If you don't know the sucker at the table, it's you
How our financial system works, and why central banks are not central
This is an article that I’ve wanted to write for weeks. I never knew quite how to start, so I didn’t. Thankfully Ben Hunt has given me an opening. Ben, in an interview he gave a month or two ago, brought up the well-known poker analogy; if you’ve been at a table for 30 minutes and you don’t know who the sucker is, it’s you. Ben suggested that although we might not all play poker, most of us have some interest in markets. It would be wise, Ben claimed, to understand the game that’s being played.
Indeed Ben, indeed.
This article is about the financial system, money creation, why central banks aren’t central, and how to not be the sucker at the table.
Core thesis
Central banks do not control the creation or destruction of money
Central banks are not central to our financial system
Central banks are effective when they can prod & coerce people & institutions to act in an ordained way
Central bankers mostly just push wet spaghetti around
Central bankers are the man behind the curtain from the Wizard of Oz. If/when the world wakes up to this fact there will be a great deal of volatility
Here’s a question: who creates money?
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If you answered the Federal Reserve, I’m sorry but you’re going to have to repeat the 4th grade. Commercial banks create money. This system of money creation has an inherent advantage that the gold standard lacks: flexibility. Banks can create more $$$ when demand for money is strong, spurring economic growth. If demand for $$$ is sluggish, banks won’t loan. Alternatively, there may be a lot of money demand but banks still won’t lend for a multitude of reasons. That’s a rabbit hole too deep for the purposes of this article…
Do central banks play any role in creation of money? Well, sort of. They create bank reserves, also commonly referred to as base money. Bank reserves are the collateral that commercial banks use to print new money against (although I believe treasuries can also serve as money creation collateral). The Fed creates bank reserves and uses them to buy treasuries from the Primary Dealers (large commercial banks). When the Fed buys treasuries from a PD (a process you’ve heard of called quantitative easing) they’re hoping to accomplish three things.
Reduce the number of yield generating assets (treasuries) that the primary dealer is holding. Deprived of their precious treasuries, to earn yield the bank is *theoretically* forced to lend into the real economy thus stimulating economic growth
Ensure that banks have plenty of base money to lend against
Reduce interest rates to incentivize borrowing
What the Fed cannot do is force banks to lend into the real economy. For all their bluster, the Fed is powerless to directly create new money. They can stuff bank reserves down the banks throats till they’re puking on excess, but there’s no guarantee that banks will lend. 2010 to 2020 is a pretty good example of central bank impotentence.
From today’s perspective it seems wacky but for the last decade the Fed tried and failed to create inflation. They couldn’t create inflation because they can’t print real money. They can create bank reserves and do hundreds of billions in QE, but if the banks won’t lend there will not be money growth. Most of that QE just stayed in the financial system and propped up asset prices. You could argue that one of the greatest legacies of QE is the unprecedented wealth inequality we’re currently experiencing. Thanks Fed, mission accomplished.
The sucker at the table
The Fed’s number one currency is belief. Expectation policy is the name of the game. It would be inaccurate to say that the Fed is powerless, however, they certainly don’t have the power that most ascribe to them. The central bank of the United States is not the center of the financial system.
So far the Fed has been able to keep the illusion of their omnipotence alive. I am suspicious they’ll be able to keep the fairy tale going indefinitely. At some point people en-masse are going to realize that the emperor isn’t wearing any clothes. If we come to the brink of another financial apocalypse, the Fed may not be able to save us. What happens when the Fed throws everything they’ve got at the market but prices keep collapsing? What happens when the Fed can’t solve a systemic blowup?
According to several smart people I listen to, the 2008 financial crisis ended when the Fed said that banks didn’t have to mark to market all their toxic assets. In other words, banks were still bagholding great gobs of worthless assets but then the rules changed so that they didn’t have to report how much shit was on their balance sheet. Faith restored! Problem, solved?
The suckers and the champs play the game together. The champs know when to take their chips off the table and get the fuck out of the building. The suckers keep playing until the casino’s ceiling collapses and pancakes everyone’s sorry corpse into cherry-colored financial goo.
This article is fairly abstract and I apologize for that. The difficulty is that making it less abstract would mean writing a novella. I may do that one day, but not today. If you have any questions, pushback or ideas, leave a comment below!
Excellent article of yours so far. You mentioned that Fed has failed in effective QE, and most of it stayed in Financial system, so the inflation numbers that we are seeing right now are not coz of QE that fed(or should I say commerical banks :p) has done from the start of covid ? Also would like to know why commerical banks might not lend when there is enough money demand (may be in your next article).
Thanks!