The Inflation Question

Inflation has been the hot topic recently, and rightfully so. Prices are accelerating everywhere while supply chain woes have sprung up all around the globe. That in tandem with unprecedented fiscal spending and another deluge of Quantitative Easing has inevitably led to the highest levels of inflation since the Great Inflation.

Powell and so many others (myself included) cried that inflation was transitory and merely a product of supply-side issues during the early rise of inflation. Saying that once things normalized inflation would tame itself.

It’s been over a year now and inflation has yet to relinquish.

So was team transitory wrong? Has the Fed unleashed an unstoppable wave of inflation? Can the Fed even combat inflation with their litany of tools? Well, as any economist would say, it depends.

In this installment I will break down various potential causes of inflation, looking at the supply, demand, fiscal and monetary cases for rising inflation.

Supply Side

Supply-side issues have most definitely played a role in Inflation, primarily the earlier spikes in inflation we experienced. The New York Fed keeps an index for supply chain stress, where they measure domestic and global disruptions of supply chains.

The graph below overlays this index with domestic CPI, and it’s quite clear to see that supply chain tightness has moved in step with inflation in the U.S. throughout 2022. Importantly, supply problems appear to be tapering, but inflation continues to surge. Suggesting that the recent wave of inflation may not be supply driven.

Both inflation rates and supply chains are strongly influenced and related to global inflation and supply chain pressures. So by looking abroad we can ascertain if the US is an outlier or not.

The graph below shows the supply chain pressures for both the US and globally. They move together, but global supply chains have been relatively worse for most of the last two years. So if inflation was merely a product of supply factors, Europe, and the rest of the developed world should have relatively equal or higher rates of inflation.

But that isn’t the case. The graph below shows the inflation rates as measured by the CPI in a sample of developed nations. The United States clearly stands out. The Eurozone in particular is experiencing elevated rates of inflation (poor Japan), but not nearly so high as the U.S.. The redline at 2% represents the Federal Reserve’s inflation goal.

There is clearly more to the story of increasing prices than supply chain disruptions, given how unique the American case is.

Fiscal Side

One strong line of evidence that accounts for the differences between the US and the Eurozone is the fiscal response during the lockdowns. Between Trump’s CARES act and Biden’s Rescue Plan, households have found themselves with fiscal largesse to spend freely.

A paper at the Centre of Economic Policy Research found that the US had the second largest fiscal response in the entire world.

Source: Tax Foundation

Given that the US has around a 3% higher inflation rate than Europe, could we chalk up, say roughly 3% of the inflation, on this fiscal profligacy?

Probably not without further investigation. But it’s certainly something to look at. In a stroke of serendipity, some recent work from the San Francisco Fed found that the fiscal response in the US may have been responsible for up to (surprise!) 3% of the recent inflation rise. Or in other words, the approximate gap between Europe and America. So it’s certainly laudable to attribute a sizable portion of the inflation to fiscal spending.

Disposable Income

Another way to look at the impact of these policies is to analyze real disposable income. This measures the amount of spending money Americans have, accounting for inflation.

The graph below shows massive spikes in the amount of excess money Americans had because of stimmy checks and the like. However, that boon quickly turned onerous. Real disposable income, along with real wages which isn’t shown, fell below trend during the first half of 2021 and currently shows no signs of coming around. Those excess money holdings were quickly shed (typically used as spending money early on, then later rounds of stimulus were used to pay down debt), and it appears that the stimulus only had beneficial short-run effects. Inflation is now eating away at the purchasing power of consumers.

Monetary Side

Milton Friedman famously said, ‘inflation is always and everywhere a monetary phenomenon.’ While that adage doesn’t seem to hold up in today’s environment, it all depends on your definition of inflation.

Playing semantics here serves an incredibly important role when regarding policy implications. There is a pertinent difference between price changes that stem from supply and demand movements of goods and a broad based rise in prices stemming from excessive money supply vis a vis money demand.

Supply shortages and changes in demand can be relatively easily remedied by the market. However, monetary inflation is much more pernicious and difficult to snuff out.

Below is a graph of the growth rate of a money supply metric known as Divisia M4. Divisia M4 includes near moneys like Treasury Bills and Commercial Paper, which serve as the medium of exchange in the banking system.

In an effort to boost the economy in lieu of the lockdowns, many loans were guaranteed by programs like the Paycheck Protection Program. These programs spurred lending and increased the money supply in the economy.

This explosion in the money supply seems fit to explain the current bout of inflation, as it generally takes some time for a change in the money supply to manifest itself as a change in the inflation rate.

Even the Eurozone experienced this expeditious growth.

The precipitous collapse in the growth rate that occurred in the (ominously reoccurring) timeframe of the first half of 2021, would suggest that inflation should begin falling (if inflation expectations remain anchored). Of course, how soon remains the million-dollar question.

Demand Side

In regards to monetary policy, one paradigm I view favorably is Nominal GDP Targeting. The goal is to keep NGDP stable on its trend, so let’s apply that framework to today.

Coming back to Q1 of 2021, nominal GDP reached its previous trend, before subsequently beginning to ‘overheat’. Just around that time real GDP began stalling before going negative in Q1 of 2022.

Thus, we can see that excessive demand, stemming from both fiscal and monetary responses is more than likely the primary reason for the more recent surge in inflation. Of course, given the supply constrictions, creating excessive demand probably did not take much. Additionally, those supply constraints are now manifesting themselves in limited real growth. This all implies that the government’s responses to their own lockdowns were rather extravagant.

Ultimately, under the NGDP targeting lens, the Fed is right for raising rates but is rather late to the tapering party.

Takeaways

If it were possible to easily dissect the underlining causes of inflation, monetary policy would become a whole lot easier. That being said, supply chain issues have certainly played a role in the rise in inflation, primarily in its nascent stage. While it does appear that the supply chain disruptions have peeked, the current war in Ukraine casts far too much doubt to be optimistic.

Fiscal and monetary responses to the lockdowns induced a dramatically higher money supply, which has led to nominal GDP rising above its trend. This excessive demand has manifested itself into higher prices, and I believe this dynamic is largely the culprit behind surges in inflation as of late.

Despite this excessive nominal spending, inflation is now taking its toll on the economy like a plague. This is evidenced by falling real incomes and GDP. Likewise, consumer sentiment is at lows not seen since the Great Financial Crisis.

Source: University of Michigan

Various indicators around the world have also been indicating for quite some time now that the global economy is rolling over into recession/slump (albeit inflation is more than likely not the only cause of this global rollover). While those indicators will be the topic of the next installment, suffice it to say that rising inflation and falling growth present quite the quandary for the Fed and the world alike.

With money supply growth plummeting and financial conditions becoming increasingly tight, I expect inflation to subside, and unfortunately growth along with it. Because of that, I also don’t believe the Fed gets very far into rate hikes before they again attempt to ‘save’ a struggling economy.

If only there had been some sort of proverbial canary in the coalmine that the Fed could have used to foresee this conundrum.

Oh right.

An Empirical Investigation in QE

With the school year wrapping up and summer being just around the corner, my spare time to write these blogs has returned.

For this installment, I will present a terse overview of some work from one of my classes. In particular, this post will cover a couple of empirical methods I used to investigate whether Quantitative Easing had any causal effects on long term yields, with the focus on medium to long run effects.

One of the stated goals of QE is the lowering of interest rates. With a low interest rate, businesses can borrow and invest in capital, boosting long term growth. Likewise, consumers can borrow and spend at a higher rate than before, boosting nominal spending. This shift in the aggregate demand curve should help spring the economy out of recession faster than if the economy was left to run its course. So the question remains, does the Federal Reserve have the power to sway interest rates, and more specifically, is QE the tool to do that?

From a bird’s eye view, it doesn’t appear that QE lowered interest rates. It actually seems that QE raised them. Obviously, distinguishing causality from mere correlation is key here.

Relevant event studies in the academic literature have shown rather conclusively that QE did indeed lower long term yields. However, what event studies lack is a wide enough time window to allow for lower yields to manifest themselves into stimulative real economic impacts. The problem being if yields fall one day because of QE, but the next day they bounce back up, businesses and consumers don’t have enough time to take out loans to increase the money supply or boost the economy. Thus, a wider purview is necessary.

Model 1: Dummy Variable Model

My first test to see whether QE had a significant impact on yields was through the construction of a dummy variable model. If the inclusion of the dummy in the model was significant, it would posit evidence that QE significantly altered yields.

I included some controls in the model, and included a lagged term to account for autocorrelation. I also de-trended both the yields so I could account for the long term decline in yields. My model took the form as shown below.

Where my response variable is the de-trended version of either the 30 or 10 year yield. My explanatory variable is the lagged yield. EUD is my control for economic conditions via 3 month Eurodollar Future rates, and QE are my four dummies for each QE period.

I ran a regression for the 30 year, 10 year, and the difference between European rates and American rates. [I will touch on this interest rate differential metric in one moment] Ultimately, All of my results were insignificant and most pointed in the positive direction, contrary to the mainstream view of QE. So, when you account for the long term decline in interest rates QE had an inconclusive impact on yields.

Model 2: Cointegration

My next model was much more rigorous, and stems from a relatively novel method of analyzing interest rate policy. The rationale for this analysis stems from the increasingly interconnected and globalized economy that has emerged since the 1960s. In the developed world, interest rates tend to follow one another, as they are all affected by global economic conditions.

With that in mind, I use German yields as a proxy for the Eurozone because German bonds are typically regarded as the safest and most pristine European asset, so they are the European version of the U.S Treasury bond. We can see there is a disconnect around 2013, which was at the same time of the European Sovereign Debt Crisis, but prior to that they moved in lockstep.

So what?

Well, when we have two time series that move in such a pattern, we can statistically test for what is known as cointegration, formalizing the existence of a long term trend. If we can establish that a long term trend exists for Eurozone and American yields, then we can test for any structural breaks or divergences in the relationship during periods of QE. Because remember, Europe did not engage in QE until 2014. Thus, a divergence could be argued as the result of QE.

If the difference between two trended time series is stationary, then we can say that the two series are cointegrated. I found that the time series above was stationary by performing the Augmented Dickey Fuller Test. Now I can formally test for cointegration.

So my hypothesis goes as such, if QE had a significant impact on domestic yields, then the relationship between U.S and Eurozone yields should have been augmented or temporarily broken.

Here is a zoomed in version of the previous time series. As we can see, the difference between U.S and German yields grew throughout every QE period, meaning U.S yields rose vis a vis Europe, the exact opposite of what we would expect had QE been effective.

To statistically test for cointegration, I performed the Johansson Cointegration Test between German yields, U.S yields, and their exchange rate. My results confirmed that there is a cointegrated relationship between the three. My long run model for the 10 year takes the following form:

Essentially, when U.S interest rates fall, the EUR/USD exchange rate raises, causing the dollar to depreciate. This makes sense intuitively, but isn’t too pertinent to our discussion.

Structural Break

Now that I’ve established this long term relationship, I can test for a structural break and see if any appear during the periods of QE. A break appearing during QE would lend credence to the effectiveness of QE.

To test for this, I take cumulative sums of the recursive residuals to see if the residuals begin to deviate at certain points in time. If I find any parameter instability in my model, then there is probably structural instability in the time series.

The red line crossing outside of the 95% confidence band suggests parameter instability. Looking at the 10 year residuals, we can see that around 2000 and 2012 there appears to be structural instability in the long run relationship between Eurozone and domestic yields. These can more than likely be explained by the recession of 2001 and the early rumblings of the European Sovereign Debt Crisis.

Shifting our attention to the 30 year residuals, structural instability does appear right at the announcement of QE1, and it persists all the way through QE3. This result lends credibility to the claim that QE caused a structural break. However, similar to the 10 year residual plot, the decline of the red line precedes the announcement of QE. So it could very well be that outside influence like the Great Financial Crisis caused this distortion. Alas, its difficult to say definitively.

Conclusions

There is a growing body of research that impugns the idea that QE is the sort of omnipotent policy that has become the rote tool of the Fed. While there is much to be improved upon in my work, my results tentatively suggest that crediting QE to the decline of interest rates is rather inane. Once you account for transatlantic interest rate trends the impact of QE appears not to have any lasting impact on long term yields.

Repo Basics

In this piece I will explain the basics of how repos work, and give a shallow overview of the different repo markets. I hope this overview is broadly informative, as delving into the depths of the financial system is a foreboding challenge without understanding many things that are often brushed over and never explained.

Fundamentals

Repurchase agreements, or colloquially, repo agreements, undergird a large portion of interbank lending and funding that is crucial to the functioning of the modern financial system. Despite being a relatively niche topic, the importance of this form of transaction is paramount for forming a cohesive view of how banks operate.

Formally, repurchase agreements are a ‘sale and repurchase’ of an asset. Someone who requires dollars will sell the collateral and agree to repurchase it on a later date. However, it is much simpler to think of repos as collateralized loans. Where the repo borrower borrows dollars and the repo lender borrows collateral. When a borrower places an asset as collateral (think of a pawn shop where someone in need of money places something of value as collateral for a loan) to protect the lender against default risk, the loan becomes collateralized or securitized. Many of these repo transactions are overnight loans that are securitized (collateralized) by a U.S Treasury. This is illustrated in the abstract below.

Here a U.S Treasury (UST) is transferred from the borrower to the lender, and reserves (dollars) are transferred from the lender to the borrower.

Repo borrowers usually pay haircuts on their collateral, meaning that with a 2% haircut, a $100 UST may only be able to be used in a loan of 98 dollars, this is to cover fluctuations of the collateral’s price. Haircuts vary given the pristineness of collateral (UST vs. junk bond) as well as exogenous financial conditions.

At the end of night, these two parties could continue this deal and roll it over, or unwind it by repaying the loan and giving back the collateral. In the instance where the borrowing party cannot pay back the loan, the lender seizes ownership of the collateral.

Specialness

As an aside, sometimes certain collateral will become highly valuable due to supply and demand interactions and trade at a premium, making repo rates significantly less and often negative. This is called trading ‘special‘. It is formally defined as a repo rate that is distinctly below the General Collateral Repo rate. This happens quite often but is not very intuitive, as it postulates that someone is paying money for someone else to borrow it. A special trading repo can be thought of as a collateral driven repo, where it is the collateral that is being pursued, not necessarily the cash. This quirk fits in nicely with the larger post-GFC global collateral shortage theme, where these pristine assets are highly sought after.

Market Structure

While the commonly referred to ‘Repo Market’ implies there is one broad market, there are quite a few different markets that each are distinct.

Tri-Party Repo

The most observable repo market is the Tri-Party Repo market. This market is quite large, averaging $1.1 trillion dollars daily on average in volume. Here there is a 3rd party that facilitates repo settlement, called clearing banks (Bank of New York Mellon and JP Morgan Chase). They settle the transactions on their own balance sheets take custody over the collateral during the transaction. They also provide various services including daily evaluation of the collateral and daily remargining of the collateral among other things. The lenders in this market do not know the specific collateral that is pledged, which makes rehypothecation somewhat difficult.

The other participants in this market are cash investors and the security dealers. Cash investors are typically money market funds, securities lenders, and mutual funds, though they are much more diverse than the security dealers. These cash investors serve the role of the repo lender, lending cash and receiving collateral.

On the flip side, security dealers are typically large Primary Dealers. These dealers are banks that have permission to trade directly with the New York Fed, and compared to the cash lenders are much more concentrated in number.

Bilateral Repo

The other main type of repo is bilateral repo, where there is no third party involved in the transaction. Within the bilateral repo domain there are the uncleared bilateral repo market, the General Collateral Finance (GCF) repo market, and the Delivery-versus-Payment (DVP) repo market. The Fixed Income Clearing corporation (FICC) is the central counterparty for the GCF and DVP repo markets, and the GCF market additionally has tri-party custodian services. These markets are more opaque than the Tri-Party market, but arguably more important. Uncleared bilateral repos in particular have little to no official data, however there has been attempts to understand how this market functions. I will go over the differences of each of the markets without going into too much detail.

GCF Repo

The GCF Repo market is a blind interdealer market, wherein participants do not know who they are dealing with. Transactions are intermediated by an interdealer broker. This market also has tri-party custodian which offers collateral management services akin to the Bank of New York (BONY) Tri-Party Repo Market. Dealers use this market frequently to finance their inventories (assets being used as collateral), as well as using it for collateral upgrades. For example, they can obtain cash by posting a Mortgage-backed security, then use that cash to obtain a U.S Treasury. Only collateral that can be transferred using Fedwire, a real time settlement system used by the Fed, can be used in this market, which limits collateral to Treasuries, Agencies, and Agency MBS. This market is typically an inter-bank or inter-dealer market, where large dealers will lend cash to smaller dealers. Transaction volumes in this market was reported at $126 billion per day in 2020, making it noticeably smaller than the BONY Tri Party Repo Market.

DVP Bilateral Market

Similar to the GCF Repo Market, this market allows Treasuries and agency collaterals to be used over Fedwire, however unlike the GCF market, this market does not allow use of agency MBSs. This market primarily uses Treasuries as collateral, and repo lenders know the specific type of collateral being pledged, making collateral rehypothecation much more frequent in this market. There is also no tri-party custodian in this market unlike the GCF repo market. This market is much larger than the GCF Repo Market, averaging $1 trillion dollars in volume daily. On net, money market funds are primarily repo lenders in this market while Hedge Funds are overwhelming repo borrowers. However both dealers and banks make up the majority of the market on both sides.

Uncleared Bilateral

There is scant data or information on this market, so I will keep this section short, however this market is still vital to the financial system functioning efficiently. There is no central counterparty in this market nor tri-party intermediary. This market consists of individually negotiated contracts between borrower and lender. Thus trust is typically an important factor in this market as well as the usage of high quality collateral (U.S Treasuries). We do know hedge funds are the most prominent borrowers in this market.

Summary

Below are two figures which do a excellent job visually outlining this web of markets, and I do recommend reading the articles from which they came from as they are both very informative. The figure below shows the differences between the different repo markets.

Office of Financial Research

This figure outlines the web of markets and how they all relate to one another.

Monetary Mechanics

It is insightful to view repo as a form of money, as it supplies a medium of exchange for the financial system. By allowing the short term financing of securities, repo serve as the expedient form of exchange that our credit and market based system depends on. Banks are inherently funding constrained and thus rely on short term funding to meet marginal demand for loans. Repo serves as an incredibly dynamic role in the extension of liquidity in markets and credit to the real economy.

The Shackles of the Free Market

From extremely violent cyclical crashes in the stock market to stagnating wages and economic growth, it’s easy to lambast the free market and question the efficacy of voluntary exchange. Many socialists claim we are in the midst of late-stage capitalism, and that the current struggles we face are merely the harbingers of a radical leap from capitalism to socialism. This is a quixotic fairy tail of course, as many thought the 1930’s were also proof capitalism was a fatally flawed paradigm centered around waste and human greed. On the contrary, claims today from presidents and central bankers lead the public to believe that the economy is thriving, and that we have assuredly escaped the depths of the Great Financial Crisis. Glancing at the data impugns that narrative. The evidence many leftists point to regarding the decay of capitalism shouldn’t be brushed off lightly, merely examined from a different point of view.

The graph (from an excellent article) below maps RGDP per capita from various economic downturns throughout their respective recoveries. It is clear to see that our ostensibly booming economy of the 2010s rivals the illustrious periods like the 1930’s and the late 1800’s.

Despite experiencing the longest bull market in history over the last decade or so, growth was slow and underwhelming. Yet is this the withering of the free market? Has she croaked at last? Or is what we call our economy today something entirely different than capitalism?

If quick and painful liquidations of bad businesses and loans are the modus operandi of the free market, where does the moribund, slow stagnation of an economy stem from? Certainly not from the mistress market, scythe in hand, doing her rounds to better allocate resources. Taking a look at total bankruptcies in the United States it would be impossible to detect the devastating recession that locked the entire country in their homes and brought unemployment to 15%. Surprisingly, (or not) bankruptcies went down during the recession. Clearly, this phenomena is not of the free market’s design.

Total Bankruptcies in the United States

It doesn’t take much perspicacity to realize that calling what we have today a free market is just as much as a pipe dream as late-stage capitalism. The last bastion of the free market was broken quite some time ago as it certainty went gentle into that good night.

While there is a rich and exciting history of the pernicious decay of capitalism in this nation, in this article I wish to focus on the post-GFC environment. I aim to take steps to elucidate the frowsy growth and disinflationary undertow that drags the global economy that has been overwhelmed with pernicious central bank profligacy and financialization.

Eurodollars (offshore US dollars) serve as the global reserve currency, emerging in the 1950s and 60s to solve Triffin’s Dilemma, and ever since the last line of defense was broken in 1971 by Nixon, the financialization of the economy has deformed and bloodied the waters of the free market. One of the worst deformations was the Greenspan Put. In a foolish attempt to keep the economy healthy through wealth effects, interest rates were kept low and the Federal Reserve would backstop a stock market crash by any means necessary, including bail-outs. While Open Market Operations such as QE & the Fed Funds Target are arguably inefficient in lowering interest rates, the Fed’s Open Mouth Operations were more than enough to persuade gamblers to go wild in the casinos of Wall Street. While the Fed is not central by any stretch of the imagination, by acting like they are, through expectations policy, they can manipulate the economy. The ensuing low-interest rates hurt the middle class and traditional savers, forcing them to play in the casinos of Wall Street with their life savings in an attempt to retire happily.

One of the essential hallmarks of capitalism is private property, that one may reap his own profit while equally be held responsible for any losses he occurs. Prices contain valuable information and are signals for investors and consumers alike. By privatizing profits and socializing losses, the playing field has been heavily skewed towards gamblers and against the followers of fundamentals. Much more risk can be taken, leading to procyclical trends. Furthermore, investment projects and businesses can survive with a lower level of marginal efficiency, as cheap credit and lower interest rates allow for the suboptimal endeavors to stay afloat. Research from Japan has shown that these low-interest rates create zombie businesses, dependent on the cheap credit to keep their suboptimal business and investments afloat. Additionally, productivity falls in lieu of a lack of incentives, especially if businesses anticipate the cheapening of credit. Even in America, zombie businesses are in full swing as productivity and real investment in fixed capital have fallen.

This has gone hand in hand with the concentration of businesses via M&A takeovers since the 1970s due to various developments including artificially cheap credit. The rise of big businesses and debt zombies have stunted marginal wages, productivity, and economic growth. Much of these takeovers were found not to be economically beneficial as they destroyed shareholder value, and most were only possible through the prevailing cheap credit and speculative crazed stock market leading up to 2008.

We can empirically view the decay of productivty and investment as resources are used more and more for financial assets

Further distortion of lending occurs through the Federal Reserve’s direct actions. In order to make banks’ balance sheets more liquid, central banks will buy illiquid collateral off of banks for relatively cheap. This in turn hampers market discipline. Additionally, as Kjell Nyborg elucidates, by accepting only certain kinds of collateral, central banks incentivize the use of certain collateral, and the underlying production of those real assets the collateral is tied to. As he puts it, if the central bank only accepts igloo-backed securities, more igloos will be built.

We can also apply Gresham’s Law in this regard, as pristine collateral is hoarded and only used in bilateral repos, while the lowest quality collateral is used with central banks. The increased use of suboptimal collateral incentivizes the real creation of these suboptimal loans, distorting the investment decisions of banks. Meaning that precious balance sheet space will be increasingly used on bad loans. This also plays in tandem with spread compression, forcing banks into suboptimal, risky investments. Both of the factors distort real economic activity towards risky investments, projects that can pragmatically only stay alive because of cheap credit. It is these suboptimal investments that help spawn the creation of the aforementioned debt zombies.

Another pertinent deformation brought about by state intervention and incompetent central banks is the financialization of the economy. Ironically, much of this financialization occurred under the guise of market liberalization during the 80s and 90s. However, the free market at that point had long been abandoned as sound money was a thing of the past. In the graph below the rampant growth and inflation of the financial sector is quite clear when compared to the real economy.

The disconnect between the real economy and the financial economy over time

The authors of that paper claim that this dire discrepancy between the financial and real economy induces capital misallocation, as savings are funneled towards financial assets instead of productive and beneficial investment. This slows economic growth, putting CEOs’ bonuses ahead of higher living standards and cheaper prices.

They further elaborate that both naïve deregulation and regulation itself played a role in the financialization of the economy. For example, the Basel Capital Accords skewed bank lending away from smaller firms and in favor of residential real estate through regulatory risk weights.

The fate of small businesses are directly tied to the fate of the middle class, as roughly half of Americans are employed by small businesses. They serve as the lifeblood of the American economy and the middle class. However, Small and Medium Enterprise (SME) lending has largely fallen off since the GFC. Owing to the beforementioned regulation, spread compression, and balance sheet constraints regarding inherent fragility, SME lending has declined dramatically when compared to big business lending.

The red dotted line represents small business loans while the blue solid line represents big business loans

Furthermore, lending as a whole has not recovered from the GFC, illuminating balance sheet constraints, risk, and excessive debt that the entire system faces.

Commercial & Industrial loans benchmarked at the recession start, the lagging green line indicates a stagnant lending environment since the GFC

Another stab in the gut of small businesses is the centralization of the banking industry. In 1966 there were roughly 24,000 commercial banks in the USA, now there are under 6,000. Research by Professor Richard Werner has shown that small banks tend to loan to small businesses, and vice versa. With the consolidation and rise of these large banks, lending to small businesses has dried up. As these large banks are unable and unwilling to extend loans to smaller businesses. Smaller banks have information advantages in the form of relationships with their community, and thus are much more willing to give out loans to small businesses with that advantage.

The most crucial point in this discussion also comes from Werner in his distinction between productive credit allocation and unproductive credit allocation. Through low-interest rates and the emergence of the wholesale lending system, the global economy has deformed into a debt-based system. Given all this credit creation one would expect that inflation would certainly be higher, and some would postulate that economic growth should be booming. One of the reasons for the lack of inflation in the real economy, as Professor Werner stresses, is the allocation of credit that helps determines inflation and growth.

From The Quantity Theory of Credit
and Some of its Applications by Richard Werner

In the free market, loans would be given out to businesses looking to invest that money in the economy. This expansion of the money supply supports innovation and ensures savings are put to productive use. As the diagram states, the result is growth. As goods and services are created, increasing the standards of living while also increasing productivity. Technological innovation and this competitive creation are deflationary phenomena, so it’s unlikely that excessive levels of inflation will take place. Furthermore, if money demand rises in step with money supply, inflation will not take place.

Conversely, if loans are used for consumption, this causes inflation as excess holdings of money are shed throughout the economy, driving up prices. Money demand falls as money supply rises. While profits increase for the businesses, this is only nominally and temporarily. Productivity nor investment has increased here, and the Austrian Business Cycle Theory will play out with an inevitable bust.

Finally, and most pertinent to today, is the scenario where new credit is spent on financial assets. As I’ve detailed above, it is this scenario that has occurred because of the deformation of capitalism in this nation due to state intervention and eradication of sound money. Much of the money creation in the shadows of the Eurodollar System have gone towards this mode of allocation. Under this framework, we can see just why economic growth, wages, and productivity have all seemingly struggled despite rampant asset inflation and ostensible money printing. Of course, this asset inflation only serves to benefit the already rich, further exacerbating the disparity between Wall Street and Main Street. Over the last 50 years or so, the economy has been increasingly decapitalized and exported offshore. Spurred by cheap credit, financialization, and a central bank backstop, scarce savings have flowed to the benefit of CEO bonuses and asset prices instead of productive and beneficial investment.

One of the biggest problems the global banking system faces is a systemic lack of pristine collateral. This collateral typically takes the form of US T-bills, but also corporate bonds and the like. This in turn causes acute dollar shortages to arise every so often that have real economic impact. It is here where a feedback loop has been plaguing the entire system, not allowing the invisible hand to right the wrongs of the past. Given systemic risk and unprofitable lending conditions, banks pull back their lending and resort to buying safe financial assets. Because of that lack of lending, real economic conditions falter, especially for small businesses. If banks were able to lend efficiently and businesses invested productively instead of gambling through stock buybacks and M&A takeovers, banks would have high-quality collateral to conduct their day-to-day operations and the real economy would improve likewise. The allure of cheap credit and crony capitalism has seduced and corrupted both banks and businesses to gamble in the casinos of Wall Street, leaving the real economy out to starve.

For over a century the free market has been mangled by quixotic intervention to “save the economy”. Gorging the system with the delusion of grandeur that can only be obtained through debt and deficits. Like a drug addict, our crony capitalist system fiends for deficits, cheap debt, and political favors. Yet these are not economic panacea, they are the very malady that rendered our system compromised to begin with.

Transmissions of QE

In this piece I will briefly overview how the Federal Reserve’s Quantitative Easing policy works, and discuss whether these large scale asset purchases are inflationary, helpful, or simply bureaucratic largesse for the political elite.

It is first imperative to understand the notion of a hierarchy of money, and what form money manifests itself as at each level in the hierarchy. When we think about money, we usually refer to the currency and bank deposits, both of which are merely one block of the pyramid.

At the top of this pyramid are bank reserves, and they are distinctly different than money we think about in our every day lives. Reserves, replacing gold since the end of the gold standard, are liabilities to the Federal Reserve and serve as the medium of exchange for banks. Reserves are used to settle interbank transactions. Reserves, for the most part, are simply bank ledger and are not used in the real economy.

The next level are bank deposits, which are liabilities of the commercial banking system and serve predominately as money in the real economy. This along with physical currency, which is a liability of the central bank, is what we typically consider money.

This hierarchy becomes more complex with the introduction of the Eurodollar System and the wholesale financial system. As I’ve written previously, many institutional cash pools cannot hold their vast sums of money as deposits and elect to safeguard their wealth in U.S Treasuries and other forms of high quality, liquid assets. Furthermore, many banks use these safe, liquid assets (preferably U.S T-bills) as a form of funding through repo transactions. This repledging and rehypothecation of collateral is the backbone of credit creation and liquidity in the financial economy. Collateral has its own hierarchy as well, relating to the quality of the collateral, with the collateral multiplier and haircut on the collateral dictating the general magnitude.

Going back to QE, in the most basic sense, the central bank expands both sides of its balance sheet to buy Treasuries from Primary Dealers. For the Primary Dealer this is merely an asset swap, swapping Treasuries for reserves.

The balance sheets of the Fed and Primary Dealer in Step 1 of the basic QE process

These Primary Dealers act as intermediaries and help allocate liquidity needs in the financial economy, so the reserves obtained would then ostensibly be repoed out into the commercial banking system.

The Primary dealer goes into the repo market as a counterparty

Here we can see that the net result is an asset swap, wherein U.S Treasuries were swapped for Reserves. Considering how fungible and integral collateral is to credit creation (money creation) in the financial economy, there has been no meaningful expansion in the money supply in this scenario. If anything, stripping away pristine collateral from the system puts unnecessary strain on the stability of the entire system as the collateral multiplier is forced to increase in order for the banks to stay afloat in their day to day operations.

An important caveat to this non money printing money printing is when the Fed or any central bank buys Treasuries from a non bank entity. Joseph Wang, or commonly known as Fed Guy recently illuminated this distinction. If the original seller of the US Treasury is a non-bank entity, there will be additional bank deposits in the system, in effect increasing the money supply at the real economy level. In the diagram below I will refer to this non-bank entity as Seller.

A stylized abstraction of balance sheets when a non-bank entity sells US Treasuries to the central bank

The blue lines and numbers follow the flow of the U.S Treasury, as it goes from the Seller, to the Primary Dealer, then ultimately the Fed. The orange lines and numbers indicate the opposite side of this transaction, showing the flow of reserves to the Primary Dealer, wherein reserves make their way to the commercial bank and ultimately the Seller’s Bank. The seller bank then makes deposit liability and issues the $100 to the Seller.

The crucial distinction here is that the U.S Treasury does not reside on the balance sheet of the Seller’s Bank, because the non bank does not have an account at the Fed and thus cannot accept reserves, so an additional bank deposit must be made by a bank that does have an account at the Fed. So while the previous example was merely an asset swap, here there is the creation of a bank deposit.

These bank deposits will typically go to pension funds or hedge funds, not commercial businesses or consumers. Meaning that much of this increase in the money supply will not be put towards productive measures like investment, rather simply be spent in the obtainment of different financial assets, like stocks. So while one part of QE does increase the money supply, it only serves to inflate asset prices and increase wealth effects, or more colloquially put, enacting trickle down economics.

In the best case scenario QE can create additional bank deposits in the commercial banking system. However, much to the chagrin of those who claim QE is hyperinflationary, that is only a theoretical possibility. In practice it is very doubtful that QE in this paradigm would achieve the inflationary results that the Fed pertinaciously believes. When QE is conducted through banks, the key result is financial instability through the stretching of the collateral multiplier and extraction of pristine collateral. On the other hand, when bank deposits are created, they mainly benefit Wall Street as asset prices increase, disrupting price signals and further detaching asset prices from real economic factors and conditions. Needless to say, Quantitative Easing is far from the paragon of monetary policy that the Fed imagined it would be.

It is true that a rising tide lifts all boats, and I believe that much of the dismay over inequality is inappropriately placed, or at least misguided. However, it cannot be gainsaid that the financialization and state intervention of the economy has severely hindered prosperous growth, and programs such as QE only serve to raise the height of the dam that keeps the financial economy and elites rising higher and higher. While the real economy and middle class sulk in stagnant water.

Shadow Money & Deflationary Riptide

The Federal Reserve’s balance sheet has ballooned from around 870 billion dollars worth of assets in 2007 to near 8 trillion dollars currently. Despite such a monumental increase, inflation and economic growth have been both dull and underwhelming during that time frame.

It seems a quandary as to why despite rounds and rounds of Quantitative Easing, fiscal stimulus, and various interventions that inflation along with economic growth have remained stubbornly low. Despite exorbitant excess reserves and even Jerome Powell admitting that he “flooded” the system with liquidity, inflation has only recently began to rise up. Even that too is marred with ambiguity as bond yields are falling once again. That alongside various other indications have been pointing to the conclusion that the long overdue inflation the Fed has been adamantly striving for may be transitory, and the recovery short-lived. There is a plethora of angles one could take in order to explain the Fed’s inefficacy, however for the intents of this paper I will focus on the Fed’s favored policy of Quantitative Easing.

Quantitative Easing, simply put, is an asset swap. Wherein assets are exchanged for bank reserves. Assets typically take the form of government bonds but can also include corporate bonds, mortgage-backed securities, and even stocks. This provides banks with liquidity which can be lent out, expanding the money supply while simultaneously lowering interest rates. This expansion of the money supply and lowering of interests rate would, ceteris paribus, be inflationary as investment is spurred and spending is increased as consumers attempt to maintain their current level of cash balances. However believing in this assumption as many central bankers do, is not seeing the forest through the trees. While much focus has been put on the level of reserves and liquidity banks have, very little effort has been allocated to the investigation of the flip side of these large scale asset purchases. There has been much less emphasis and research comparatively on what role collateral plays within the financial system.

It is imperative to understand that collateral, these securities that are extracted through the process of QE play a pertinent and integral role in money creation that underpin the entire financial system. Furthermore, theses assets are heterogenous by nature and have varying degrees of liquidity, desirability, and blank.

For example, the demand for safe, liquid assets has increased greatly over time in part due to the rise of institutional cash pools. These cash pools are centrally managed cash balances of large corporations and institutional investors, including the likes of asset managers and pension funds (Pozsar 2013). Looking at the graph below, it is clear to see the expeditious accrual of these idle dollars.

However research by Zoltan Pozsar has shown, typical M2 quantifiable money does not satisfy the pecuniary demand of the cash pools. That is because these managers do not desire money for its medium of exchange value, rather for its investment purposes. Additionally there are a plethora a legal obstructions that bar these cash pools from holding their money in typical deposits. It logically follows that typical bank reserves do not adequately satisfy money demand. Thus, facing a systemic shortage of safe liquid assets, namely government bonds, the Eurodollar system turned to securitization and collateral intermediation to cope with the excessive demand. Pozsar writes,

“At any given point in time, the volume of maturity transformation conducted outside the traditional banking system is closely related to the shortage of offshore-term, government guaranteed instruments relative to the volume of institutional cash pools.”

The figure below illustrates this observation, showing how financial innovations within the shadow banking system attempted to equilibrate with the excess demand for these near-moneys.

Jeff Snider, head of global investment research at Alhambra Investments, has done extensive research on the Eurodollar System (I strongly recommend his work and podcast with Emil Kalinowski) and comes to similar conclusions in regards to the systemic disinflationary pressures crippling the post 2008 monetary environment. In a recent article he explores these different aggregates of money to elucidate why despite so much alleged money printing and the flood of liquidity that could rival the days of Noah, inflation has yet to stick.

For reference the dark grey region of the graph represents commercial paper, which serves as a proxy for asset backed securities here (ABS). ABSs are a product of securitization and one of the shadow banking system’s methods of creating private alternatives to pristine government-backed collateral. The increase in checkable deposits is dwarfed by the vaporization of these other near-moneys. Just gazing in the shallows of the shadow banking system allows us to see the pecuniary destruction that would lead to deflationary undertow.

These findings are consistent with the body of research that attempts to quantify the size of this global shadow banking system. Various private sector estimates varies from $13 trillion to $60 trillion, however what is for certain is the dramatic decline in size after the Great Financial Crisis. After 2008, this wholesale funding network fragmented and become systemically impaired. The drying up of useful collateral (mortgage-backed securities), constrictive regulation (Dodd-Frank and various balance sheet constraints), and the perversion of the collateral allocation process and interbank trust all played contributing roles in unravelling the Eurodollar System. Thus it is hopefully clear to see 1) that money printing that the Fed has not ameliorated the monetary destruction plaguing the modern monetary environment and 2) it is increasingly non-bank institutions supplying liquidity into financial markets, these non-bank institutions cannot hold bank reserves, instead preferring various near moneys like Treasuries.

I now wish to focus on collateral intermediation for the purpose of illustrating why there is an immense demand for pristine collateral throughout the banking system, and how collateral takes on the role of the medium of exchange when bank reserves cannot.

Collateral intermediation benefits the real economy by facilitating financial transactions and lending. Given a general deficiency of collateral, or even wrong types of collateral, intertemporal coordination becomes distorted as a suboptimal allocation of wholesale funding and consumer savings occurs. This suboptimal allocation may very well result in a general decline in interbank activity and lending as banks cannot put up the sufficient collateral to enable the desired transaction. This accompanied with various other factors help explain the lack of lending and inflationary pressure after 2008.

One of the primary methods of obtaining funding with the shadows of the banking system, or colloquially the Eurodollar System, is through repo agreements. These banks and various financial institutions find funding for their daily operations by posting their collateral to obtain a securitized loan. Typically, collateral rich institutions like pension and investment funds obtain collateralized loans through a money dealer, which usually take the form of a wholesale bank. While on the flip side these institutional cash pools will provide the liquidity to these dealers as they prefer to keep their wealth in the form of safe, liquid assets. These wholesale banks play a vital role in the optimal and efficient allocation of collateral and liquidity dispersion, and its clear to see how any apprehension from these money dealers could impinge the entire monetary system. Jeff Snider, once again, illustrates succinctly what I’m outlining. However, it is important to note that this outline is extremely generalized as the real system is much more intricate and complex. In the figure below, Snider maps out how collateral flows from these pools into the hands of money dealers, wherein collateral can be transformed, rehypothecated, and allocated efficiently. A crucial point here is that money dealers are not completing transactions and balancing their balance sheets on a 1 to 1 basis, rather they are transacting an array of assets against an array of liabilities that needn’t cancel each other immediately.

A critical distinction of the post GFC1 environment is that central banks now also possess silos of collateral. This collateral lay mostly idle in the Federal Reserve’s SOMA portfolio, thus also hampering the efficient allocation of collateral to finance funding and lending.

Now we are beginning to see the forest through the trees, yet there is still much more to unravel. One of the more intriguing elements of this collateral intermediation is the rehypothecation of collateral. While the briefly mentioned securitization is also pertinent to this discussion, its use has largely fallen off compared to collateral based operations after 2008. Where the same piece of collateral, whether it be a treasury bill or a junk bond, is repledged and reused to finance multiple collateralized loans.

I’ll use a simple thought experiment to illustrate this dynamic.

Say a hedge fund desires funding to cover a previous debt or position, so it goes into the repo market and finds a money dealer. The money dealer gives the hedge fund the funding it desires on an overnight loan. This loan is collateralized and allowed to be reused in order to get the cheapest rate possible, meaning the hedge fund gives the money dealer an equivalent amount of collateral (plus a haircut) as “insurance” for the loan. The following day the hedge fund will come back and pay back the loan and take back their collateral, before that however, the money dealer will reuse, or rehypothecate this collateral to another party to obtain funding for a variety of financial operations. So lets say that hedge fund pledged a US Treasury bill, the money dealer takes that T-bill and repledges it to another financial institution. Then that financial institution will repledge that T-bill again to fund their daily operations and so on and so forth.

We can see how there is a “collateral multiplier” in the same vein as the textbook money multiplier effect. This collateral velocity underpins much of the financial system and has real economic effects. Furthermore, the collateral itself is taking on the medium of exchange role within the wholesale interbank lending markets. There are various examples of banks, even whole markets zealously overbidding for treasuries, indicating the intrinsic value they possess in this modern ecosystem.

Quantifying the collateral multiplier allows us to gain invaluable insight into how the shadow banking system is performing. Some research has been done to uncover this collateral multiplier, but this is an incredibly difficult proposition as there is such little data on this. Manmohan Singh’s research found that the total volume of collateral transactions and general volume of collateral both fell substantially after 2008, which is consistent with our previous observations. More modern research places the multiplier between 6 and 8. In the figure below illustrates the collateral multiplier for U.S Treasuries, the most pristine collateral.

Furthermore, independent research of dealer banks confirm these findings. One intriguing line of research is the discovery that local maximums of the collateral multiplier correspond to what Jeff Snider refers to as Eurodollar crises, which are periodic dollar shortages which plague the post 2008 environment. (For further information on these events I once again recommend his work)

What matters here is that Snider’s claim holds under empirical scrutiny, that much of these reflationary sub cycles where reuse increases while total collateral is largely unaltered have to deal with dealer bank’s perceptions of risk and fragility. The next logical question is why, despite this ostensibly healthy collateral chain, excess reserves, and a competent central bank would this system be marred with fragility?

While this collateral intermediation and it’s multiplier effect are invaluable to wholesale funding, it is not without its respective pernicious effects. Going back to our example, lets say perceptions of risk change, (or useful collateral dry’s up like in 2008) . Our hedge fund now needs funding to pay off the debt it accrued from the financial institution. So the hedge fund goes to another money dealer it is acquainted with in attempt to find funding. However due to the increased perception of risk, the dealer bank requires a qualitative increase (a shift from for example a corporate bond to a treasury) or a quantitative increase (simply more collateral) in order for the money dealer to deem the transaction worthwhile given their balance sheets considerations. The hedge fund is not able to cope with this change and is forced to liquidate their assets to pay off their debt or default. This drives the dollar up, exacerbating the issue. While simultaneously, margin calls typically ensue as the financial institution will look to sell the collateral immediately. In the short term the price of the collateral will fall, which may very well lead to more margin calls and more seizure of collateral. This spiraling effect is amplified by the length of the collateral chain, or how many times that collateral had been repledged and reused. Additionally, the hedge fund needn’t have even owned that piece of collateral it lent out, it may have obtained that collateral from a reverse repo agreement. The distinction of ownership becomes very blurred here as increased collateral chains increase the interconnectedness of the financial system, leading to systemic risk of collateral runs and inherent fragility. We can view these perception tendencies through the figure above. As perceptions of risk increase, the volume of lending and repledging decreases, drying up the financial markets and manifesting deflationary effects.

It seems the system is in a catch-22, where by decreasing the interconnectedness and fragility (decreasing velocity) the systems liquidity dries up and leaves wholesale transactions frustrated. This has delirious effects on the real economy (that are admittedly hard to pinpoint)

Now lets bring all of this back to the Fed and QE. How do these large scale asset purchases that the Fed uses affect this wholesale system? When the Fed strips treasuries and other assets from the system, it is stripping away the valuable collateral that underpins the entire system. Furthermore we can logically deduce that banks would be forced to increase the already existing collateral chains to maintain the same level of activity, increasing the fragility and interconnectedness of the system. Recent research from the Federal Reserve itself have begun to analyze this process, a 2020 paper found

“A $33 billion dollar increase in weekly Fed purchases leads to a 0.5 increase in the collateral chain”

Given the Fed’s activity in 2020, that would suggest a 0.66 increase in the collateral multiplier. So the remaining collateral in the system is stretched out 0.66 more times on average just to maintain status quo.

Viewing this from another angle, Jeff Snider has taken the time to analyze data from the Federal Reserve bank of New York on triparty repos. He finds that during reflationary periods, a wider variety of collateral is put up in these repo agreements. While conversely during these Eurodollar crises, or periodic dollar shortages, the opposite generally ensues. This is what we would expect, he states, as economic conditions falter the arrays of collateral being used in repos should condense into safer, more liquid assets.

On the graph above it is clear to see the number of observations (variety of collateral) increases during these reflationary periods, while during Euro$ events they stagnate or fall. Furthermore he points out that the overall increasing trend of observations suggests that the Federal Reserves persistent removal of useful collateral like treasuries and MBSs forces banks to use a wider variety (and more quantitatively) of collateral to maintain their operations.
Taking these remarks to a logical conclusion, the aforementioned Federal Reserve paper sums it up nicely,

These observations combined suggest that the central bank can effectively reduce the interconnectedness of the financial system by reducing the size of its balance sheet.

By selling treasuries, not buying them, can the Fed help extirpate the inherent fragility within the system. This seems counterintuitive, as the primary Keynesian solution for downturns in money injections like QE, and furthermore even in a Monetary Disequilibrium lens an excess demand of money should be offset by an increasing supply of money. Of course that is exactly what is being prescribed. As I’ve mentioned before, money in this topic is heterogenous, in a similar way that Austrians describe capital as heterogenous. So just as the Austrian Business Cycle Theory accentuates mal-investment versus over-investment, the distinction between different types of money is of vital importance. Haphazard money printing measured in aggregates is futile in this regard and simply profligacy. Instead, focusing on the types of money that will satisfy demand is a much more effective tactic. By unwinding the Fed’s balance sheet, and releasing Treasuries into the market, the most pristine form of collateral, the Fed would be directly mitigating the excess demand and fragility of the system brought on by overstrung collateral chains. This solution isn’t of course without unideal side effects, so further analysis of this proposition is warranted.

Furthermore, research has shown that central banks typically have a bias towards illiquid and precarious forms of collateral, as they typically buy up all the unwanted forms. This induces a positive feedback loop as it incentivizes the production of those collateral types, inducing suboptimal intertemporal allocation of savings which will exacerbate business cycles. We can additionally apply Gresham’s Law to collateral in order to further illustrate this concept. Just as Gresham’s ‘good money’ will be used deliberately or trade at a premium, pristine collateral (US Treasuries) will act the same. Banks will save their most pristine collateral for bilateral repos, intermediate collateral for tri-party repos, and their worst collateral for transactions with their central bank. As banks use the pristine collateral sparingly, the increased usage of the ‘bad collateral’ is something we can empirically observe.

In the blue are the pristine forms of collateral, while the green colors indicate the ‘bad’ forms of collateral. We can see how despite the ‘good’ collateral making up a large section of usable assets, only a fraction of that is actually used in collateral based operations. Meanwhile the ‘bad’ collateral is used quite a bit more. This is simply one more angle to view the distinct problem this system has.

An immediate response from a proponent of QE would be that is accomplishes its goal, that it lowers rates to increase lending. So by doing the opposite we would stifle recovery. To the contrary, given what I’ve laid out I would argue that it is the stripping away of collateral and increasing of collateral chains that exacerbates the demand and lowers yields. Not necessarily the Fed’s direct buying. Even New Zealand’s central bank came out and stated they found that a 10% of GDP QE program lowered rates by 50 basis points. This extremely pitiful number lends credence to the claim that it is the negative side effects of QE that lowers yields, not the “stimulating” direct ones. The financial sector is already flocking towards treasuries and other safe, liquid assets, the FED, merely adds insult to injury.

In short, Quantitative Easing has extremely detrimental effects that distort the underpinnings of the entire financial system. That is because bank reserves are only half the story. While dollars serve as a medium of exchange for traditional banking and retail purposes, it is this ever so disregarded collateral that facilitates exchange in the shadows. However, while unwinding the Fed’s balance sheet and supplying more treasuries should help to alleviate short term stress, it does not solve everything, nor does it come close to doing so. Much of the problems stem from the system itself and its fracturing during the Great Financial Crisis. However that is a discussion for another time.

This modern system can be likened to the beach, with periodic reflationary waves surging towards the shoreline, while strong deflationary riptide pressures pull the waves back into the ocean. As we all float upon the sea of liquidity aboard Powell’s Ark, the inflationary waves draw all the attention and headlines. Yet it is the deflationary riptide that warrants concern. The longer this murky undertow goes unnoticed, the further we will all be drawn out to sea.