WBD694 Audio Transcription
Money Printing & the Debt Spiral with Macro Alf
Release date: Wednesday 9th August
Note: the following is a transcription of my interview with American HODL. 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.
Macro Alf is the founder of The Macro Compass, an investment strategy firm. In this interview, we discuss different types of bank money, QE, deficits, money printing, and whether a debt spiral is looming.
“This direct connection that mainstream economics wants to draw between the amount of bank reserves in the system and lending, stimulating the economy, doesn’t exist.”
— Macro Alf
Interview Transcription
Peter McCormack: All right, Mr Macro Alf, how are you, man?
Macro Alf: Hey, Peter, nice to be here. I'm good, and you?
Peter McCormack: Yeah, good, nice to finally meet you. We tried so hard to do this in person, but that's the way of the world. We couldn't get you here in Bedford and I couldn't get to you. But Danny has been pressuring me for a long time. He's like, "Get Macro Alf on the show, he's brilliant". And I was like, "I know he's brilliant, I follow him". So, we want to get into a few things with you today. We want to talk about credit ratings because we had a downgrade this week, so we want to get into that; but we also want to get your take on money creation because we've had various people on the show talking about it, we've had Jeff Snider on, we've had Lyn Alden, we've even had them on together debating the whole subject. And then morons like me sit in the middle going, "I've got no idea who's telling me the truth here". So, I think I want to start there. Can you talk to me about money creation, what are the truths, what are the myths?
Macro Alf: Whoa, that's quite a question. Let's see if I can disentangle that. So the answer is there are a lot of different forms of fiat money and there are two main forms. One is the money that we use, "we" namely the private sector, households, corporations, that's what you would refer to as potentially inflationary form of money or real-economy money, as I would call it. And then there is another form of money, which is the result of our mysterious [unclear] with the financialisation of our economy, and that's a financial form of money. It's money for banks. Those are bank reserves.
Bank reserves are often associated, correctly so, with monetary expansion from central banks. So when a central bank does quantitative easing, for example, it creates bank reserves. It expands its balance sheet and it gives commercial banks more financial money. And this is the main distinction that people should understand. There is money we use and there is money the financial system uses. And those two things might interact, but they have to be separated in order to really understand how money is created.
Peter McCormack: Okay, so can you explain in those scenarios how it is actually created?
Macro Alf: Okay, so let's start from the thing that people call more often money creation, which is quantitative easing, or central bank balance sheet expansion. That's what people refer the most as printing money, right? That is printing money, that is printing a financial form of money, bank reserves. And how that works is, well, the central bank wants to buy bonds, so from the liability side of their balance sheet, they expand it, they print digitally new bank reserves, they can do that. And they take these bank reserves and go and buy bonds from the private sector. It might be a primary dealer, it might be a bank, it might be a pension fund, but they take it away from the private sector.
By doing that, what happens is that the private sector overall has less bonds available and banks are given in exchange bank reserves. So, the bank reserves that are created on the liability side of the central bank end up on the asset side of the banking system. And there are a few ways how this might happen. Maybe if the central bank buys bonds directly from the bank, it's easy to understand. The bank had a bond before, now it hasn't, sold it to the central bank and instead it has bank reserves. There might be more different and difficult steps where, yeah, the central bank is buying bonds from a pension fund. That might be slightly different. But at the end of the day, for the system overall, you have reduced the amount of bonds available and you have injected more bank reserves in the system. This is often called money printing. And it is a form of money printing, it's printing bank reserves.
So the real question we need to tackle here is, what the hell are bank reserves in the first place? So what are these, right? Okay, so my advantage point, hopefully I understood a bit more of how his works, is I have worked for a European, a global bank actually, and also in their Treasury department, which means I have been the recipient of quantitative easing exercises. I was the guy, I was taking bonds away from when the European Central Bank or the Federal Reserve was doing quantitative easing. I was the guy getting the bank reserves. So what do I do with them, right? What are they?
So, bank reserves basically fulfil two main roles for a bank. The first is they allow banks to settle transactions with each other. So, if Danny is banking with Peter, Danny is banking at JPMorgan, Peter is banking at Wells Fargo, they make a bunch of transactions during the day, JPMorgan at the end of the day needs to settle a balance with Wells Fargo, okay, might be a positive or negative balance. The way they settle with each other is they give reserves to each other, they pay each other in bank reserves. First function, just the payment settlement mechanism. Second function, let's say it's a regulatory liquidity function.
So we have imposed rules on our system for which banks must own a bunch of liquid assets on their balance sheet, because if Peter wants to take away his money from a bank, as we have seen in March, we'd better make sure that the bank has enough liquid assets to serve Peter or we have a problem, especially if there are more Peter going there at once all of a sudden, right? So, bank reserves serve that function because they can easily be translated into, let's say, deliverable cash that Peter can bring home. They can serve that function. They're a liquid asset, basically, or considered to be so by the Federal Reserve and the ECB.
So then banks hold these reserves. They regulatorily look fine. They make some yields on them, depending on what is the rate that the central bank sets on them, and that's it. This is it. There is no other thing that a bank can do with reserves, if not settling a transaction against another bank, while it might be that, you know, they're buying a bond from another bank. They're making a repo transaction with another bank. So they pay other banks with bank reserves. Each chartered bank has a bank reserve, let's say an account at the Fed, so they can take these reserves in and deposit them in the Fed. Only banks have these accounts. I don't have a reserves account, Peter, you neither. A pension fund doesn't have a reserve account at the Fed, so it's literally only money for banks. They can settle with each other.
Now comes the key thing. Banks don't use reserves to make loans. Geez, this is the most misunderstood concept in modern finance. A reserve is an asset for a bank, okay? Remember, reserves are created as a liability from the central bank. They end up as an asset for a commercial bank. When a commercial bank makes a loan, it's not transforming or multiplying the existing amount of reserves. When a bank makes a loan, and then we are moving to the second step, creation of real economy money, a bank expands its balance sheet. It creates the new money by lending. We can cover this. It's a bit more complicated, but reserves are not used to lend money. Also, because I don't have a reserve account, you don't have a reserve account, nobody else has. There is no direct channel for this financial form of money to enter the real economy. There is no way.
Peter McCormack: Okay, so now I think I understand it. So, it's really just a tool for the banks to be able to continue on their normal day-to-day business with each other. How do they get themselves in a position where they need these reserves?
Macro Alf: Yeah, so I've talked about, let's say, the entire banking system overall, but each bank works differently. A certain bank might have more needs to settle transactions with each other overnight. A bank might have a certain preference to hold less reserves or more reserves on their balance sheet. Maybe they're more prone to risk or less prone to risks. So effectively, the distribution of reserves amongst each bank is different depending on the preference of risk and liquidity that a certain bank has. So it might be that one bank is running scarce on reserves. Okay, so they need to bid them up, they need to find these reserves somewhere. So they will go in the repo market, try to post some of the collateral they own. Let's say they own Treasuries. They post more Treasuries, they go to other banks and they say, "Hey guys, you have more reserves, can you lend them to me?" And so they operate with each other and they try to move around these reserves in the system, depending on their personal preference.
Important thing, at emergency, the Federal Reserve can always, as we have seen during the banking turmoil in March, the Federal Reserve can always produce new reserves to make sure that the entire banking system, or the fragile parts of the banking system, kind of hold together. So what happened in March is a couple of banks acted a bit like cowboys, they didn't really do the risk management, right? And therefore, all of a sudden they found this value of this collateral, Treasuries, that they were told were super-safe and stable, especially if you hedge interest rate risk, but they didn't hedge, all of a sudden they found the value of this collateral down by 30%, 40%. Depositors said, "Well, I want my money out" all at once, and at that point, you need to be able to transform this collateral back into reserves, into liquidity, basically, to service your deposit outflows. That single bank is in urgent need of these reserves, right, of this funding, basically.
Well, the problem is that the haircuts were massive. This collateral had gone down 40% at some point. So, you can try to do that, but you will destroy your capital. You will basically deplete your equity very quickly, and you will default. It's basically a liquidity spiralling crisis. What happens? The Federal Reserve shows up and says, "Well, to us, Federal Reserve, that collateral is worth 100 cents on the dollar. We don't care whether it's marked at 60 by the market. To us, it's worth 100. So you post that collateral to the Fed, and the Fed says, here is your bank reserves, here is your funding, please service your deposit outflows. So, the Federal Reserve in that case serves as the lender of last resort for financial money. For that financial form of money, bank reserves, the Federal Reserve, or the ECB can always act as the lender of last resort for domestic banks.
Peter McCormack: So this is always on the demand side from the bank, they are solving an issue for the banks, but does it ever become that the Federal Reserve wants to force the banks to have more liquidity; can they force assets onto them or does it always just directly come from the banks?
Macro Alf: Actually it's the Federal Reserve that decides the aggregate level of bank reserves in the system, or can influence it the most. So, if they do QE, they're expanding the level of reserves in the system, they're taking away bonds and they're giving more reserves to banks. If they're doing these collateral lending programs, like in March, they're doing the same. They're saying to banks, "Lend these bonds to us, we'll create new bank reserves", they're expanding basically the amount of bank reserves in the system. When they do QT, quantitative tightening, normally the amount of reserves goes down. So they are trying to drain the amount of reserves from the system.
The European Central Bank had a program called TLTRO, Targeted Long-Term Refinancing Operations, I think. So basically it's a lot of words to say, "Hey, European banks, here is a very cheap loan for you. You're going to post some collateral to us, exactly like the Fed did. We're going to lend you money very cheaply at negative interest rates". European bank got a loan from the ECB for four years at negative interest rates. And the idea was, "Here is your cheap funding, try and do something with it, please. Sustain the economy. I mean, please do something with it". And when they changed the terms and conditions on this TFTRO, banks all of a sudden didn't find appealing to renew this funding. So, the funding compressed and the amount of reserves in the system compressed too. So, it's really up to the central bank generally to decide what is the amount of reserves in the system, more or less.
Peter McCormack: Right, okay. And so, in a time where the economy looks like it's struggling, they might want to expand the balance sheets to stimulate the banks, to stimulate the economy, and eventually they want to QT because if the economy is a bit too -- I mean, is QT one of the reasons to actually just -- is the goal eventually not to have huge reserves?
Macro Alf: You are leading me to where I want to go, and I'm going to bring Japan into the mix now. I mean, I love the global market...
Peter McCormack: Let's go. Come on, Japan!
Macro Alf: It's all over the place. So, you're telling me, and this is how central banks think, by the way, and that's because of distinction between real economy money and financial money that yet we have to draw, but we will, what I'm about to say is the way central banks think, but it's not correct. So, central banks think that by injecting more reserves into banks, banks will somehow lend more, they will sustain economic growth more. That's the thinking, right? You do QE, you print money, "financial form of money", and then from there, banks will act more aggressively, they will take more risks, they will support economic recovery. This is the thinking, right? Right. Let's go back to Japan. Let's do that.
Around 1990s, after the real estate bubble burst in Japan, the real estate bubble burst, Japanese households are hit very hard and they were chasing the dream. The Imperial Palace of Tokyo in 1989 was valued more than the entire state of California. This is the level that we've reached back in Japan in 1989. The Bank of Japan raised interest rates, deleveraging happened, the real estate bubble burst. The so-called balance sheet recession unfolded. That meant that the Bank of Japan cut interest rates aggressively back to 0%, it has effectively never moved since then, and started later on quantitative easing. And the idea was 0% interest rates, quantitative easing, access to credit will be as cheap as it can ever be. Banks will have more bank reserves and they will "multiply" these bank reserves by lending them to people and we will restart the economy.
There is a chart that I posted on The Macro Compass a couple of times, which is incredible, it's from the BIS. And it shows between 1995 and 2000, the amount of bank reserves in the system in Japan went through the roof. They did quantitative easing, monetary expansion. So, they threw bank reserves at Japanese banks and the amount of bank loans went down during the same amount of years. So you're like, "What?" They not only didn't lend these reserves, they didn't multiply these reserves. I mean, there were more reserves in the system and less loans.
Peter McCormack: Is it because the demand isn't there for the loans?
Macro Alf: So it's very simple. Banks don't lend reserves. To make a loan, a bank looks at three things. Do I have a credit-worthy borrower that has a demand for a loan in the first place? If there is no demand, the bank cannot shove you with credit. You need to show up and ask for credit first. So you need a credit-worthy borrower; first condition. Second condition, you need loan yields, the money you make on these loans basically to be good enough to reward you against the risk. If you bring down interest rates to 0% and you look at banks, they're actually less likely on the margin to make loans because they're going to take risk on you and they're not going to make much money out of it. And the third condition is return on equity. So, regulators attach a certain capital. They ask banks to retain capital against the risk they're taking. And of course, if regulation says you need to retain a lot of equity against that loan, banks might be disincentivised to lend; they might look for other ways to generate return on equity. Those are the three conditions.
If you give banks 100 million reserves, one billion reserves, one gazillion reserves, but those three conditions are not met, banks are not going to lend. And that's exactly what happened in Japan between 1995 and 2020. And this direct connection that mainstream economics wants to draw between the amount of bank reserves in the system and lending stimulating the economy doesn't exist. There is no direct pipe for bank reserves to fill and go into the real economy.
Peter McCormack: So what do bank reserves actually do then? And, are there any winners and losers created by expanding the bank's balance sheets; sorry, the reserves?
Macro Alf: Yeah, it's a very good question because there is a theory called the portfolio rebalancing theory. So, I've been there first hand. Let me tell you what's true and what's not true about it. So, the portfolio rebalancing theory works as follows. You're a bank, regulation forces you to own liquid assets on your balance sheet, so you must own about 15% of your entire balancing sheet in what the regulator says are liquid assets. And to make it simple, it's mostly Treasury bonds, mortgage-backed securities, some corporate bonds and bank reserves. That's it. Equities are not deemed to be liquid. Other commodities, Bitcoin, by the regulator, they're not deemed to be liquid. You have to look at basically bonds and reserves.
Now, say we do QE, Peter, and the central bank is taking the bonds away from me. I'm a bank, and they're giving me more reserves. They're skewing the composition of my portfolio forcefully, without my consent. They're skewing it towards more reserves and less bonds. And you know, reserves make less money than bonds. Bonds might have interest rate risk embedded in it, credit spreads embedded in it in the case of corporates. So I, as a bank, want to own liquid assets, but I also want to make some money on this liquid buffer. It's 15% of my balance sheet. I mean, I'm supposed to try and make some money on that portion, right? So, if you force on me to have more reserves and more reserves and more reserves, there might be a point where I might ask myself, "Where do I want to rebalance my portfolio back to bonds?" So that means that I will try and get rid of these reserves, give it to other banks, "You take it, I don't want it any more". Remember, it's a closed system, you cannot delete reserves, you can only pass them away like a hot boiling potato.
But maybe there's a competition to do that, to pass away these reserves, and instead rebalance your portfolio back to corporate bonds, for example, or mortgage-backed securities. If everybody tries to do that at the same time, what you will have is that credit spreads will compress. So corporate credit spreads and mortgage-backed security spreads, they will compress. The portfolio rebalancing theory proceeds further and says, if I'm a pension fund or an equity investor and I see that credit spreads are compressing, maybe I want to own more equities, it's a good environment, right, because credit spreads are tight and everything is good and volatility is low, so I'm going to buy more equities and so on and so forth.
So, the portfolio rebalancing effect basically says that by doing QE and flooding the system with reserves, as long as the volatility remains compressed, banks will be incentivized to rebalance back their portfolio towards more credit risk, and that will lead other investors to be more risk-seeking in the cycle. This is the truth, the true part. The wrong part now. It doesn't really make --
Danny Knowles: Can I just ask a quick question before we go on to the next part?
Macro Alf: Of course.
Danny Knowles: So as a commercial bank, you can't buy treasuries from the Treasury with bank reserves?
Macro Alf: As a primary dealer you can. So, let me put it like this; a primary dealer can settle in auction with reserves. Bank treasury can participate in auction and also settle the purchase with reserves directly. So the answer is yes, they can.
Danny Knowles: So why would they not do that as a way of rebalancing, rather than going to other commercial banks?
Macro Alf: That's one way to do it as well. The problem is that the Treasury is issuing new bonds but don't forget, if QE is going on, the Federal Reserve is buying these bonds away. So as a system overall, the Federal Reserve is taking the bonds off the system. You might go to auction and buy them, but then you'll have the Federal Reserve buy them from you in secondary markets anyway.
Danny Knowles: I see.
Macro Alf: You see my point? So the Federal Reserve is crowding out basically the system by taking away these bonds. That's why QE takes away the collateral from the system and puts the reserves on the balance sheet of banks. And at some point, these banks might be incentivised to feel a bit more risk prone. This is the true part of it. The wrong part of it is the following.
Let's say you're a European guy. It's easier to explain, okay? So you are a European bank treasury and the European Central Bank is running QE and it's taking the bonds away from you, it's flooding you with reserves. At some point, you own all your liquid assets are reserves and you want to buy some fricking bonds, okay. Good, I want some risk, I want some Greece, let me buy some Greek bonds, some Portuguese bonds, some Italian bonds. The limits, the risk limits, my risk preference that the risk manager sets, it's not going to change because the central bank is doing QE. They are not going to allow me to be reckless on risk because I have more bank reserves. That's not how a risk manager thinks. So there are limits and constraints, let's say, to how much this portfolio rebalancing effect might work.
But to answer Peter's question, this is one of the ways or second-round effects that printing financial money or bank reserves might actually unfold with. When it comes to direct link between bank reserves and lending, bank reserves and inflation, bank reserves and stimulating economic growth and making the economy run hot, there is no direct link between the two.
Peter McCormack: How is a normal Joe meant to understand all this fuckery when he just wants to go to work, get paid, maybe have a holiday once a year? It feels like all this financial fuckery goes on in the background. How's he meant to understand what he's meant to do?
Macro Alf: That's a very valid question, Peter. I don't know what to say apart from I hope that with the work I am doing and other people are doing on this topic, it's become a bit more accessible, a bit more democratised.
Peter McCormack: Definitely.
Macro Alf: I hope, that's all I can say, but look, I always wonder. A friend of mine is a mathematician and a PhD and she went into finance and then she's modelling stuff for a pension fund. And she asked me some time, "What the heck? This is all a bunch of convention and machineries you guys are doing. But in reality, it's really the principles are very simple, but we are trying to really make this overly complicated, aren't we? And yeah, to a mind of a mathematician which thinks in reading processes and steps, this is really the case. Also in my mind, by the way, I'm not a mathematician, but this is really overly complicated.
Peter McCormack: Well, this is the best explanation I've had of this side of money creation that I've heard so far. Tell me about the real money creation.
Macro Alf: Okay, let's do that. Now comes the fun. A few of the listeners here might think, God, is this guy nuts? But I'll try to explain where I come from. So, there are two ways that Peter, Danny and I, and you at home can get more money to spend, more real-economy money, inflationary money to spend, there are really two ways. The first is, hear me out, the government runs deficits. What? So, think about it. The government of the United States is basically the issuer of the dollar. You can think of it like 1,000 years ago, it would be like the king. The king coins and says, "This is the currency in my kingdom", and let's assume it's the dollar. Now we don't have kings any more, we have a democracy, but the government of the United States has the same power to issue the dollars. Okay, good.
Now, the government says, "I want to send cheques at home to Peter", that's what the government did, by the way, in 2020, 2021. So what happens then mechanically, what happens then? Well, the government has a balance sheet, assets and liabilities, and it says, "Well, I want to print dollars because I have the power to do so. I am the guy that basically decides whether dollars are worth dollars. So let me print them, okay? And I'm going to make deficits". What's a deficit? It's a negative equity. You spend more than you have. Basically you're drawing down, you're blowing a hole in your equity structure. Good. So, on the liability side, we're going to mark minus deficit spending, and it's the government spending money. Okay, they decide, so good.
They send the cheque at home to Peter. Awesome. So, Peter has more bank deposits, spendable bank deposits. I mean, Peter can just spend it on a computer or on going to the theatre, or whatever. He can spend it in the real economy, right? This is new money that Peter didn't have before. Most importantly, Peter doesn't have a liability attached to this money. It's not like somebody told Peter, "You have a mortgage to repay, you have a debt attached to this". You just have new money, it's a cheque in your mailbox. You open it, you cash it, you're done. So Peter has new money, new bank deposits. And on the liability side, Peter is richer, he has a higher equity at this point. He has more money, very simple, no liability attached to it. Good.
Peter McCormack: And when you do that across the whole country, there's a massive increase in --
Macro Alf: It's a lot of money. Real money.
Peter McCormack: -- real money.
Macro Alf: I'm going to get there. What does that mean and why do people always underestimate the power of fiscal deficits when it comes to inflation? It's much more powerful than bank reserves, but we're going to get there if you bear with me for a second more. So then, well, what happens? There are more bank deposits in the system, right? And so Peter has deposited money at JPMorgan, I don't know, at a bank. So the bank now has more bank deposits, right? They have more deposits than before Peter has deposited them. So, a deposit is a liability for a bank. Liabilities goes up, that's deposits.
What goes up on the banking side is asset side, is reserves. And now we come to the point where the government has to issue bonds. That's again something we decided. The King, 1,000 years ago, didn't have to issue bonds, guys. But okay, now we say that amongst the 3,000 [unclear] we use, we cannot run a negative Treasury General Account at the Fed, we cannot have a negative equity at the government, and so on and so forth. We have thousands of these rules. The government of the United States says they cannot have more than a certain amount of debt, the debt limit, right, or the debt ceiling. So, then we have this political circus every X years where we have to raise the self-imposed ceiling. So we have a lot of these self-imposed structures, right?
One of it is that the government must issue bonds to fund its spending. Well, they do. They issue bonds. Banks have more reserves, remember, at the end of this exercise. They just show up, exchange the reserves for bonds, and we are done, and this is the process. The most important part is Peter has more money, he can spend the money. This is not bank reserves in the financial plumbing system, repo, reverse repo and complicated stuff; this is Peter with a cheque in his mailbox, which he can go and spend it. And when you do, $5 trillion dollars of debt all at once, like the United States did between early 2020 and mid of 2021, well, guess what? It's a lot to be spent and can you expand the supply of services, the supply of goods as rapidly as the demand goes up? No, you can't. That's $5 trillion, it's too much.
So what's the release valve? It's inflation. One method to print real-economy money and to destroy it, it's fiscal deficits and fiscal surpluses because if I am taxing Peter more, I can do the opposite exercise. I am destroying Peter's wealth. I'm taking Peter's ability to create money through his income, his work, whatever, and I'm saying, "Peter, I'm sorry, let's cancel that money. I'm going to tax you more". So I'm destroying money and I'm slowing down the economy very rapidly. With deficits, you do the opposite. You print real economy money.
Peter McCormack: So could you argue that reducing taxes would drive inflation?
Macro Alf: Yes, I can argue that. I can even, and I'm going to post an article next week --
Peter McCormack: I can stand up for that inflation though.
Macro Alf: I am posting an article next week on the Macro Compass where I will show that most of the difference in GDP between the United States and Europe, between 2013 and 2019, can be explained by the difference in fiscal stance between the US and Europe. So, Europe ran austerity programs basically between 2013 and 2019. That was the result of, "Yeah, we need to pay down that, we need to reduce our fiscal deficits, we need to tighten the screws and tax the system more and balance our budgets and so on and so forth". The United States did less than that. They mostly did deficits between 2013 and 2019.
If you take the difference between the US fiscal stance, lose deficits, and Europe, and you basically plot that against the difference in GDP, you will see that most of the GDP overperformance of the US, most of the nominal GDP overperformance, to come back to your Peter thing, so it's real and inflation on top of it, it's due to the fact that the United States is printing more money than Europe did. Europe was trying to destroy money by taxing the system more by doing austerity.
Peter McCormack: Well, why do austerity then? Is it because, well, my assumption is one of the reasons for austerity is that money printing itself and the real economy, it's an unfair system that creates a wider wealth disparity eventually. I mean, we know inflation disproportionately affects the poorest the most. I've referred to Avik Roy's article. He said even at 2%, over multiple years, inflation has a catastrophic effect on the poorest. So my assumption, even though the austerity by the Conservative Government seemed to actually attack the poorest, ultimately it was for balancing the economy to ensure that we didn't have this disparity.
Macro Alf: Look, austerity in Europe is basically in the DNA of most northern European countries. It comes from a school of economics that actually dictates this kind of thinking. It also comes from historical experiences. If you think about the Weimar Republic in Germany, for instance, Germany doesn't have a good relationship with fiscal spending and inflation, I can tell you. So, they are wired to think that government debt is bad, it's terrible, we should reduce deficits, we should cut down debt.
The interesting part of this is that in all AAA-rated countries left in the world, Denmark, Germany, Netherlands, Norway, Australia, I'm going top of my head now, in all of them, government debt-to-GDP is very low, private debt-to-GDP is extremely high. So what did we do? We basically said the government doesn't want to create new money for the private sector, it doesn't want to cut taxes, it doesn't want to do cheques and send them over to Peter. In Switzerland, that doesn't happen, they have a balanced budget or a surplus every year.
Well, what then? How does the private sector get this lifeblood of credit and new money that other parts of the world get through government spending? Well, they get it through private credit. Households and corporations in Switzerland borrow up to their nose, and the same is in Australia, and the same is in New Zealand, and the same is in all other AAA countries that I just mentioned that have a low government debt-to-GDP, they use the private sector to lever up. So they create money, they create leverage, they create credit through mortgages, for example. They create that wealth through the housing market, and this is more risky actually, because it drives stronger imbalances in the system than government debt drives.
So, the second form of real-economy money printing is private sector credit or leverage. Bank lending is one way to get access to it, but now we also have capital markets to do leverage and to do credit. So, if you take the simple form, bank lending, basically when a bank makes a mortgage, you can think it this way. So, Peter wants to buy a house, shows up at a bank, doesn't have the money to buy a house, doesn't have the cash to buy a house, but he has a job, he has a good job, and the bank feels like he's a credit-worthy borrower. Okay, good. So the bank is going to lend money, it's going to make a mortgage. So, Peter doesn't have the money, but Peter gets a credit, a mortgage, €500,000, whatever he needs. He buys the house from the seller.
The seller had a house, now has €500,000 that he got from the proceeds of the sale. He deposits the money in the banking system. And what happened? Peter has a house that he didn't have before with money that he didn't have before. A new loan is created, a credit is created, a mortgage is created, a new asset for a bank. And also, a new bank deposit is created, which is the €500,000 that the seller of the house didn't have before, and now it has, and it deposits at the bank.
So, bank lending creates new money. It gives Peter the ability to buy an asset with newly created money that Peter didn't have before. It's a new loan and the seller now has new bank deposits, new spendable money. The seller can spend it on whatever he wants now, that €500,000. And so when banks make loans, they are increasing credit and leveraging the system. They are blowing up their balance sheet, both on the assets and on the liability side. The flip side of it is more private sector debt. Peter has a new asset that's a house, but he also has €500,000 of debt to pay back. And if everybody does the same year over year over again, you'll have the situation that many AAA countries have, private sector debt gets very elevated.
Peter McCormack: But that's a more healthy way of growing the economy.
Macro Alf: We can debate about that. So let me put it like this.
Peter McCormack: If I'm credit worthy and I'm borrowing, I can pay it back. It means I'm creating something of value in the economy that leads to me having the money to be able to pay that back. Therefore, you're increasing the economy through prosperity rather than through just stimmy cheques and printing.
Macro Alf: So, that's an excellent point in the sense that the government isn't really the best allocator of resources historically, right? So when the government does deficits, they are unilaterally without asking for your consent, they are unilaterally deciding where to allocate newly created money. I mean, spending goes to where? To whatever, agriculture subsidies, cutting taxes, whatever. They are deciding unilaterally, they are allocating newly created money. Peter, you're right. To create money through private sector credit, you need a willing borrower to start with.
As we discussed this before, it's not like the bank can make you a mortgage if you don't ask for one. You have to show up there. You have to have a productive intention behind this creation of credit, right? You need to want to do something with the new money. Buy a house, invest in your company, do something, right? That's already a first filter for the productivity of this. And in general, the private sector might be deemed to be a bit better and more efficient at allocating new money than the government is.
The flip side of it, the government limit to "fund" its deficits and its increasingly high levels of debt, it's only inflation and reckless spending. If you don't get inflation, massive and sustained inflation, if the populace doesn't lose their trust in the currency, you're fine. Look at Japan. Japan has been doing this for over 30 years and not much happens there. The only limitation is inflation rate. If you do too much, you go over the edge, then people start to wonder whether that is sustainable or not. But that's a limitation that you can try and manage around. If you're Peter and you are indebted privately up to your nose and you have an economic downturn and you lose your job and companies start making less earnings and they start firing people, you cannot print money to repay your mortgage. You need to find a way to generate income, right?
So the inherent fragility, let's say, potential fragility in that leverage when things get bad is higher than it is in government debt, let me put it like that. So, the productivity is higher as well, but the risks of private sector leverage are generally higher if there is an economic downturn.
Peter McCormack: And so is that disparity exacerbated by the fact that if I borrow €500,000 to buy a house because I can, I have the opportunity, lots of people are doing that, and even despite the fact that they are being productive in the economy, it is still leading to higher prices. And for those who maybe are lower on the economic ladder, everything's being pushed further and further away from them. Whereas, if you had a system which was, say, fully reserved, or let's talk about what the bitcoiners talk about, the value of the money itself becomes worth more as a unit, and therefore even if they can't afford to buy a house, the growth of the economy at least means the asset, the Bitcoin they own, becomes worth more. Am I seeing that right?
Macro Alf: So you are describing -- so basically, we so far defined the two forms of money that we can print in our fiat system. We have financial form of money and we have real-economy form of money. The real-economy form of money is credit. It's either government debt or government credit or private sector debt or private sector credit. So, we're talking about a fully elastic credit system, that's what we have today. So, today we can always create new credit. We don't have anything that really pins the value of these dollars that we create. It used to be gold where we tried the gold standard, but today we don't really have that. We can create new credit and it's only really an accident, a deleveraging episode, inflation, something like that, that makes people wonder about the sustainability of the system. But otherwise, the system doesn't have any inherent limits, any strict limitations, it's a fully elastic credit system.
There are advantages and disadvantages with this system. The advantages are, if you use it well, being fully elastic, during downturns, you can anti-cyclically expand your credit. So, you can stimulate the economy when the economy needs it, right? And you can also create credit for productive purposes. This is a bit utopistic because we don't do neither of that. We tend to run on animal spirits. So, we stimulate when the economy is already running hot. Today, the US Government is running an annualised $1 trillion deficit. So, it's literally printing new money for the private sector with inflation not yet fully contained. And they've been doing that for six months still. So we tend to stimulate, well, sometimes we run with animal spirits. We are not anti-cyclical, right? Well, most of the times we run with animal spirits. But in principle, if you use the system anti-cyclically, it's a useful tool, right? You can expand credit when you need it the most, and you can contract it when you need the least.
The downside is expanding credit generally, if you don't do it for productive purposes, but you do it for increasing house prices, increasing asset prices, it will lead to disparity, because credit is easily accessible from people that have collateral, from people that already have assets. They can access credit generally cheaper and in a more friendly way. By doing that, they just become richer. They own more assets. The newly created money ends up in houses. They push up the housing market and the guy at the bottom of the ladder is left out and is left behind. So, that's the downside of this system.
The alternative is a non-elastic or much less elastic form of monetary system that basically has let's call it firm money, has a firm anchor effectively to the unit of exchange that we use. And it could be gold, it could be Bitcoin to this extent, because these assets are effectively extremely limited in growing their supply. It's very predictable. You can't make new gold out of gold, you can't make new Bitcoin out of Bitcoin. Well, you can, but really the underlying assets is an anchor that is limited in supply. And so when you do that, what happens? When you do that, you can rely on the value of that firm money because you can't water it down, you can't create more of it, basically, not that easily. That's good, that's a good feature to have, but during an economic downturn, that might be a problem because you cannot expand credit, you don't have an easy way basically to make sure that you give more resources to the private sector when they need it the most.
Peter McCormack: Yeah, see that's where I always come to the point where if it's too easy to access the tool to expand the credit and if you combine that with the political cycle. then there's always a skewed incentive to make promises to the electorate. I've just seen that, I've just been to Argentina and they have very severe economic problems right now. They have 43%, I think, living in poverty and the controlling party will continue to make promises to that large election bloc, that large bloc of voters. And so, they're incentivised to constantly use the money printer rather than using it for a time when a country needs it.
So, I don't know what the answers are, but I always wonder how do you -- because I understand the desire for an elastic money supply, I understand why people want that. As a bitcoiner, I want Bitcoin because I'm fed up of this overly, overly used elastic money supply. But how do you even create rules where it's used when it's most needed? Or, should we just not have an elastic money supply and we deal with and handle and accept there will be boom and bust cycles. Is the problem that we're trying to eliminate the bust?
Macro Alf: Yeah, that's most of the problem, you're right. So, we are trying to engineer a system where recessions aren't allowed. They aren't allowed anymore. The US hasn't been in a recession for 15 years. So, 2020 of course, you can call it a recession, it was more of an exogenous shock, 2020. It lasted for a few months until the US Government said, "Well, here is $5 trillion, let's see if you now have a recession any more". Obviously, we didn't have one any more because it's way too much money being created all at once. The last true recession was in 2008. That's 15 fricking years ago. And I'm not cheering for one, it's not like recessions are good, nobody likes them.
Peter McCormack: Yeah, but they're a necessity.
Macro Alf: If you think about a healthy economic system, then generally speaking they have been historically part of the cycles, and now instead we're trying to eliminate them.
Peter McCormack: Hold on, sorry. You say that, but it feels like at the moment they're trying to engineer a recession in the UK and the US. And there's a solid argument that we are in recession, but they are trying to engineer it right now.
Macro Alf: So look, what they're trying to do is what central banks and politicians care the most about, which is get back control. Credibility status quo, get back into a box that is controllable and predictable is the number one, two, three, four and five priority for any elected politicians or central banker. When I was in my previous job, one of my upsides was that I could speak to these Prime Ministers and central bankers. Look, I talked with a G10 Prime Minister back then, and we were talking about what its country might need to improve the long-term potential for growth. So, we're talking about the judiciary reforms, we're talking about structural reforms, education and investments and stuff like that. And it would be like, "Yeah, sure, I mean, I can see the merits in all of that, but I have an election in two-and-a-half years. So, if I spend my political capital on all that stuff, the results will be evident in five to ten years from now, and I'm going to lose the electoral cycle, then the guy who benefits from this is the opposition. I'm not going to do that".
I'm like, "Geez, man, I mean, you're supposed to be a statesman. I mean, if you don't think about this, who will think about this?" And he's like, "Yeah, I know, but you know, if I get re-elected, I have a stronger political base, and then maybe at the next round I can think about this". So you're right, political incentive schemes are extremely important.
Peter McCormack: Bullshit, yeah, it's just such bullshit.
Macro Alf: Unfortunately, the political incentive schemes are bad, this is the way we have constructed our system. They play a big role in it, and that's why now you say people, they want to engineer a recession. Well, what they want is for inflation to come back, because if inflation is somewhere where they can feel it's controllable, they go back into a mechanism where they feel comfortable and they feel in control. For a policymaker, not feeling in control is the worst feeling ever. That's also why we have a 2% inflation target, because 2% is enough far away from the scary deflation; if you deflate a debt-based system, that's a serious problem. You are making the debt, the credit, the leverage, the future promised dollars worth more. You are making your problem bigger, in other words, with deflation, so you don't want that. In a credit system, you don't want deflation.
Peter McCormack: Some people want that.
Macro Alf: Well, sure, some people want that, but people that live in a fiat money system and are part of it and architect of it, they don't want deflation.
Peter McCormack: Of course they don't.
Macro Alf: Basically, the debt and the credit that we have built and engineered the system with will become a huge problem in a deflationary episode, right? It becomes worth more. And instead, they don't want 5% inflation, 6% or 7%, uncontrollable inflation. They want 2% inflation, well maybe 2.5%, 1.5%, 3%, 1%. Those are the acceptable outcomes. But 0% or 4% or 5%, again they are not acceptable because they go outside the comfort zone. They go outside the area where political incentive schemes kick in. So what they want now is to bring inflation back down. Why? To gain control. Is it going to cost something to the economy? Sure. Do they lose their job because of it? No. So again it's important to understand the political incentive schemes.
Peter McCormack: Yeah, okay can we talk about credit ratings?
Macro Alf: Sure.
Peter McCormack: Because, yeah, bit of a surprise to me because I didn't see it happening, but there was a downgrade of the US credit rating. So, just for people to understand, what are these credit ratings, who gives them, what do they mean, how important are they?
Macro Alf: So how important are they? The answer is pretty much zero in the very, let's say, deep sense. This is another self-created structure where we give three rating agencies the power to say that a certain credit is worth X. Let's remember that Fitch, S&P and Moody's gave AAA rating to subprime mortgages two months before the Crisis unfolded. So please, I mean, also Italy was rated AA+ and Greece was rated AAA. So I mean, again, from the deep sense of things, they really don't matter, but they still are an important part of this weird architecture that we have created around our financial system.
So, why do they matter in the first place? The United States now has two AA+ ratings and only one AAA rating. So what happens is that the second best rating of the United States is now AA+, not AAA any more. Good. Why second-best rating matters? In the price of bonds, an interesting part of it is the supply and the demand for these bonds, right? And while people like to focus a lot on the supply, it's easy to measure how much bonds are being issued by the government, how much deficits are we doing. It's a very easy variable to measure. What about the demand? Who's buying this stuff in the first place? Are they buying more or are they buying less?
Amongst the biggest buyers of Treasuries out there are banks, pension funds, and foreign exchange reserve managers. Now, banks, we covered them before, right? I mean, these are the guys that take the reserves. They are forced by regulation to buy bonds, to hold liquid assets. And now, bear with me, because the regulator told banks, "No capital requirements. You want to buy Treasuries? 0% capital required". "But what do you mean?" "No, no, no, it's fine. It's safe collateral, AAA, nothing can happen, 0% risk weight, go for it, 0% capital". Between a AAA rating or a second-best AA+ rating, there is no difference. Banks still get the 0% capital requirement there.
So for banks, Peter, this downgrade doesn't really change the equation. It's marginally irrelevant. Big buyers, pension funds, so why would a pension fund buy Treasuries? Well, they have long duration liabilities. They promise pension premiums 30 years from now to the pensioners, right? So as they have long duration liabilities, they need long duration assets as well. And they need these assets first to hedge the interest rate risk of long duration liabilities with long duration assets. They also use it as a part of a portfolio. The portfolio has equities and corporate bonds because they need to generate a return as well. And Treasuries are seen as a safe hedge against the moment where equities drop. So the structure will need these Treasuries.
Also for them, regulators have decided again that Treasuries are super safe. And whether it's rated AAA or AA+, that doesn't change for a pension fund. Same goes with all the collateral management where they take the Treasury, they lend it, they get cash, it doesn't really change. Again, regulation is the key word here, because it's the regulator that decides what is the capital, what is the financial incentive schemes behind these operations, and they've basically decided that Treasuries are a 0% capital requirement asset for banks and pension funds.
Last and super important is the FX Reserve Manager. Who the hell is this guy? This guy is China, this guy is Brazil, this guy is Saudi Arabia. We've built a system where about 70% of the transaction of goods and services that happen in the world are denominated in dollars. 70%, that's a lot. So that means that if Brazil is selling soybeans, they're getting dollars in exchange for soybeans. And so they get these dollars, the dollar enter the Brazilian banking system and they ultimately need to be invested in some assets, right? I mean, these dollars need to be kept safe and invested. And what's the asset? Well, you're looking for something that is very liquid, has a good repo market, you can trust it, it's well regulated, they're nominated in dollars. So, you buy treasuries as well. Also for them, they tend to put bonds rated between AAA and AA- in the same safe bucket. So from AAA to AA+, it really doesn't change.
All this story to say that for the main actors out there in the market, the ones that are either driven by the system, take the FX Reserve Managers, they get the dollars, they have to invest the dollars, or by regulation, banks and pension funds, this downgrade really doesn't change much.
Peter McCormack: Right. Is there a wider issue in that they've almost been put on notice, and also this is happening at a time where there is now global competition to be the reserve asset? Yes, Bitcoin is small, but there are people moving to Bitcoin, but there is this fast growing BRICS group of nations which is expanding and is questioning or considering its own reserve asset. Is there a risk that the US gets downgraded further?
Macro Alf: So, well, it's hard to look at the political incentive scheme of a rating agency. I mean, you can always make a story and say that the US isn't worth a AA+ any more and it's worth AA- and get people really scared about the story. So again, it's a lot about incentive schemes. And for me, I don't have an edge to understand these incentive schemes. But what I can comment on is the BRICS story.
So remember what we discussed, what we discussed is a system where who sells goods and services to other countries gets mostly dollars in exchange today, right? But what if we start selling them and getting yuan or Brazilian real or something else in exchange, not dollars; what happens then? So, one of the keys of our system is that you need to have a safe place where you can invest the yuan and the Brazilian real that you get from selling your goods and services. Because once you sell them and you get your Brazilian real and your yuan, what are you going to do with it? You need a safe place where to invest this surplus, because then your country might need to sell down these reserves in case of an economic downturn, or if you need to do so. But you need a liquid asset for that. You need something that you can sell and you can monetise very quickly and you can trust. And the Chinese bond market doesn't particularly strike me as a very open, transparent and trustable market. Does it to you, Peter?
Peter McCormack: No.
Macro Alf: I like Brazil in the sense of in this particular cycle, I'm even invested in Brazil as part of my investments, but would I think that Brazil can be the example for a liquid transparent, non-corrupted, rule-of-law dominated country? I can't make the case for that either. So, the story is that unfortunately, as per today, it's very hard for BRICS to gain traction because of inherent instability and inherent lack of transparency and rule of law. That is one of the requirements that global investors will have when they say, "Well, I'm very happy to sell you my goods and I'm very happy to get yuan back. What the hell am I going to do with my yuan though if you have capital controls in China?" I mean, seriously, think about the practicalities of this. At the moment, it really wouldn't work unless we see a different behaviour from this group in general.
The second problem is when you get away from dollar income in a dollar-based system, you might have some leverage issues. There are $12 trillion of dollar-denominated debt that exists today. It has been issued by countries outside the US jurisdiction. So that means Brazilian corporates, Indian, Chinese, they have issued dollar debt. So how do you repay your dollar debt; how do you service; how do you pay your coupons? They are denominated in dollars. Well, you need dollars to pay dollars, that seems very clear to me, right? So, where do you get these dollars from? Well, you sell soybeans in dollars, you sell goods and chips and whatever, you need to sell in dollars. The moment you don't sell them in dollars anymore, you understand that you might have a bit of an issue in servicing your $12 trillion of dollar-denominated liabilities. You can choose to default on them, sure, but this is going to further harm your credibility as a BRICS reserve currency if you choose to default on existing debt.
So, there are a lot of complications and people like an easy narrative. They like to say, "The US is doomed and the BRICS are going to replace it". I'm here just to explain a few facts that might complicate the matter, let's say.
Peter McCormack: That's fair. What about the level of interest payments on the debt? Fitch pointed out that interest payments are nearing $1 trillion a year. We know tax receipts with the US Government is about $6.5 trillion, it's growing, it's continuing to grow. Is there not the risk that they head into some form of debt spiral?
Macro Alf: That's another good point because it brings me to think about two things. Interest payments from the United States on their debt are interest income for somebody else. Think of it. Who owns these Treasuries that are paying 5% risk-free rate today? I own them, that's super-good. You can just get paid 5% on T-bills now. You basically have no risk; I mean, you have no interest rate risk. They mature in three months to a year, you get 5%. So, the $1 trillion, which is a payment for the United States Government, is income for somebody else. Just something to consider.
Nevertheless, the moment that your interest payment represents a larger and larger portion of your tax revenues, of your spending also, you might run into some decision-making to do, right, and there are really two ways to do this. Well, the first is to say, "I'm going to stop issuing all this debt. So, I'm going to clamp down, I'm going to raise my taxes, I'm going to --" well, basically slow down the economy, right, "destroy money, raise taxes, and repair my budgets". And that's the standard way of thinking about it. That's what fiscal orthodox people would think about. That's what Germany would do straight away, immediately.
The second way is, "Well, I might run more deficits so that I print new money with which I can try and repay my interest on that". That's a very dangerous path to go through because what happens is you're basically snowballing your debt by doing so. And there is a point at which markets might doubt your ability to bring this thing under control. This is a typical emerging market problem, right, when people start to wonder, like in Argentina, whether they're ever going to be able to get a grip on this snowballing inflation or budgetary problem. And yeah, look, it's a very valid concern, Peter. I don't think it's biting yet, but I think it's something to watch.
There has been a recent paper that actually I've opened right here, and everybody should read it, from the Federal Reserve Bank of St Louis, so it's literally the Federal Reserve branch that is publishing this paper, it's called Fiscal Dominance and the Return of Zero Interest Bank Reserve Requirements. So it covers fiscal dominance, it looks exactly at this snowballing effect. So just to say, Peter, even policymakers are starting to think about this. And there is no easy fix really. You either slow the economy down, you either try to repair your budgets, or you try to say, "Well, look guys, if I am paying interest on that, you are making money, you are receiving this interest. So you should be happy about it in the first place". It's a very difficult thing to communicate, but it is correct.
You could also say, "Why would we tax you and reduce this wealth creation effect? We are just going to try and run this smoother so that we do more deficits, we inject new money into the system, you guys become richer", remember, money printing fiscal deficits, but will the populace get this? How do you communicate this in a smooth manner while everybody starts to wonder about, "Are you going to be able to repay your debt?" So, it's really a communication issue in the first place. We are not there yet, but it's a very valid concern to put through.
Peter McCormack: It does feel like we are walking an economic tightrope at the moment with someone trying to push us off one side and winds coming the other side and rain coming down on us and the rope is wobbling about a bit. I don't like this position. I constantly worry about where am I going to get fucked, who's going to fuck me here?
Macro Alf: Well, look, there is a thing in markets, two mottos that I really like. One that basically says that markets need reasons to go down, they don't need reasons to go up. It's a thing that made me think a lot. It's like, well, in a system where we have still some productivity levels, we are able to generate some levels of structural growth much less than 30 years ago, but somehow we are, the world grows and it's a credit-based system. So, if it doesn't grow fast enough, we'll throw credit at it and make it grow. That's what we did for the last 30 years. Great. And it's a very dangerous system to run because the growth up is linear, right? It's a nice growth trajectory. And as long as you can keep everything under check, it works nicely.
But because we're also repressing the normal release valves, we are not allowing for a recession normally speaking, we hate recessions, we're basically going to the second part of the motto that I like the most from Hyman Minsky that says, "Artificial stability leads to further instability down the road". So the system is created through artificial stability. We try to keep everything in check, we have a fully elastic credit system, we do wealth disparity, we now run into some fiscal dominance problems, maybe even. But in the meantime, as long as everything is kept in check, asset markets go up, asset prices go up, and everybody seems to be relatively happy about it. But you go up via the stairs and you go down via the elevator in such a system, because it's so leveraged and so financially complicated really and the financial architecture is so embedded and leveraged now that obviously the breaking points can be extremely vicious. So, I understand why you say, "Where am I going to get fucked?" because the jump risks in such a system are something to always consider.
Peter McCormack: We should have done this a long time ago, this was brilliant. I understand some things I didn't fully understand before, so I'm very grateful to you for that. Please tell people where to go to follow the work you do.
Macro Alf: If you google The Macro Compass, themacrocompass.com, it's the website of my company. It's a macro investment strategy firm, which basically means I not only blabber about macro and seriously, I try to be as educational as I can and explain all the things in details and follow the economy and follow markets, most importantly try to make it practical. So, I'm an investor in the first place and I try to make it in a way that it can become actionable as well. And if you want to follow my work, it's on themacrocompass.com.
Peter McCormack: Amazing. Listen, thank you for this. I can see us getting you back regularly to discuss these issues, because you explain it so well with so much clarity. So thank you. Danny, anything from you?
Danny Knowles: No, I think that was good.
Peter McCormack: All right, man, well listen, have a great weekend, and yeah, we'll speak to you soon. Hopefully, at some point we can do this in person, but yeah, speak to you soon, my man.
Macro Alf: Thanks, guys, talk soon.
