WBD640 Audio Transcription
The Global Financial Crisis 2? With Lyn Alden
Release date: Monday 3rd April
Note: the following is a transcription of my interview with Lyn Alden. 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.
Lyn Alden is a macroeconomist and investment strategist. In this interview, we discuss the recent run of bank failures: the causes, the impacts on the banking sector, federal support and exposure, and the likelihood of continued stress in the system. We also discuss a coming decade of recurring inflation and the emergence of reserve currency competition in a multi-polar world.
“The end game, that’s where it gets tricky, because there’s really no plan to ever stop the fiscal deficits. Debt to GDP is very, very high. And the world’s never been in this position before where we have an entirely Fiat-based system with debts this high. And especially because it’s not due to war. It’s due to accumulated promises over decades. So there’s no light switch, that can just change it next year.”
— Lyn Alden
Interview Transcription
Peter McCormack: Lyn, hi, how are you?
Lyn Alden: Pretty good. Long time, no talk.
Peter McCormack: Well, about a month.
Lyn Alden: Yeah.
Peter McCormack: That's a long time in our world. We've got Danny sat here next to me.
Danny Knowles: How are you doing, Lyn?
Lyn Alden: Good, how are you?
Danny Knowles: Very good, thank you.
Peter McCormack: We could talk to you nearly every day, the way everything goes so crazy. We could do a daily show with you, Lyn, with everything that's going on. It's a crazy world out there right now. I mean, you've got that little wry smile on your face. I think it's more of a, "What the F!" smile with everything that's going on. It's good for you though, it's great content.
Lyn Alden: Yeah, it's been a lot to write about. It's funny, because like I said before, I'm working on the book and I'd prefer actually markets to be chill for a couple of months so I don't have to spend as much time on them, and they keep pulling me back in. It's certainly been a pretty wild three weeks here.
Peter McCormack: Well, so we spoke about a month ago, we made a show which people should go and check out, but was covering essentially your article about how the Fed has gone broke. And then since then, it seems like most of the banks have gone broke, most of the commercial banks have gone broke. So, it's a good topic to get into with you. I spoke to Caitlin Long as well to cover the subject, but I really wanted your take on it as well. So, how have you taken in all of this craziness over the last month or so with the banks.
Lyn Alden: So a couple of different ways of looking at it. One is, if you go back to the prior discussion we had around the Fed going broke, essentially a similar thing happened to a lot of these banks. So, to quickly recap that discussion, Fed liabilities, their interest rates, increased very sharply while their asset side didn't. And so, the Fed's now operating at a loss, they have a financial loss ongoing, and they have about $1 trillion in unrealised losses in their Treasuries and their mortgage-backed securities. Of course, the difference is that nobody can do a run on the Federal Reserve. But if an individual bank has a situation, they can get a run.
It's funny, most banks are not as in bad shape, relatively speaking, as the Federal Reserve, because their liability interest rates go up more slowly than the Federal Reserve's, and their assets are a bigger mix of types of things and they have more capital relative to assets than the Federal Reserve. But of course what differentiates them is that they're vulnerable to a bank run. So, what we've seen is that, if you go back to the 2008 Crisis, that was because a lot of banks made bad loans. They made subprime mortgage loans to people that can't really afford the house that they're signing up for, and so a lot of them defaulted.
In this environment, it's the opposite. You're not seeing defaults, at least not yet; there are certain troublesome pockets on the horizon, but it's not really that type of credit event. Instead, they ironically bought super-safe assets that either have no chance of defaulting, or are very, very low. But the problem was, they bought them when they were yielding 1.5% or lower in some cases, and now they're yielding way higher. And when a long-duration bond or security increases in interest rate, it means that if you were to sell it into the market, if you were to sell one of the old ones in the market, it would trade for the same interest rate as the newly-issued ones do, which means that it has to be sold at a discount, so that the effective interest rate until it matures is the same as that new interest rate. So basically, the price goes down as interest rates go up.
So, what a lot of these banks have is that they're holding safe assets that are basically guaranteed to pay back, but they're temporarily underwater. And they're able to hold those until maturity and get all their money back, unless there's a bank run that makes them sell at an inopportune time. And so that's what we saw with Silicon Valley Bank. They were on the far end of the bell curve of both sides of that risk. So one, they were all-in these long-duration assets, whereas most banks are a little bit more diversified with the type of lending they do and the type of securities they own. They instead were, for whatever reason, all-in on those longer-duration Treasuries and mortgages. And then number two, the vast majority of their deposits were uninsured because they mostly catered to businesses. So, uninsured deposits are more likely to run in the event of a problem than insured depositors.
The combination of a more flighty deposit base and having bigger, unrealised losses on their balance sheet relative to their capital with other banks, put them on the far end of the bell curve for banks that were vulnerable here.
Peter McCormack: But if they'd have just held their deposits with the Fed, these banks would have essentially been fine. This was a liquidity issue, right?
Lyn Alden: Yes, I mean if they're allowed to. For example, I think we talked about last time the narrow bank, or Caitlin's bank, they want to hold all demand deposits at the Fed, and those types of banks have not been allowed to exist. If a bank had held shorter-duration assets, like T-Bills, maybe two- to five-year Treasuries, things like that, they would have less exposure, and that's why JP Morgan, for example, they've been a lot more careful with their duration. They've been focusing on more short-duration assets, so they have less of a problem.
But yeah, basically the more that a bank has done long-duration types of assets, the more vulnerable they are to this type of situation. So, you don't really see an issue among a lot of the major banks, and instead it's small banks and some of these medium and more niche banks.
Peter McCormack: But so if one of the banks just decided to start depositing all of their funds with the Fed, and this is a bank that's already charted, would the Fed reject their money?
Lyn Alden: Well, I think it depends on the percentages. If a bank suddenly started selling its loans and security books, I think it would raise a lot of red flags and questions about what they're doing. But banks in aggregate can't do that. So, an individual bank can, but the Fed controls how much total reserves are in the system. So basically, if a bank is selling its securities and loans and it's holding that in cash, it means those securities and loans are likely winding up on another bank's balance sheet anyway. And so, the ratio of total securities and loans in the whole banking system would still be much, much higher than the amount of reserves in the system.
But even the current ratio's way better than it was in 2008. I mean, back in 2008 for example, there was $23 of deposits for every $1 in cash reserves. So, they were highly, highly levered, very little actual liquid reserves; whereas currently, it's below $6. So, it's not historically high. I mean, I still think in a fractional-banking world, $6 is high, but historically speaking it's not an unusual ratio at all, if anything it's on a lower side of my lifetime. But it's a faster world and it's a world where they have more unrealised losses on otherwise safe assets than they've ever had in modern history, because the Fed's never gone from zero interest rates to 5% interest rates in such a short period of time so quickly.
Peter McCormack: Well, that faster world's an interesting point. That was what Caitlin was referring to with me. We live in a world now of APIs and instant access, and that's why, was it $42 billion was withdrawn from Silicon Valley in a day, was it?
Lyn Alden: I believe that was the headline number, yeah. And to Caitlin's point, they had things like software APIs, so you could pull your money out without even going to the bank website, let alone going to the bank in person. A lot of these regulations are built on like grandma going to the bank and pulling out her nickels, but it's not, it's all software APIs. And, as Caitlin's pointed out, it's going to get faster with the Fed now later this year.
And it's funny because right now, as we speak, there's a very large brokerage in the United States called Charles Schwab, and they're technically insolvent. So, their assets are lower than their liabilities, because they did the same thing as Silicon Valley Bank did. They bought a lot of long-duration safe assets that are now very much underwater and the losses exceed their capital. But if you look at Charles Schwab stock, it's down but it's not cratered, it's still trading at an above-average price-to-earnings ratio and no one seems to be concerned. And it's in a large part because they don't have the other risk that Silicon Valley Bank did. Less than 20% of their depositors are uninsured, so they're a much lower flight risk; and it's a more diversified deposit base nationwide, and it's in the almost too-big-to-fail category.
But it shows the extent of this problem. You have JP Morgan that's basically unaffected by this. If anything, they're benefiting from this. Some banks, like say Bank of America or Citi, they have some losses on their balance sheet, but they don't exceed capital, and they're not at any sort of deposit flight risk, quite the contrary. Then you have a couple of other banks in the top ten that sometimes they have unrealised losses, but again they're not exceeding capital and they're not at risk of deposit flight, a very low risk of deposit flight. So, mostly this is affecting very certain types of banks but unfortunately, that includes a long tail of smaller and less liquid banks.
Peter McCormack: This Charles Schwab situation, is there any part of that the confidence that even if Charles Schwab were in particular trouble, that Janet Yellen would jump in and quickly backstop all the depositors?
Lyn Alden: Yeah, I think it is. That goes back to my point that it's viewed as systemic and so one is most depositors are under the FDIC limit, because they're not really business deposits; and two, the probability that Charles Schwab would be allowed to fail and investors lose their securities or their cash is considered very low, so there's not really any sort of panic in the air, even though one of the biggest brokerages in the country is technically underwater.
Peter McCormack: Oh my God! Okay, so let's go back a sec. I asked you about whether people, say Silicon Valley, had their full deposits with the Fed, but you said they wouldn't allow them. What are they allowed to do, or what are they specifically expected to do? We know, for example, pension funds have certain mandates to own certain things like Treasuries or maybe securities and there's certain things they can't hold. Is there specific guidance on what banks are meant to do with deposits?
Lyn Alden: Well, kind of. I mean, they have various regulations. The funny thing is it's usually the opposite. It's usually not about regulations preventing them from being too safe, it's usually regulations preventing them from being too risky. But it's funny, there's a difference between what a bank signs up to do and what it does after it exists. So, we've seen a general trend where if a bank goes to the Fed and says, "Here's our plan, we want to hold all demand deposits at the Fed, we want to be a full-reserve bank", the Fed says no. So, the narrow bank was told no, Custodia was told no, that's something they don't want. They've ironically turned down full-reserve banks.
Now, if a bank, after it exists and it's a normal bank, it then decides that it's going to be less risky, it's going to sell securities, it's going to sell loans and create a lot of reserves, move a lot of reserves into the Fed, it would probably be allowed to do that, but it would start raising questions. It's almost like it's not being a bank any more. In the modern era, banks are meant for duration transformation. They take in short-duration deposits and then they lend them out longer, so there's not really any examples of banks that don't do that.
The closest example would be some of the big custodian banks, like State Street or Bank of New York Mellon. They don't really do lending the same way that these other banks do. But yeah, most banks are based around lending.
Peter McCormack: It's kind of insane though, you can't have full-custody banks, full-reserve banks. I said to Caitlin, it was one of the things that came up, we have an insurance similar here in the UK and it's about £80,000 I think we're covered for. I don't have to worry about that; my personal account never has £80,000 in it. But a business account, we've got seven, well it's eight people now work on our show and our cash flow requires us to have way above that in our accounts. I'd much rather just pay a percentage fee each year and know that it's a full-reserve bank. That is a service I want to buy, that is a service people like Caitlin want to provide. It protects us, it makes the system more stable, yet I mean I don't know what the rules in the UK are but if we were a US-based company, we would not be allowed to purchase that service.
Lyn Alden: Exactly, yeah.
Peter McCormack: Insane!
Lyn Alden: And it's not an official rule. The Fed doesn't say outright, "You can't be a full-reserve bank". It just so happens that any bank that wants to be full reserve, they delay their application for years, they eventually say no, they give some other reason, and just almost "accidentally", no full-reserve bank ends up existing.
Whether or not you'd have to pay fees would depend on the prevailing interest rate environment. So right now, for example, the Fed pays almost 5% on bank reserves. So, a bank could easily just say, "Okay, we're going to hold our cash at the Fed, we're going to collect our 5% and we're actually going to give you 2% interest and we're going to use the other nearly 3% for overhead". Now obviously, if you go back five years when interest rates were zero, or go back during the post-COVID environment when interest rates were zero, then they would have to charge a small fee. So, they could structure it and say basically, "We'll give you whatever interest the Fed does minus X%", and sometimes that will be you paying the bank, and other times that will be the bank paying you, depending on what's going on with interest rates.
Peter McCormack: What was the Fed paying on deposits back when people like Silicon Valley Bank were buying these long-duration Treasuries?
Lyn Alden: Zero.
Peter McCormack: Okay.
Lyn Alden: Basically, it's roughly in line, the number is very similar to Fed funds rate. So, when you hear what the Fed interest rate is, their interest on reserves is currently quite similar to that.
Peter McCormack: Right. So, it wasn't necessarily they were being greedy, but they were trying to earn some kind of yield on the deposits, which kind of made sense. I guess the risk was that they put so much money into long-duration-yielding Treasuries.
Lyn Alden: Yeah. And again, they're not the only bank that did that. So, they chose two things. One is the chose to be super-long duration, which is risky; and two, they choose to have a very concentrated, business-oriented deposit base, which is riskier than not having that. And, they're not the only bank that does that. Like Citigroup, Citi is one of the biggest banks, it's one of the big four banks in the country, and they also have a very large percentage of business deposits, higher than average percentage of uninsured deposits, not quite as high as Silicon Valley Bank. But of course, their deposit base is far more diversified and as a globally, systemically important bank, they have higher capital requirements and deposits are going towards Citi, rather than the other way round.
What Silicon Valley Bank did, neither side was extremely stupid, but they're both edge cases. And then combining them together was extremely stupid.
Danny Knowles: So, with Silicon Valley Bank, obviously their depositors were largely Silicon Valley firms, like people that thrived in the zero interest rate policy world. But they knew that better than anyone. So, why did this catch them off-guard; why weren't they prepared for this? Were they basically betting that the Fed would pivot sooner?
Lyn Alden: I think they were. Also, bank runs are just hard to predict. Basically, if there was no bank run, their assets would have matured over time and they would have gotten all their money back. So, when they did analysis of, "What's the chance we're going to have a $42 billion bank run in a day?" they said, "That's probably like a six sigma event, we can't plan for that". Almost any bank in the world, if they have a multibillion-dollar outflow quickly, they're going to face problems.
I think that they were greedy with duration and I believe they had a policy where if you take out a loan, they're expecting you to hold your cash in the bank. So, they were kind of encouraging business to have large, uninsured deposits. They were making that choice, which was a very, very risky choice, because they created a flywheel which is really good on the upside, because if they make a loan to a business and they tell that business, "While you're holding that loan, before you spend it all, hold it in our bank", and then they used that to make more loans or buy more securities. So, their deposit base increased much more quickly than the average bank did. But it also means they can come down much more quickly than the average bank did.
So, there's multiple fronts where they managed risk very poorly; but there's a couple of other banks, like First Republic, that they have some risks, but they didn't really make the same types of errors, but they're still in trouble. It kind of shows how a bank run can cause a lot of problems for banks, regardless if they did anything outlyingly stupid, even though this one, Silicon Valley Bank, did.
Peter McCormack: Just going back to narrow bank, did narrow bank ever get their banking licence?
Lyn Alden: There's a difference between a banking licence and access to the Fed. They don't have access to the Fed; it's been years, like five years now, six years, they don't have access to the Fed.
Peter McCormack: Are they fighting this?
Lyn Alden: They did, I'm not sure of what the current status is. I think probably Caitlin tracks those types of things. I know Caitlin's fighting it.
Danny Knowles: Do events like this make it easier or harder for them?
Lyn Alden: You mean harder for them to get approved?
Danny Knowles: Yeah, does it make their battle with the Fed even more tricky, because it would basically incentivise people to not hold money in the traditional banks?
Lyn Alden: Well, I guess that's a social question. There's certainly more awareness now among the risks of fractional-reserve banks, there's more interest, especially among businesses, of saying, "Can I just put my money somewhere", and the Fed's getting memed on Twitter. So on one hand, if you have more and more people saying, "We want this kind of bank to exist", that is good in their favour. But whether or not that actually translates into it happening I think is another matter.
Peter McCormack: We are seeing some quite spiky questions in these Senate testimony hearings. I saw Janet Yellen being pushed pretty hard with regards to the banks, so I think some of the people in Congress are starting to realise this situation's a bit screwed. But what I was wondering also is, is the main reason that the Fed doesn't want these banks to exist is that they need the banks to be operating the way they have been operating to continue the, I think Greg Foss would probably call the Treasuries a bit of a Ponzi now; is it to keep this going?
Lyn Alden: I mean, that's my view, because if they don't allow a full-reserve bank to exist, it means that if you want to have banking services, which almost every individual in business does, they have to choose between fractional-reserve banks. There's no choice to not have a fractional-reserve bank. Whereas if you have a choice, it says, "Okay, we're going to give you basic payments and saving services, we're not going to lend the money out, we're going to be a full-reserve bank", a lot of deposits would want to flow towards that, that are not currently. There's other things they can do. I don't think it would instantly pull all money out.
Right now, for example, businesses are still underutilising money market funds. There's things like sweeps, for example, where a certain number of times per month, you can put your excess bank funds into a money market account, which is basically safer, so you might have a limit of how many times you can do that, but not all of them do that. So, there are tools that businesses have without going to say a full-reserve bank to sharply reduce their risk of major funds loss. But all of them are kind of a hassle.
There's now fintech services that let you split your account up into multiple banks and they handle the overhead for you. But actually, in some ways, it's a good thing that people are experiencing more of the frictions with banks and fiat currency, because they've always been there, it's just they're usually abstracted away and you don't have to think about it. Whereas, the actual risk is more clear in this environment. And again, I'm not taking that view that the banking system's going to fail and everything's going to change in 90 days, or whatever the case may be. Most, especially the big banks, they're very solid. It's the small banks that I think are facing problems, and then it's banks that cater specifically to businesses or specific niches that run into problems.
Peter McCormack: Is this by design, and therefore is this going to centralise banking? Because, every time we see one of these banking failures, we see one of the large banks scoops them up. I think HSBC in the UK bought Silicon Valley's Bank in the UK for like £1 or something? These other large banks are always happy to pick up these smaller banks, but are we essentially centralising the banking system?
Lyn Alden: We are, yes, it's a deposit flight from small banks to big banks. We had a multi-decade trend of a smaller and smaller number of banks in the United States. There were like say 13,000 banks 50 years ago and now it's like 4,000 banks, so it's down to a third of what it was before, and I think that's going to continue, and this particular event might accelerate to some extent, because a number of small banks might get acquired, might merge together into larger banks.
Now, I guess the counterpoint to that is the United States is actually somewhat of an outlier just to how many small banks we have. Canada, for example, their banking system's already way more consolidated into the top four to six banks. Most other -- UK, your banking system's more consolidated than ours is. So if anything, the United States is trending more towards the way that most systems already are, but that's kind of a reality of the current system, that it centralises over time, and most countries are dominated by a handful of very, very large banks.
Peter McCormack: Why is the US different? Is it because you've essentially got 50 States and the States themselves have lots of separate banks; is it because of that?
Lyn Alden: I think so. So, a banking historian would probably be able to go into more detail. I mean, we had at one point up to 26,000 banks, or some number like that, over say 100 years ago. If you go back to the history of pre-Fed banking, it was state banking. We have this long history of these small banks. We also have a separation, we have credit unions, life thrifts, where they're smaller, simplified, community banks; there's a long tradition of that that goes back a century or more. So, I don't know if it's an accident of our history, our federation, or if it's certain laws we've constructed that someone like Caitlin Long or George Selgin, or someone, could probably go into more detail. But yeah, we have just a much larger number of banks per capita than many of our peers.
Peter McCormack: I don't know if you saw recently the Hindenburg Research piece, well it was on Block, but formerly Square, and they're a notorious short seller. Some of this makes me wonder, if people have the inside information that a bank was holding a particularly large amount of long-duration Treasuries and knew that they would have a liquidity crunch, that they could be incentivised to create some kind of social media contagion of the risk of a bank and be a short seller of that bank?
Lyn Alden: They could be, yes, and that's a vulnerable scenario. For example, if big enough entities pressure Schwab, I mean basically Schwab is only functioning right now because deposits don't want to go out. And I'm not trying to cause that, I have some accounts at Schwab, so I'd prefer them not to have an issue. But the point is, the system's inherently fragile, and this is actually discussions I've had online which is, adequate liquidity for banks 100 years ago is obviously very different than today. But even going back 20 years ago, before ubiquitous social media, it's a different environment now, because people can panic and coordinate and do whatever they want. And bad actors can say, "I'm going to short a bank and do this".
It depends. I mean, there are laws on preventing certain types of things, but short sellers do have a long history of doing that. And of course, there's different types of shorts. There's ones that are exposing actual fraud, bringing awareness to it. I think some shorts play an important role in the market. But then, there's other ones that are more amoral, they just want to make a quick buck, so they're willing to short something, drum up a lot of negative hype for it and then get out of their position, whether or not they actually think that the underlying firm is a bad actor or not.
Peter McCormack: You mentioned earlier, you talked about during 2008, there was $1 held in reserves for every $23 dollars, and now the ratio's down 6:1. Why has that rate changed so much and is the trajectory still heading into even lower reserve ratios?
Lyn Alden: So, the answer's money printing, QE. Basically, during the 2008 Crisis, when the Fed did their first round of quantitative easing, followed by some later rounds, they created a lot of new bank reserves and they bought a lot of bank assets, and then they basically gave them a lot more cash in exchange for taking some of their assets. And then they changed regulations to have them hold higher levels of liquid assets.
To answer your second question, it's not trending down any more. Basically, there was a gigantic -- when all that money printing happened over a decade ago, there was a massive down move in that ratio, and now it's kind of trending sideways, which makes sense, because if anything, that's below average of the last 50 years. It's kind of back down to the lower end of its historical range, which it's really hard to get much lower than that. So, yeah, it's something like 5.5 now; it's between that 5 and 6 band. I think it reached as low as going below 5 at one point, but now it's kind of in this trend-wise band.
But of course the problem is not that the banks are historically under -- that they have less liquidity than normal, it's that in the age of social media and now that a lot of them have these unrealised losses, any one of them is very, very vulnerable. And you can argue, as Caitlin has, that even if you're not going to do full-reserve banking, even in a fractional-reserve banking environment, you need more liquidity if everything was faster, both technologically and socially.
Peter McCormack: When this was first announced that the Fed were essentially going to backstop all deposits, I mean rumoured, and the numbers they talked were up to, I think was it $4.4 trillion, I think it was, or some crazy numbers, Lyn, there were some debates over whether this was QE or not. I think it might have been you or somebody else said, "Half of TradeFi Twitter said this was QE and half said it isn't QE". Is it; or is it money printing?
Lyn Alden: So, it's pro-liquidity, but it's not QE. The Fed is not backstopping all deposits. What they're doing is, they provided a liquidity facility that if a bank, let's say Silicon Valley Bank, if there's one like it where they have a lot of securities that are safe, but that are currently underwater, and they don't have to sell them unless there's a bank run, in which case in order to honour deposits, they have to sell them at a loss and therefore become insolvent or heavily impaired, instead this facility lets them deposit them with the Fed as collateral for a loan which they can then use to deal with any sort of liquidity runs they might have, and they basically can get full face value when they make those deposits.
They still pay a higher interest rate on that loan facility than they would from deposits, so there's not really incentive for a bank to use it unless they have to. It also does not work for loans. So for example, First Republic Bank was in trouble because unlike Silicon Valley Bank, most of their assets are loans, which are unique, whereas a security is more standardised and more liquid. So, they needed other types of liquidity arrangements.
So, if you go back to the September 2019 repo spike, the Federal Reserve had to step in with repo lending, and then they had to transfer to doing some QE. And I think we're kind of in a similar environment now, where they're still doing QT, they're not outright buying Treasuries or mortgage-backed securities, that would be QE; but they're lending and they're taking some of those on their balance sheet on a more temporary basis, which as long as they keep recycling those loans, as long as those loans exist, you've had a similar effect to QE on the market in the sense that you've pushed more liquidity back into the banking system.
Peter McCormack: And raising, hiking interest rates again. So, are they basically pulling all of their levers at the same time, every one of them, "Let's just pull everything on?"
Lyn Alden: They are, yeah, they're pulling some tightening levers. Basically, they're still being tight in some areas, while they're trying to be loose in a couple of other areas, and that's actually kind of a 1940s playbook, which is to try to reduce private sector lending and private sector liquidity, while still providing liquidity for sovereign bond markets and against systemic cascades and issues.
Peter McCormack: How did that work out in the 1940s?
Lyn Alden: Well, I mean they were successful in the 1940s, because they went full command-and-control economy, there was a lot of political unity and they won the war. It didn't go well for most countries involved in the war, including a lot of countries on the winning side that were not the United States. A lot of them had a bare victory, where you were won but you were devastated and your currency was rekt. Even in the United States, we had big inflation from it.
Danny Knowles: One of the things that I'm struggling to understand is, if you're one of the smaller banks who's struggling with liquidity and needs to park their bonds at the Fed for up to a year, right, it's a year limit? Even if you get paid out at par today, after a year you have to presumably buy that bond back, I don't know how that actually works, but what if that would still break the bank at that point?
Lyn Alden: So, at that point, that bank would be in trouble. I mean, if they spent a full year and they're still unable to unwind that loan, they're probably in a position where they're going to be acquired by another bank, or otherwise have an issue, because that lending facility comes with pretty high interest rates. And so a bank can't survive with funding rates that high indefinitely, it would just become unprofitable. It would look like the Fed. So, the Fed is operating a loss.
If a bank had a similar liability interest rate mismatch, they would also be operating at a loss. And so, probably you would see that bank get absorbed into other banks, or otherwise have something like that. And if they default on the loan, if they say, "We can't pay back the loan", then the Fed acquires those Treasuries and securities and that would essentially constitute QE; they've now permanently added some assets to their balance sheet that they didn't necessarily intend to.
Danny Knowles: Right. So, really it incentivises the bank to only use this facility in the short term. They probably won't even use it for a year, it's going to be much shorter term than that?
Lyn Alden: Yeah, every bank is incentivised to use it as little as possible. How much it's used will in part be the Fed's decision, because if they keep doing quantitative tightening, they increase the odds that the banks are going to have to use it; whereas if they stop doing quantitative tightening, banks might be able to use it less. It also depends on just idiosyncratic things like social media. Initial signs show that this is no longer a problem, but for example if one day, we wake up and people are freaking about Charles Schwab, then maybe they have to use it temporarily, maybe another bank has to use it temporarily.
So, any bank is vulnerable to potentially having to use it should there be some sort of issue. But I think the overall trend is now kind of sideways.
Danny Knowles: And this might be stupid, but if you're a smaller bank with some ten-year Treasuries on your books that are way underwater, presumably is that interest rate high so you're not incentivised to park it with them and try and do something with the money over a year and then buy your bonds back; as in almost arbitrage trade it?
Lyn Alden: Yeah, you're not really incentivised to do that, because interest is higher than you're earning on it. The only catch is that you could purposely give your assets to the Fed and then purposely default on it, because it's at face value. So, if a Treasury's trading down to 80 cents on the dollar because interest rates went up, they can give it to the Fed and then default on it, and then use that capital to do something else. But one, that safeguards against that, because you can only put securities in the facility that are older than the facility, so you can't just keep recycling new securities into it to do it; and two, if a bank were to purposely game it like that, they'd get a call from the Fed right away and be like, "What are you doing?"
Peter McCormack: So, you talked about in the 1940s when they were able to control this, but it led to high inflation. If these new facilities lead to inflation continuing to be high and the Fed continue to hike rates, is this going to compound the problem?
Lyn Alden: It can. Some of it's a rate of change, right. So, the more that they hike rates, the more that they are likely to suck money out of banks, especially smaller banks, and towards larger banks and towards money markets.
Peter McCormack: But you say this is providing liquidity. Is the idea of providing liquidity just the idea of continuing this charade that everything's okay in the economy? It just feels like, I remember a long time ago, I did an interview with Giacomo Zucco, and he talked about the problem with the fiat system, it's like a drug. And whenever you're addicted to drugs, you always have to take more and more until you eventually have your crash and you give up, and then you go through the pain of stopping. But if you don't, you have to have more and more. Is this not essentially what we're doing; we're continuing to kick the can down the road of all these problems within the financial system?
Lyn Alden: Yeah, and I think that's the endgame with this type of system, that basically when all the debt's at the sovereign level, you're very, very high debt-to-GDP, it needs ongoing liquidity in order to support that market. We saw, for example, last year with the gilt market, they wanted to do QT, they wanted to reduce their balance sheet, they even had a meeting scheduled to talk about reducing their balance sheet, and then they actually instead had to start buying gilts, because you would have had a cascade. Basically, as they were all discounted, you would have had pensions selling it, and the problem is they're selling it into a market with no buyers, and it would just cascade into a collapse. So, they had to come in as a buyer of last resort and reliquefy that.
In a similar vein, if the Fed just decided, "No, we're going to do nothing", you would get Silicon Valley Bank just spewing these securities into the market, you would have other banks come in and basically the yields would rise, and other banks would have to sell theirs and you get this feedback loop of more and more securities being sold into the market until the Treasury market breaks. You'd have a similar thing that happened to gilts, you'd have that happen to US, and so they're kind of in a position where on the one hand they're helping out individual banks; but at the end of the day, what they're helping out is the sovereign bond market.
Peter McCormack: Right, so this is the reason why we might potentially yo-yo towards hyperinflation, because every round of these issues, they have to print more and more money, or provide more and more facilities, some sticking plaster here, a bit of rope there, to try and keep the system and the charade going?
Lyn Alden: So, I'm hesitant to use the word "hyperinflation" especially in any near term. Historically, every fiat currency ends with the end of that currency, so over a long enough timeline, sure. But in the near term, hyperinflation happens generally with a couple of key things. One is, you usually have liabilities denominated in a currency that you can't print. So in Weimar, it was gold-based war reparations; for emerging markets, it's often dollar debts. And basically, there ends up being no foreign demand for your currency and you basically hyperinflate. So, you basically need an infinite amount of money printing, a tremendous amount of money printing in order to hyperinflate, plus no demand for that currency.
Peter McCormack: Okay.
Lyn Alden: The United States is not really in a position where that's likely any time soon. There's still foreign demand for the currency, there's a lot of debt denominated in the currency globally, and all of that represents demand for it. But instead, it's about just generally longer-term waves of recurring inflation. And then the endgame, that's where it gets tricky, because there's really no plan to ever stop the fiscal deficits. Debt-to-GDP's very, very high and the world's never been in this position before where we have an entire fiat-based system with debts this high, and especially because it's not due to a war, it's due to accumulated promises over decades, so there's no light switch that can just change it next year.
So, I do think we're spiralling towards a fiscal spiral; I just don't think it's hyperinflation in the intermediate term, I wouldn't call it that.
Peter McCormack: Have you gamed out the potential endgames?
Lyn Alden: Well, I mean I own Bitcoin!
Peter McCormack: That's the lifeline. What's the endgame if you don't have Bitcoin?
Lyn Alden: Potentially gold, real assets. If you own real assets, if you owe fixed-rate debt, if you have a house with a 30-year mortgage, if you own high-quality equities, if you own gold, if you own commodity exposures, if you own Bitcoin. That's generally the types of answers. And you can of course reduce the volatility by also owning things like T-Bills, you don't have to be 100% in those inflation hedges, those real assets.
But it's basically a situation where in the 1940s, for example, they had to let inflation run hot -- basically, one way to think about it is that when sovereign debt-to-GDP is over 100%, it's exceedingly unlikely that that's going to be paid back in purchasing power terms. And then the question becomes, how was it defaulted on? So, if it's an emerging market that that debt is in a currency they can't print, they're more likely to just nominally default and restructure and get another recycled loan from the IMF and just continue that.
Whereas, if you're a country who can print your own currency, you're very, very unlikely to nominally default. And instead, you're likely to let inflation run higher than those bond yields for a long period of time, or in multiple ways of it. Bondholders will get every dollar back or every pound back, but those will be worth less than when they put them in. The problem that makes this environment challenging is that this debt is not due to a war, it's due to permanent military spending and due to the way we structure entitlements, and those are not things that change quickly, so I think we could get into a very long period of just recurring inflation, like how in a lot of emerging markets you have just long periods of recurring inflation, and in many cases it doesn't lead to hyperinflation, at least not in any five-plus-year period, but leads to a sustained problem that just keeps recurring.
Peter McCormack: Well, you've told me and Danny that you think the story of the next decade is inflation, many times.
Lyn Alden: Yeah, I think it's recurring and I think right now, we're in a disinflationary trend. Basically, whenever policymakers are willing to cause a recession, they can get inflation down temporarily. But I think that the story of this decade is that whenever they want to have a period of growth, it's probably going to basically coincide with a period of inflation.
Peter McCormack: What do you make of what's happening with the BRICS nations? I read recently that Saudi Arabia is trying to join the BRICS group. Do you believe this is to try to build an alternative to the dollar for political reasons; or, do you think this is a way to hedge themselves against dollar risk; or both?
Lyn Alden: I mean, I think it's a bit of both. So basically, ever since the Global Financial Crisis, you've seen for decades, for example, countries were increasing their gold reserve tonnage and increasing their dollar exposure in their central bank reserves. Starting in 2009, that trend reversed, where countries began reaccumulating gold. So, they went from under 30,000 tons to something like 36,000 tons. It's like a V-shape change. They were going down, and they started going up for 15 years now, 14 years.
They've also, around the margins, you've seen the Chinese currency go from no exposure in reserves to a little bit of exposure in reserves. So, it's grown quickly from a very, very tiny base. You've also seen the euro lose general holding while the US dollar's been relatively stable. I think there's two sides to these headlines and both extremes tend to, in my opinion, be wrong. So, there's a lot of headlines around threatening dollar reserve status; there's a lot of headlines around these alternative things, and there's been a long history of this. There's been decades of countries trying to make currency alliances, things like that.
So, a lot of people have jumped on the hype train, and I think that's in some ways overstated. On the other hand, I think it's a mistake for people that just dismiss this and say, "It's been happening for decades, it's never going to happen, don't worry about it", because obviously things have changed. This isn't 2004, this isn't 2012. Back then, China was way smaller than the United States. Now, in many measures, it's larger than the United States, so the biggest trading partner with the majority of countries now. We froze Russia's reserves, so we've pushed Russia and China closer together. Saudi Arabia's relationship with the United States has cooled while their relationship east has improved.
So, we've seen a number of headlines which is basically, Saudi's cosying up to China a little bit, Brazil and China just made some deals to exchange their currency more directly, we have China having a better prospect of being able to buy commodities and energy in its own currency. So, I think the general trend shift is that we're going towards a more multipolar world, which makes sense, because there was this 30-year period from the early 1990s, the fall of the Soviet Union until a handful of years ago, where we were in a very unipolar world. There was the United States and everything else built around it.
Now, which is the more natural state of affairs, you have a handful of different regional powers. So, China's economy is comparable to the United States now; it's higher in some ways, it's lower in other ways. You also have the Eurozone is a big block, you have a couple of other regional powers, like India, Brazil, Russia obviously. You have these regional powers and that's the world we currently live in. So, unless something devastating happens to China or some of these countries, I think the trend is towards a more multipolar world for both payment systems, so the countries are protected against getting cut off from the dollar, as well as reserve diversification so that they don't have 100% of their reserves or 60% of their reserves fully exposed to the dollar, and either an inflation risk or seizure risk.
Peter McCormack: The multipolar world, do you think we're at a stage where we're considering that Bitcoin is a relevant part of that, it's more of a decentralised, permissionless alternative, but it is an alternative to individual nation states?
Lyn Alden: I think it's on the horizon, but it's still early because Bitcoin's not big and liquid enough for that scale yet. I mean right now, we're still at the stage where large individuals can move the price, let alone countries moving the price. And so, I think it's one of those things where Bitcoin needs another zero on its liquidity and its market cap in order to be relevant at that scale. Right now, it's really about gold, dollars and yuan, and just these alternate payment systems and less so about Bitcoin. But obviously, the potential for Bitcoin is huge, and certainly you must have countries looking at it. Russia's mentioned it; a number of countries have clearly looked at it.
Peter McCormack: Are you following the Choke Point drama related to all of this, the various banks cutting people off, we've had some in the UK, we've seen some in the US, some people raising suspicions that what happened with some of the banks is part of the Choke Point; how real do you think that is?
Lyn Alden: I think there's a lot of truth to it. I think the people that are covering it are asking the right questions, so for example with say one of banks, like Signature for example, when that bank was closed and now their crypto network is up for sale now. And the FDIC is supposed to get maximum recovery for deposit holders and for taxpayers now, and they're not willing to sell that, it seems. I think there are interesting questions that should be asked to hold them to account.
Unfortunately, this goes back to the 1940s. So, if you look at the 1970s, if you have very high inflation because of excessive bank lending, the central bank can tighten a lot and slow that down, because debts are very low. You can just say everything's tighter now, super-high interest rates, and that will curtail lending. The problem is if you have a 1940s environment where the sovereign itself is very, very highly indebted, there's tons of debt in the system, they have trouble raising interest rates super-high because in addition to causing obviously all these bank problems, it also compounds into causing more and more fiscal deficits that have to be monetised.
What they generally do in that environment is they're less likely to raise interest rates super-high, the way Volcker did, and instead they keep interest rates low or moderate while then also doing capital controls or lending controls to prevent lenders from taking advantage of those negative real rates. You see that for example in Turkey today. They say, "If you're a corporation, you can't borrow lira and buy foreign currency with it", because otherwise why wouldn't you? Their interest rates are not high enough to compensate for lira inflation. There's a good incentive to borrow lira and buy almost anything else, and so they try to restrict that type of speculative attack on their currency. You've also seen Nigeria, for example, they've cut off their banking system to crypto exchanges.
So, I think around the margin, that is one of the defences that these countries turn to. And I think in developed markets, we are seeing early signs of that, basically that they're clamping down around the margins where they can and where they think they have cover to do so.
Peter McCormack: And, a lot of people would point the finger at them and say, "Well, this is all about control", and it feels like sometimes it's actually more about protecting the system. And I know they're kind of the same thing, but it is a slight difference, it's not so much like, "We don't like Bitcoin, it's baddies just using it, we want to be able to control you"; it's that actually, if there is a flight to safety into Bitcoin, it could destroy the whole system. And in terms of trying to protect stability of their system, that might be a reason to choke out Bitcoin.
Lyn Alden: I think from their perspective, yes. I mean, basically if a country mismanages its ledger or has to do things that are not popular, that's where they turn to controls. And so in the United States, for example, during World War II, or during the 1930s, even before World War II and continuing until the 1970s, it was illegal for Americans to own gold. So, 40 years, couldn't own gold, and the reason for that essentially was that the US ledger was being inflated and they had to try to ban alternative ledgers. They say, "Well, you can't use gold as your savings, you have to use the dollar and you have to sit there and earn negative real yields for a decade, and if you don't want to then tough luck".
It's funny, because the United States, so mostly they only ban upwards. So for example, the United States, maybe Switzerland aside, but basically the Swiss and the United States were the two strongest currency systems you could be in during that period, so the only thing the United States had to worry about was gold. They didn't have to worry about people wanting to go into like French currency, because they were getting rekt even more. And so, you only had to ban upwards.
Similar today, Argentina will freak out and try to prevent people from getting dollars too quickly, whereas the United States is not worried about people going into Argentine pesos too quickly. Nigeria's worried about people going into dollars, they're worried about people going into Bitcoin and stablecoins and things like that, so basically these ledgers turn to protective measures when their own system's weak and they want to try to prevent flight into something stronger.
Danny Knowles: You said this scenario makes it hard for the Fed to keep raising rates. Do you think they're done raising rates now?
Lyn Alden: So, the market is currently pricing that it thinks that they're basically done, that they're going to pause. I'm not sure about that. I would not be surprised to see another 25 basis point hike around the margins, because at this point I now have to get into the head of Jerome Powell, and I don't know him personally, so it's basically asking about one person's decision, that's how our system's built. So, I think that they're still on the path when they're slowing down and approaching a pause, because there's only so quickly you can raise rates without breaking everything, and I think that's the issue.
I think also later this year -- so, right now, the Treasury has been providing liquidity to the market ironically because of the debt ceiling. They can't issue new debt and so one of their extraordinary measures is they start drawing down their existing cash balances, which is actively pro-liquidity for the rest of the market. Basically, there's this void of capital the Treasury holds that's now entering back into the market out of necessity. And I mean, they're almost out, so roughly by the summer, or late summer, it depends on tax revenues and expenditures, things like that, they're current estimate is late summer, early autumn, they'd run out.
Whenever the debt ceiling's resolved, one way or another, when they go to refill their cash balance, that is extremely negative for liquidity, and I think the Fed's going to have trouble being tight while that happens. So, I do think there a lot of interesting factors that start hitting in the second half of this year but I think that in the next couple of months, there's really nothing outright preventing the Fed from continuing to either hold or inch a little bit tighter.
Danny Knowles: And I think that a lot of bitcoiners think that once the Fed pauses, we'll be back at zero in a matter of months or years. What do you think it more likely to happen? Do you think they're going to pause and then start hiking again in say 12 months' time, or do you think it does trend back towards zero pretty quickly?
Lyn Alden: I mean, that's a lot of steps ahead and again, it's based on human decisions, so I think we're in a new regime now where we're not going lower lows and lower highs, I think now we're going sideways or up. And so I think if they were to cut rates, they'd do everything that can to prevent cutting to zero. They could, for example, cut to 2% if there's a recession. Basically, if they can drop interest rates by 300 basis points from 5% to 2%, that's a pretty similar effect.
I think a bigger factor in some ways is what happens with their balance sheet. The question is, will they have to expand it against their will in order to keep the sovereign bond market liquid? That's what they had to do in September 2019. That repo spike was ultimately a T-Bill oversupply problem, which is why three weeks after providing repo liquidity, the Fed had to also buy T-Bills, because ultimately even the repo spike, that was being used to buy hedge funds and stuff to buy T-Bills. So eventually, the Fed had to start buying T-Bills. I think by the end of this year, the Fed is probably going to have to stop quantitative tightening, because it's just draining too much liquidity out and no one's really buying, and it might or might not have to buy some Treasury Bonds.
Now, it partially depends on also what Yellen does, the Treasury Secretary, because for example, she could issue a lot of short-duration T-Bills and suck money out of reverse repos. But if they continue their current path or trying to issue longer duration, like intermediate-duration debt, that could cause a liquidity problem unless the Fed ends up buying some of it. So again, I think for the next couple of months, the Fed doesn't really have to do much. I think the questions later this year get interesting, and it's that interplay between the Fed and the Treasury and right now, it's too many variables here and the end of March to predict exactly what's going to happen in that time.
Peter McCormack: Do you think Lyn should take over from Jerome Powell?
Danny Knowles: I mean, I think so!
Peter McCormack: I think so.
Lyn Alden: Anyone who knows the situation should avoid that job.
Danny Knowles: Why do you think he's staying in it, I don't understand?
Peter McCormack: Yeah, why does he want that job; is he a psycho?
Lyn Alden: I think when he stayed in that job, it kind of indicated that he's overconfident in how it's going to be handled. I think the problem is, if you listen to his speeches, he refers to the 1970s and he refers to Volcker. But the problem is that what's happening now has very little similarities to the 1970s. That was due to excessive bank lending and it was at a time when debt, as a percentage of GDP, was low. Whereas now, it's more like the 1940s, where the inflation's coming from excessive fiscal spending, and debts are very, very high. So, I think basically their playbook is just not looking back far enough and I think they underestimate the scale of the problem.
Peter McCormack: Do you think this is -- you refer to Volcker and that he keeps referring to that; do you think this is about him trying to create some legacy?
Lyn Alden: I do. I think he doesn't want to be know as Arthur Burns, he wants to be known as Paul Volcker. Hawks generally get looked on better in history than doves, and I think he is trying to basically fulfil his role. I think that's his view and I mean he's super-rich, I don't know why he wants the job.
Peter McCormack: Yeah, is he worth like $100 million or something?
Lyn Alden: Something like that. He's worth at least tens of millions, maybe $100 million.
Peter McCormack: Maybe it's just a game to him.
Lyn Alden: It could be, but I think legacy and reputation and power all kind of go hand in hand, so maybe it's what gives him meaning, but I don't really want to psychoanalyse Jerome Powell. I mean, who knows what drives him.
Danny Knowles: There's a bit of talk about him being under some pressure now. Do you think though this is just an unwinnable situation for anyone; would we be in the same situation whether it was Jerome Powell or whoever's next?
Peter McCormack: Not with Lyn Alden!
Lyn Alden: I do, that's why, yeah, I think that anyone who knows the situation wouldn't take the job because of that. It's essentially an unwinnable situation. Now, there are still things -- he could have been less loose in late 2021. He was still doing QE when inflation was notably above target, and then when he pivoted, he didn't have to go from zero to 5% in a year, a little over a year. He's been so active in whipping around the entire monetary base and whipping around the whole bank cash thing, and I think it's ham-fisted, it's bull in a china shop.
I think there's valid criticism that he goes to extremes too much, but that's different from the observation that this is in large part built up over decades, it's in large part due to the fiscal side; and if you put Paul Volcker in today, I don't think he would be able to fix anything.
Peter McCormack: I still think Lyn Alden would, Danny. Anyway, Lyn, this is brilliant. How's the book going; have we got a target date?
Lyn Alden: It's going well, I'm on the second editing phase. Yeah, it's going very well.
Peter McCormack: Do we have a release date?
Lyn Alden: No, but it will be this year.
Peter McCormack: Do me and Danny get an early look?
Lyn Alden: We can talk about it, yeah.
Danny Knowles: That's a no!
Peter McCormack: Bring one in person, let's have a little flick. All right, Lyn, brilliant. We're going to see you in Miami, aren't we?
Lyn Alden: Yes, yes.
Peter McCormack: Well, listen, thank you for this as ever. If you're listening and you haven't checked out Lyn's amazing newsletter, go and check it out. It's the ridiculous low price -- what is it, $199 still?
Lyn Alden: Yes.
Peter McCormack: You know there's been inflation, Lyn?
Lyn Alden: I do! Well the funny thing is, when I originally priced it, I anticipated inflation and therefore I priced it a little bit above what my price was going to be so that I purposely wouldn't have to change it for a few years.
Peter McCormack: You're way under Doomberg; I pay a lot more for Doomberg's email. Anyway, listen, go check that out. It's lynalden.com, we'll put it in the show notes. Lyn, me and Danny love you. Thank you so much, we will see you in Miami in May. Yeah, take care.
Lyn Alden: Looking forward to it, thanks for having me.
Danny Knowles: Thanks, Lyn.
