Beware of Fake Financial Experts (a critique of Lyn Alden, Luke Gromen and the like)

There is a sense in the world that 'something' is wrong with the global economy- the rise of populism in numerous countries evidencing the growing discontent of the people. Unfortunately, with this rise in discontent has come a number of monetary 'experts' who attempt to address this sentiment by propagating narratives that are not only extremely ignorant, but dangerous, profiting themselves as they take advantage of the emotions of the people.

For example, Raoul Pal runs a financial platform called 'Real Vision' in which he continuously states that advanced economies are trapped by high debt levels (which he claims will require high inflation / financial repression to escape) and that people only have 5-6 years to make as much money as possible before the monetary system collapses. He uses this fear mongering as a tool to herd people into crypto assets and to subscribe to his $4,000-7,000 yearly subscription.

Lyn Alden and Luke Gromen propagate similar narratives with similar objectives. Perhaps even more damaging is the fact that these commentators use these narratives to sow distrust in our governments. For example, Lyn said recently that the wars / conflicts in the world have been deliberately used by the United States as a scapegoat for inflation, so that the country's debt may be inflated away without the people blaming government officials.

It is thus extremely important to illustrate the flaws in the narratives propagated by these commentators.

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Let's start with a quote on Lyn's website, as this quote forms the cornerstone of many fallacious beliefs. She writes, "If the government borrows too much from its people, it competes with and replaces a lot of investment they could otherwise do... the lenders could have put it in the bank and now that bank has more lending power."

The idea she puts forth sounds intuitive; unfortunately, it is completely incorrect. As strange as it sounds, banks actually do not "lend out" your money. They literally create money out of thin air. This is one of the most important things to understand about how the monetary system works, and it is something that (respectfully) people like Lyn Alden still fail to appreciate even though it was recognized by economists a century ago. For example, Keynes wrote in 1939 that "increased investment will always be accompanied by increased saving, but it can never be preceded by it." In other words, savings does not 'finance' investment: deposits do not create loans. On contrary, investment causes savings, and loans create deposits.

I'll get into more detail regarding these phenomena in future posts. The crucial thing to recognize for now is that central banks have an interest rate target. Because the Federal Reserve targets an interest rate (the overnight interbank rate), it must supply reserves should reserves become too scarce. Banks are thus never reserve constrained, contrary to Lyn's claim that "banks can also be constrained by reserve requirements, meaning that banks are required to have a certain percentage of deposits stored as cash reserves."

For example, imagine your bank issues a million dollars in loans (creating deposits). This is all well and good as long as those deposits (your "money") stays in your bank. However, it is very likely that you will take some of this money and pay someone who is a customer of a different bank. Your bank must now transfer your money, using "reserves" to do so.

If your bank does not have sufficient reserves, it will need to go into the "wholesale" money market to borrow reserves from banks that have an excess supply. Crucially, when reserves in the banking system become too low, the central bank must supply additional reserves in order to hit its desired interest rate target. If it did not, the rate to borrow reserves would go above its target.

Central banks are thus in an entirely defensive position to the activities of commercial banks. It is for this reason that the banking system doesn't need your money: banks simply issue loans when they want to and search for reserves weeks after the fact if they need them for clearing. As such, banks do not have more lending power when their reserves are higher- this is why Quantitative Easing was always doomed to fail. The banking system is never constrained in its ability to finance investment, and for technical reasons (balance sheet space, collateral, etc.) increased reserves can actually restrict bank lending activity (indeed, in the QE era, many banks have been trying to get reserves off their balance sheets).

There is simply no fixed "supply" of funds, as someone like Lyn imagines. Believing so is completely ignorant of the fact that we have a credit based monetary system, with "money" ebbing and flowing with the demand for loans and the willingness of banks to provide them. Higher levels of government debt thus does not "drain" money that could have otherwise been "supplied" for lending. Mainstream commentary simply gets the causation completely backwards: the demand for investment causes an increases in the money supply, with savings being the residual of loans that have not yet been repaid.

Interestingly, you can find quotes from Federal Reserve branches acknowledging this decades ago- e.g., the Federal Reserve Bank of Chicago wrote in 1994 that "the actual process of money creation takes place primarily in banks... of course, they do not really pay out loans from the money they receive as deposits. If they did this, no additional money would be created."

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Lyn, Raoul Pal and the like often refer to Quantitative Easing as "money printing", claiming there to be inflationary consequences. For example, Lyn writes (with respect to QE) "based on history and math, the inflationary side of the argument is eventually correct." These commentators in particular cite the need for Quantitative Easing to "monetize" government debt, claiming that high debt combined with a lack of demand from the private sector will lead to high inflation, as the Fed 'needs' to step in to buy the debt itself.

These fears are again rooted in a complete lack of understanding of monetary operations. I know this sounds strange, but the US government actually never needs to issue debt (treasuries). Additionally, in a strict sense, when the government issues treasuries, it actually does not increase the amount of debt outstanding.

This all sounds weird and unbelievable, so let's unpack what I mean.

The government only has one way of spending- crediting bank accounts. It is very important to appreciate this, as commentators often get confused with 'how' the government spends (i.e., how this spending is 'financed'). But spending is a standalone act: the government spends and this results in bank reserves and "new money" for the non-government sector. Whether the government chooses to issue bonds afterwards is a completely separate act and has no bearing on the inflationary impulse of government spending.

The spending 'finances' itself: the government simply marks up account numbers. It spends as easily as you type "+100" on your computer: you do not "need" anything to do so, and the government doesn't need anything to credit bank accounts.

A corollary is that there is no need for the government to increase taxes to "pay" for government spending. Future generations thus do not "pay" for the "excesses" of the present period. This was something that was acknowledged as far back as 1945 by former New York Fed Chair Beardsley Rumsl, who gave a speech titled "Taxes for Revenue are Obsolete." Taxes simply function to decrease the spending power of the private sector. They lower "aggregate demand", thereby reducing inflationary pressure. In short, think of taxes as simply deleting money, not redistributing it.

Okay, so if the government doesn't need revenue from the private sector to spend, then why does it issue bonds at all?

Historically, the Federal Reserve did not pay interest on reserves. As such, the government needed to utilize bonds to drain reserves in order to hit the interest rate target. Without issuing bonds, the overnight interest rate would have been driven to zero, as excess reserves remained in the banking system. The issuance of bonds was thus simply to support interest rates: it was not to "borrow" money from the private sector.

In the current regime, the Fed does pay interest on reserves, meaning there is now a natural floor to overnight rates. Treasuries are thus no longer needed to buoy the rates market. Strictly speaking, this means there is now no need for the government to ever issue bonds. So what is the modern day function of sovereign bonds?

Large institutions (pension funds, corporate cash pools, etc.) use sovereign debt as a safe place to store their money (banks have insurance limits, while treasuries are insured by the government, making them a safer place for large cash pools). Furthermore, government debt is vitally important for "lubricating" the pipes of the financial system. This is something that is often extremely misunderstood, even by people who claim to be "financial plumbing" experts (e.g., Michael Howell). Post-GFC, there is practically no "unsecured" lending anymore. Thus, if you are a financial institution and you want to borrow cash, you must post government debt as collateral to do so. One further wrinkle is that reserves must stay within the banking system, while collateral can flow between banks and non-bank financial institutions. Collateral is thus critical for the functioning of the "shadow banking system".

Interestingly- given the mainstream narrative of "excessive debt" - we have actually had a persistent shortage of sovereign debt post-GFC. There are a variety of metrics to proxy this (see my banking crisis post), but the key takeaway is that the issuance of debt is a public good- it is a service that our government provides. If we are worried about there being "too much debt" then advanced economies can simply stop issuing debt. This would in no way affect the ability of governments to spend or affect inflation.

All the narratives surrounding excessive debt and the "need" for inflation / higher taxes / financial repression simply stem from ignorance regarding these operations. For example, picture the "dreaded scenario" where foreigners no longer want to buy US debt. Most pundits assume this would result in higher interest rates or inflation as the Fed has to step in to "monetize" our debt (the Fed would buy the debt itself).

Putting aside how ridiculous this worry is during a period in which the yield curve has been inverted for the longest time in history (evidencing an extremely high appetite for US debt), let's assume that for some reason people stopped wanting to buy US debt. What would be the result?

The US could simply stop issuing treasuries, as I mentioned before, or the Fed could buy treasuries itself. Would this 'monetization' be inflationary? No! Funds would simply shift from the "savings" account at the Fed to the "checking" account- from treasuries to reserves. This would be akin to moving cash from your left pocket to your right pocket. Your spending power would not change one bit; likewise, moving funds from treasuries to reserves has absolutely no impact on the net worth of the private sector, and thus no effect on inflation.

Furthermore, because our monetary system is built upon safe "collateral", there is actually an argument to be made that "monetization" of debt is deflationary. For example, when bonds are held by financial institutions, they are used and reused for funding- i.e., $100 in debt can be leveraged for a multiple of that in spending power. On the other hand, when bonds are held by central banks they are "siloed" and inert- they do not move around the financial system and are not leveraged. In this case, the $100 in bonds is simply $100. *This concept is a bit technical and I will save the details for a future post. The main takeaway for now is that there is no inflationary pressure stemming from the Federal Reserve buying government debt.

Lastly, both cash and treasuries are debts of the United States: they are both "IOUs". As such, issuing treasuries actually does not increase the debt of the US. It simply changes the form that these IOUs take. Historically, this change was from an interest bearing IOU (treasuries) to non-interest bearing (reserves). However, because the Fed now pays interest on reserves, the distinction between the two is increasingly moot.

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This post has focused mostly on the function of government debt and money creation. Going forward, I will go into greater depth regarding inflation / economic growth / liquidity and other macroeconomic topics. Doing so- while outlining the perspectives of mainstream commentators- will add light to my claim that 'only a handful of people in the world understand the monetary system'.

This is not meant to be hubristic or snarky; rather, properly understanding these issues is crucially important to improving the well-being of people across the globe. As such, it is simply not a time or place for niceties. The primary goal going forward will not simply be to educate, but also to illustrate how these contrarian insights can be used to improve the efficacy of one's investments.