Modern Money – Part III: 1984
by Menachem Sahler (@UraniumFarmer)
In part 1, I described the basics of how money comes to exist as a result of commercial loans being originated by banks.
In part 2, I explained why the USD is not a fiat currency, and when an economic contraction is likely to happen.
In this last part, part 3, I will explain what would happen if major economies decide to stop issuing loans in USD and using the USD in general, and I will discuss some qualitative ideas about my expectations for how money responds to various scenarios
- U.S. dollars are in large part originated from non-U.S.-domiciled banks, as some banks can issue loans that aren’t denominated in their national currency, but in dollars.
- With some exceptions, borrowers don’t usually have much demand for other forieng currencies aside from USD.
- If governments of major economies discourage or bar their banks from issuing USD loans, the effect on the strength of the USD would be positive, until those loans matured, as they would lower the supply of the USD.
- It’s not as important how much currency is being created through loans, as it is important what the money is used for. If people hoard cash, this has the effect of making it more difficult for borrowers to service their obligations and strengthening the currency.
- Seemingly small changes in the regulatory regimes, which control lending, may have outsized impacts on the inflationary or deflationary trajectory of an economy.
- Non-bank loans, like corporate bonds and government debt, do not contribute to money supply.
- If total debt increases relative to commercial bank debt, the currency can strengthen dramatically as many debt claims are creating demand for the same limited supply of money.
- The biggest inflationary driver has been the reflexive relationship between the real estate markets and money supply.
- The risk that the real estate markets go into reverse in a major way for the first time since 2008 seems alarmingly high to me.
- Some debt payments were paused when there was a legal moratorium on foreclosures, evictions, and so forth. This doesn’t directly add to money supply, but it has the effect of diminishing the extinguishment of current money supply that would have otherwise occurred if loan payments were being made normally.
Turning an understanding of the credit creation structure of the monetary system into useful, guiding principles is difficult. It’s all an interconnected web made up of millions of different loans, each with their own origination dates, maturity/payment schedules, interest rates, and dynamic collateral values. And if that wasn’t enough, consider how many different currencies there are being continuously traded back and forth. But it gets even crazier when you consider that banks can even issue loans that aren’t denominated in their own national currency! In fact, U.S. dollars are in large part originated from non-U.S.-domiciled banks. Those foreign issued USD are what are referred to as “Euro-Dollars”, although they are neither segregated nor distinguishable from USD created by U.S. domiciled banks (if you have a eurodollar in your bank account, it can be converted into a physical dollar bill with some fee/effort).
For the most part, loans are either issued in a country’s native currency or dollars, but not other foreign currencies. For example, a loan issued in Mexico will almost always be denominated in either Mexican pesos or U.S. dollars, but not in Turkish lira or Israeli shekel. With some exceptions, borrowers don’t usually have much demand for other forieng currencies aside from USD.
On that note, there is much talk of countries rejecting use of the US dollar. It is seen as an unfairly imposed hegemony, even though it is obviously at least partially self-imposed. If governments of major economies discourage or bar their domestic commercial banks from issuing USD denominated loans, the net effect on relative dollar strength would ironically be upward until those loans matured, as they would cut the global dollar issuance of new supply they were contributing.
If this picture seems very chaotic, well that’s because it really is. No wonder there’s so many polarized opinions floating around financial media. If there was a globally unified ledger that cataloged every single loan involved in credit creation, it might be possible to get a really good handle on when money in a specific currency denomination might become scarce. We could look for periods where a large portion of loans simultaneously approach maturity and expect that without a sudden impulse of credit creation, that currency would strengthen significantly. But no such reference exists. Instead, each banking regulator runs their own accounting systems; some “talk” to each other and many do not. While banks interact over the global SWIFT system to execute transactions, they aren’t individually sharing their internal accounting records.
If there was a period where lots of similar loans were issued in a given currency, they would collectively cause deflationary pressure at some later point in time as they mature together. The currency denominating those loans might inexplicably have a period of great secular strength relative to other currencies and/or to goods/services domestically, and perhaps globally as well. What is effectively happening is that those loan holders are simultaneously competing to extract that limited pool of currency from the global system, in order to service their debt payments.
Another set of considerations have to do with what the money created by loans is being used for. Demographics play a part in this, as do social norms. If people tend to hold some currency as cash, this has the effect of making it more difficult for borrowers to service their obligations and strengthening the currency.
It could be argued that extremely low rates for sovereign bonds might actually have the counterintuitive effect of being deflationary for the simple reason that those holding cash won’t bother putting the cash in a yielding asset. I myself don’t bother putting my emergency cash in a short term CD or a short dated bond because the return is so low that it’s not worth my effort and the added friction to use.
Likewise, seemingly small changes in the regulatory regimes, which control lending, may have outsized impacts on the inflationary or deflationary trajectory of an economy. If a rule is imposed by a central bank on commercial banks which inhibits or disincentivizes them from lending, this can reduce credit expansion and tighten money supply. Conversely, if there is some economic condition that induces loan activity, for example a sustained housing boom or a technological revolution, there might ensue a prolonged period of elevated inflation (assuming the banks have the risk appetite to accommodate).
Among the topics Richard Werner points out in his monetary study is the secular trend of banking practice on a national level. He conjectures that Germany has somewhat overcome powerful deflationary backdrops by having a system of numerous small regional banks throughout the country which excel at originating commercial loans. Conversely, in the U.S. there has been a powerful multi-decade trend towards consolidating ever larger banks. These large banks make proportionally far fewer loans that support economic activity. They are much more focused on investment banking and large customers than originating individual commercial loans; they would often rather trade a mortgage than issue one to begin with. While USD/eurodollars are an especially complicated case because of the foriegn eurodollar loans, the general secular effect that I would expect is for currencies with weakening loan issuance to strengthen relative to those operating in countries with strong economic growth and better demographic profiles.
Non-bank loans do not contribute to money supply. This category includes things like corporate bonds or government debt, which are among the largest global asset classes. While they share the semantics of “debt” and “loan”, they are different in how they impact balance sheets. When a government or a corporation auctions bonds in order to raise cash, they are effectively trading their debt for the public’s cash. They create the debt instrument, not the cash, whereas commercial bank debt creates both debt and cash, as described in Part I.
In this way, corporate and government debts create an excess demand for dollars, just like commercial bank debt, needed to service the bond coupon or interest portion of the debt, but they do not create money when issued and do not extinguish it when repaid. If total debt increases relative to commercial bank debt, the currency can strengthen dramatically as many debt claims are creating demand for the same limited supply of money.
The really major impact that governments have on the monetary system is to impose regulations on lenders. For example, after the Great Financial Crisis, lending standards [along with sentiment for both counterparties] changed in dramatic ways that inhibited credit creation relative to the accelerated rate in the preceding years. It is possible that the eurodollar crises which have been boiling over periodically since the GFC are in part the result of inhibiting new loan issuance.
At the onset of the Covid pandemic in the West, the global economy plunged into an artificial recession and economic uncertainty soared off the charts. As markets collapsed violently, the central banks sprang into action, deploying dozens of monetary intervention schemes, most of which were developed during and subsequent to the Great Financial Crisis. Despite the interventions, market volatility not only didn’t abate, but got worse and worse, with the largest indices swinging up and down on a daily basis by percentages that rival many annual moves. Today, it seems like most every financial commentator has already forgotten how impotent the central bank efforts were during those weeks in 2020.
Behind the scenes, I think much more significant things were happening in the monetary system that had nothing to do with governments. Companies around the world maintain credit facilities set up with commercial banks, which are intended to service their short to medium term cash requirements. When the global economy shut down, and so many companies had no visibility of what would happen to their revenues in the indefinite lockdown environment, they drew down those credit revolvers en masse to try to survive tomorrow. I believe that this action was a big part of the upward asset price trajectory we’ve seen since then. Calling on all those lines of credit around the world at roughly the same time probably created a massive synchronized impulse of new money creation.
The question is now, what happens to all that money that was created in early 2020 through corporate credit lines being drawn on. I’d speculate that much of the money was not used since governments stepped in to directly subsidize both consumer demand and corporate expenses. As explained previously, money that sits idly by as interest accrued is deflationary because it does not contribute to the growth of global collateral supply. Regardless of how the money was used, such lines of credit typically have payment schedules from 1 to 5 years, usually on the shorter side of the range. If a credit taken in 2020 must be repaid in 3 years, the inflationary impulse would have already dried up by now; it would currently impose a significant deflationary drag on money supply as the interest would amount to ≈25% of the principal amount (assuming around 8% interest).
Another major event that now gets almost zero attention is how some debt payments were paused when there was a legal moratorium on foreclosures, evictions, and so forth. While this doesn’t directly add to money supply, like credit creation does, it has the effect of diminishing the extinguishment of current money supply that would have otherwise occurred if loan payments were being made normally on schedule. It basically deferred some of the reduction in money supply that happens as debt is repaid. This dynamic freed up money to be spent elsewhere in the economy as for many, their bills coming due was tomorrow’s problem. Well, tomorrow has turned into today and yesterday’s deferred debt payments are now doubly deflationary.
Finally, what is perhaps the biggest inflationary driver has been the reflexive relationship between the real estate markets and money supply. Real estate is the largest pool of collateral, by far, so when its value rises, the capacity for increasing commercial bank debt does too. A frenzy of home sales, new mortgages, and refinancings, with assessments and sales prices rising much faster than in prior years has likely contributed greatly to inflationary money supply. Furthermore, home loans tend to be among the longest duration loans that people take, meaning that the inflationary effect of the money created lasts much longer and the deflationary impact might not happen for 10 or 20 years, by which time the home is often already under a new, larger loan post sale or refinance. Conversely, it’s interesting to note that the U.S. markets are nearing a point where the prior real estate boom in ~2005-2008 would put any of the home loans still existing from that era at an age that they pose a deflationary drag on supply. However, U.S. home loans from that era are somewhat less common now as the length of time between homeowners either selling/moving or refinancing has seen secular decline.
The combination of rapidly rising home prices and rising mortgage rates is a scary combination that has the potential to really choke off a lot of the money supply growth. If homes become too expensive, buyers cannot afford the upfront down payment, even if they would otherwise be able to afford the loan payments. Likewise, if rates rise too far, they cannot afford the loan payments either. The risk that the real estate markets go into reverse in a major way for the first time since 2008 seems alarmingly high to me. If home values fall, and recent home buyers find the value of their homes to be less than the amount they still owe on their mortgages, they may become trapped. The Chinese economy is exhibiting some clues as to what might happen if the credit impulse slows as real estate markets stutter – in particular discretionary spending/investments could face headwinds.
In this final part, I discussed some of my qualitative ideas about my expectations for how money responds to various scenarios. However, I also want to make clear that I haven’t done the research required to put these closing ideas to the test, rather they are just the result of some basic logic or mental experiments that follow from my understanding of the credit creation nature of money.
The biggest reason why I haven’t done the research to solidify any stance below is that it would be A LOT of work to try to dig up that information and I suspect that it would result in a low confidence anyway, so it’s just not worth the time I could be spending on other tasks that have more utility. This means that you as the reader can decide for yourself what is likely significant and correct and what doesn’t sound right. If you do have data or insight on some topics, feel free to reach out as I’d love to hear any ideas you’re willing to share.
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