bonds that are being issued by the Government are generating a higher yield, let's say 3%. I want to get rid of my bond, I want to sell it to you, Peter. Are you going to buy it for that same $100 knowing that you could get a higher interest rate if you were to buy it directly from the Treasury?
Peter McCormack: Of course not.
William Elman: So, I've got a bond that yields 2% and you could buy a bond that yields 3% elsewhere; you're going to offer me less for that bond, right. So, even though I paid $100 for it, let's say I sell it to you for just $70. That bond is still earning $2 in annual interest, because 2% of $100 is $2. So your yield, Peter, since you bought it for $70, your yield is going to be higher; it's specifically going to be 2.9%, because you're going to get $2 every year in interest on a $70 purchase. That right there is how yields change over time.
Peter McCormack: To sell it to me, you're sacrificing your principal.
William Elman: Right, because who knows, maybe I need that cash right now. I'm a business, I'm strapped for cash, and I need it, or I identify a better investment opportunity and I'm like, "Hey, I'll take the hit to get the cash because I want to put it into the stock market". People need cash, businesses need cash all the time, and so sometimes they'll be willing to settle for less than what they bought it for, absolutely.
Peter McCormack: The opposite is also true, if the yield drops to 1% your bond is suddenly much more valuable.
William Elman: Exactly, that's exactly right. So, what you're describing is this seesaw or lever, this inverse relationship between the prices that bonds sell at on the resale market and the yields that they generate. If I have a bond that declines in value, the purchaser of the bond will have a higher yield, so the price goes down, the yield goes up and then the inverse is true.
I think that's what's so confusing for many people when you see something; like Peter, you opened with saying, "Bond yields are rising that's a good thing, right, because going up intuitively seems like it must be good". What that actually means is that bonds are becoming less valued so the price of those bonds that are existing on the market is actually going down because they are less desirable, and the yields are going up as a result.
Peter McCormack: But, yields are directly related to inflation, because if the US was facing potentially 3% inflation, or say inflation was rising from say 2% go 4%, they're going to have to raise the yields because otherwise people won't want to buy them.
William Elman: Yeah, you're absolutely right and I think you're leading us into our next topic there.
Peter McCormack: This is like what Greg was saying, we're essentially borrowing from the future now?
William Elman: So, you're absolutely right that the expectations of inflation drive the market's valuation of bonds. If the market at large expects that there is all this inflation coming, they're not going to settle for a bond yielding a measly 1.5%, they're going to expect more; and that's what we saw a few months ago is bond yields, on the ten-year at least, went from maybe about 0.7% to about 1.5%, 1.6% because the market refused to accept those low yields with the expectation of inflation down the road.
Now, what I think you were getting at, Peter, is government manipulation of yields. Is that something that you'd like to chat about, the manipulation of the yield curve?
Peter McCormack: Definitely, please do.
William Elman: Greg, do you want to take a stab at that, and I can help out?
Greg Mercer: Sure. I mean one of the real key pieces of what economists call monetary policy, and monetary policy, just to give the 101 definition, is adjusting the money supply; that is creating or destroying money to essentially manipulate the business cycle or the economy in some way. You create money for a certain objective, you destroy it for another; that's essentially what monetary policy is. And, manipulating interest rates is a core feature of monetary policy.
There's a couple of ways that central banks do this, and this is what we do in the US and it's what happens in other countries as well. One of the ways that the Federal Reserve Bank here in the US manipulates interest rates is through something called the Federal Funds Rate. Peter, please stop me if we're getting too weedy here, but the federal funds rate is essentially a market determined rate, but the Fed help set it, and it's essentially the rate at which banks lend to each other on an overnight basis.
So, banks are required to hold reserves, this is required by the Federal Reserve Bank, and if a certain bank has excess reserves, they're above the reserve threshold, they can lend those reserves to another bank that's below the threshold, so that on a daily basis each bank is meeting their reserve requirements.
So, that is a very technical weedy thing, but the manipulation of this thing called the federal funds rate trickles throughout the economy and influences interest rates or yields economywide. So, if the Fed manipulates this federal funds rate, let's say they raise it, it's very likely that across the economy in the treasury market that William was speaking about, in terms of mortgage interest rates, car loans, whatever it might be, you're going to see interest rates or yields on those things rise.
There's a couple of other ways that the Fed does this, but manipulating interest rates is one of the most powerful tools that the Federal Government has to shape what happens in the economy.
Peter McCormack: Okay. Have you heard Greg Foss talk about this?
Greg Mercer: I have not.
William Elman: I have.
Peter McCormack: I'm trying to remember exactly what he said, but he talks about Bitcoin being an insurance against bond yield rates.
Greg Mercer: Yeah, I mean I would guess -- the first place my head goes is that bitcoiners, the Bitcoin community, talks about Bitcoin as an inflation hedge. If the bond market perceives inflation, yields are going to go up, bond prices are going to go down, so there's less demand, there's less interest in those bonds, they're worth less essentially. Then Bitcoin could be seen as protection against that.
So, regardless of what happens with inflation, regardless of what happens with interest rates, the price of Bitcoin is independent of those fluctuations, and so I would guess that that's what he's referring to when he talks about Bitcoin is kind of a protection against that.
William Elman: Yeah, my understanding of what Greg was talking about is that, Greg Foss very much sees "money printing" as the knee-jerk response, the default response now of government to economic crises and we're going into this debt spiral that is somewhat inevitable and that Bitcoin is a hedge against that. Bond yields, how do they play into that? As you said earlier, Peter, bond yields are a reflection of what the market at large expects in terms of inflation down the road. So, if all of this money creation were to in fact lead to inflation or the expectation of it, that would manifest in bond yields and that's what happened in a very small fashion earlier this year.
Peter McCormack: Greg, the big question really is then, based on this information and your understanding of yields and inflation, what do you see happening right now; what are the big risks; and what do you see happening over the next decade? I feel like a crunch is coming, I don't know when, I don't know how, but I feel like it's unavoidable because the stimulus packages keep coming, they seem to be getting bigger, and I just feel, I mean I don't know what to expect, but I'm certainly fearful of what is coming.
Greg Mercer: Yeah, I guess I would preface my answer just by saying again that this is a totally unprecedented time. Never before have we turned an economy off and turned it back on again, and I think one of the results of that is that we are getting signals right now in the data that are really hard to interpret. It's incredible the extent to which the financial and the economics community is missing on some of these numbers. Two months ago the general consensus was that we were getting a million jobs; we got 250,000. The general consensus on CPI was that we were going to see a small bump; we got a much bigger bump.
So, I think that where we're at right now, we really do just have to have some intellectual humility and recognise that the models that we used to use to predict these things don't necessarily work right now and that it's just really hard to see through the noise and understand where we're going.
Peter McCormack: So basically, who fucking knows?!
Greg Mercer: Who knows; that's where I'm at! If I had to give a prediction, my best guess is that we are going to see inflation increase. I don't think there's any doubt about it, but I don't think we're going to see it increase to levels that are devastating to the economy.
Peter McCormack: It depends where you are in the world. I fear more for smaller states, small countries with less important sovereign currencies on the global stage. We've seen what's happened to Lebanon over the last year, I'm aware of higher inflation in Turkey, etc, people in Argentina are continually getting fucked. Some of the dollarised nations are slightly more protected, but obviously they don't see the benefits from the stimulus cheques.
I guess one of the most interesting case studies will be El Salvador over the next decade, because we know the bill passed yesterday, Bitcoin is legal tender; if you're an economic agent, you legally have to accept Bitcoin; you can convert it back to the dollar. What we're going to see is in injection of Bitcoin capital into that country in a number of ways.
People are going to want to buy it and hold it, maybe spend it; there's going to be companies in the Bitcoin sector who are going to want to invest in that country; the percentage of that fixed supply currency is going to increase in El Salvador over the next decade, whilst we may see different levels of inflation. The interesting thing will be to see is that, will the net wealth or the net purchasing power of the people of El Salvador increase over that period because there's more Bitcoin there? That's, to me, the most interesting country to look at right now, with this.
Greg Mercer: Yeah, absolutely, I mean I'm fascinated to see where that goes and in general, I'm glad that you brought up the non-US perspective and particularly that of smaller countries that don't have a dollar, a euro, a yen or renminbi driving their economy. Those countries are really struggling right now, for a ton of reasons.
The pandemic has had a massive impact on small economies; those economies were forced to spend, often in an unprecedented way to combat the worst effects of the pandemic, to put in place health response measures, to make sure small businesses didn't shut down. For those countries, spending, increasing their debt-to-GDP ratio, has an extremely profound impact on the rates at which they borrow in international capital markets. So, if you're a country that has spent a bunch in the pandemic and the market sees that your debt-to-GDP ratio has gone up, the market sees that as a risk and they're going to ask for a higher yield from you in order to lend you money.
What happens then is that you get into this situation where they have limited fiscal space, they don't have a lot of money to spend, but they also can't borrow because borrowing is becoming really expensive. So, it's a disaster situation for a lot of small economies. I think, Peter, you're right on that the inflation risks there are real, both in terms of domestic inflation; but also, if we do see runaway inflation in the United States and the Fed does have to tighten and raise rates, that has really strong impacts on some small economies.
If you're an investor and suddenly lending your money to the US yields a higher rate than it did six months ago, you're going to be much more attracted to that opportunity and you're going to need more from smaller countries in order to lend your money there, so it even becomes harder for them to borrow. It's a tough situation.
Peter McCormack: Yeah, there've been some really snarky comments with regards to El Salvador, some people pointing out, "This isn't so important; look at the size of the El Salvadoran economy; they're just a small country, it's irrelevant", but actually I think the complete opposite. When I see what's happened in El Salvador or today a politician in Tonga going laser eyes or someone in Paraguay, what I actually think is these people are realising that they can protect themselves, these countries can protect themselves: one, from the risk of whether they are a dollarised country and subject to the inflation levels of the US; or they've got their own currency which is at risk. I see them having the opportunity to increase the net wealth of the country with a fixed limit asset.
I actually think the reason we're seeing these smaller countries take this interest in Bitcoin is because they have the bigger use case, they have something which is harder for them to protect, they aren't the US Dollar, they don't have the tools that the Federal Reserve has; so I actually think it's a fantastic use case for these countries.
William Elman: Yeah, what's really interesting about Bitcoin is how adaptable it is, how flexible it is, in spite of aspiring to be the global currency or financial network. In many ways it's very localised, because it adapts itself to local needs. My neighbours, for example, are from El Salvador; for all I know, they might be sending remittance payments to family in El Salvador using Bitcoin because it's a hell of a lot easier and cheaper than wiring money over Western Union.
I'm using Bitcoin much differently from them, I'm using Bitcoin as a hedge against inflation, because I think it has vast asymmetric upside. And so Bitcoin I think has this really unique capacity to mould itself to individual needs.
Peter McCormack: Yeah, it's interesting you say that. I'm hedging inflation with Bitcoin, but only at the time where Bitcoin's going up in value and that can be on a short term. Anyone who has bought Bitcoin since $64,000, they haven't hedged inflation at that period because their Bitcoin purchasing power has gone down, but we know we should wait long term.
I actually think about it in a different way. Yesterday, I realised I am speculating on smaller nations hedging inflation with Bitcoin. That's what I am actually speculating on, rather than hedging against inflation in the UK which whilst growing, I would be very surprised to see inflation above 3%, 4%. I am speculating on those countries who may see double-digit inflation and see Bitcoin as an opportunity.
William Elman: We tend to, especially in the US, we really tend to suffer from short-termism, talking about inflation over the next six months, over the next year; and to me it's like I don't even care, it doesn't really matter. If you're buying Bitcoin as a hedge against inflation, your time span should be at least a decade, it should not be six months.
You asked Greg earlier, "What are the big dangers that we foresee in the global dollar driven system?" For me it's that the US has become, as you said, Peter, somewhat addicted to a combination of fiscal stimulus and quantitative easing where the central bank, the Fed, purchases government debt and just kind of winks and nods and says, "Let's just pretend it doesn't exist for now and we trust that you'll pay us back someday".
My fear is that that someday will never come, that the central bank is just effectively monetising US Government debt and any kind of promise that it will be paid back is illusory; and if that ever happens then we have some real problems. That is when Bitcoin becomes a real viable solution and a real viable hedge.
Peter McCormack: It's wild times, guys. It's so fascinating to watch it happen, the fact that we do have this opportunity now with Bitcoin, to opt out from all this fuckery which, I mean you guys say it's strange times; someone like myself who struggles to comprehend or understand what's happened in the economy, I just feel pretty safe I have this option with Bitcoin, which is pretty awesome.
Okay, is there anything we've not covered yet that you did want to cover as well in this interview?
William Elman: I do think it is important to chat a little bit about what I call the two types of quantitative easing. I think it would be helpful to listeners to explain what quantitative easing is and isn't, because I know that that term gets thrown around a lot and people might have an intuitive understanding, but not really understand what it means in practice. Would that be helpful, Peter?
Peter McCormack: Yeah, please do.
William Elman: I think it's really helpful to distinguish between the governmental response to the 2008 Great Financial Crisis and COVID, because there you see two different varieties or flavours of quantitative easing at play that have different consequences.
In 2008, what started as a housing crisis then devolved into a financial system crisis, a banking system crisis, because banks were overleveraged, they had all these crap assets on their balance sheet that they thought were better than they were. When that happens, banks just essentially freeze up, they stop lending because they lack sufficient reserves; everything's in chaos. When banks freeze up, so does the economy because of just the role that banks play. And so the purpose of quantitative easing in 2008 was essentially to just get banks back afloat and lending again.
What the government did was really two-fold, the first thing it actually bought a fair amount of those troubled assets that were on banks' balance sheets from them in exchange for cash, so that they could lend against that cash. The other thing that they did was they purchased treasury bonds from banks, so banks hold bonds just for the same reason that anyone else would, just to earn a little bit of interest on your idle cash. What the Federal Reserve did, it approached the banks and said, "Hey, we'll buy these bonds off of you, you'll get cash in return, and you can lend against that cash", because the banks were illiquid, they didn't have cash, they couldn't lend.
What all this did was it just freed up the banks to start lending again. It did create new money because the Federal Reserve just did create this cash, this cash that they provided to banks was just zeros that they created on a balance sheet. However, that cash that was injected into the banks really just stayed within the banks so that the banks could continue to maintain their pre-existing levels of lending. It didn't make its way into the real economy and that is one explanation for why the economic recovery in 2008 was as slow as it was. It was also because the package that congress approved of then, what was it called, the American Reinvestment Act I think, was $800 billion or so, which if you compare it to the COVID package, is small potatoes.
I think that's a helpful way for understanding why creating money out of thin air does not always lead to inflation, I mean we had a very low inflationary period from 2008 until the present day. Now, what's different about COVID, and I think this is where it gets really interesting, is that the Federal Reserve, rather than purchasing existing treasuries off of banks, they are purchasing newly created treasuries, or I should say newly issued treasuries that have just recently been issued by the Federal Government via fiscal stimulus packages.
So, when the US Government, Congress, approved of a $3 trillion COVID package in February or March, whenever it was, it had to finance that and so it issued $3 trillion of debt, which was bought up by banks; and then the Fed actually took it off of banks and created Federal Asset Reserves, which is we say creating money out of thin air.
Now, the difference there is what did what the Government do with the money? They used that money to inject it directly into the economy, by sending people cheques, by giving businesses loans, by sending funds to state and local governments for projects on the ground. So, in 2008, you had a bunch of money that basically just recapitalised banks; whereas this time around, you have a bunch of money created that at least is designed to go into the real economy. And so, that's why I think this time around there's a much stronger case that we will see inflation that we did not see ten years ago.
Peter McCormack: Okay, right, that's fair. But the reality is, everything you've both said to me today, the only answer I'm thinking is, "Okay, I'll just buy Bitcoin". Bitcoin fixes everything.
William Elman: Call me in 20 years.
Greg Mercer: Stocks aren't doing bad either, I guess right.
Peter McCormack: Yeah, they're not doing bad. All right, listen, guys, this was really useful. William, I particularly appreciate you taking the time and effort, I can tell you've done a lot of planning to try and help prepare and explain this in a really easy way for people to understand, so I know there's going to be a lot of appreciation for that, the audience will love this. You are writing; if people wanted to read some of your work where should they go?
William Elman: The writings are on Medium, and I can link that from my Twitter because I don't actually know my Medium handle off the top of my head, but you can find me on Twitter @soymemoelman and I'll make sure to link my Medium page on my profile there.
Peter McCormack: I'll put it all in the show notes. What about yourself Greg; are you interested in me sending a bunch of bitcoiners your way to harass you and shout at you?
Greg Mercer: I'd love it, Peter, I'll send you my Twitter handle as well and if you can throw it in there, that'd be great.
Peter McCormack: I'll make sure I do that. Listen, we've survived this with a really horrible delay. I know my engineer, Danny, is going to do a great job to fix the gaps, but I think we've gone back to a two-second delay with every time I ask a question and you two have adapted to that pretty well, so I appreciate that. I appreciate your patience, thanks for coming on. I hope we do this again in the future.
Greg Mercer: Excellent, thanks, Peter. Great coming on.
William Elman: Likewise, thank you, Peter.
