January 14, 2021 Personal Wealth Rational Reminder Podcast Episode 132: Cullen Roche: Understanding the Modern Monetary System Cullen Roche founded Orcam Financial Group in 2012 to help investors obtain better access to personalized and reasonably priced financial help. Cullen’s primary areas of expertise include global macro portfolio construction, quantitative risk management, monetary economics, financial accounting and behavioral finance. He worked at Merrill Lynch Global Wealth Management where he worked on a team overseeing $500MM+ in assets under management. Upon leaving Merrill Lynch, Cullen managed a private investment partnership which took advantage of accounting irregularities ahead of major corporate events. After running the fund Cullen transitioned to institutional consulting where he worked with large institutions and traders to help analyze the macroeconomic impacts of Quantitative Easing and the way these new unusual policies would impact flow of funds, the banking sector and macroeconomic accounts. In addition to the weekly musings on his website Pragmatic Capitalism, he is the author of the popular book Pragmatic Capitalism: What Every Investor Needs to Know About Money and Finance as well as Understanding the Modern Monetary System, one of the top 10 all-time most downloaded research papers on the SSRN academic research network. He is also the author of the popular white paper Understanding Modern Portfolio Construction. Watch this conversation on the Rational Reminder YouTube channel Subscribe to the Rational Reminder podcast With so many moving parts, it’s difficult to develop a clear view of the US monetary system. Today we speak with Pragmatic Capitalism author and Founder of Orcam Financial Group Cullen Roche, leveraging his expertise to build a comprehensive understanding of the monetary system. We open our interview with Cullen by asking him the deceptively simple question, “what is money?” We then explore where money comes from, the role of the central bank in securing our money supply, and why poor capitalization restrains banks. After discussing where the value of money derives from, Cullen shares his insights on how decentralized digital currencies are challenged by their lack of flexibility and credit options. We talk more about the role of central banks before diving into quantitative easing; what it is, why it’s used, and how interest rates impact its usage. Following this, Cullen unpacks whether quantitative easing leads to asset inflation along with the influence that stimulus policies have on inflation. Reflecting on the relationship between the Federal Reserve and US Treasury, Cullen shows why the US government is in no danger of becoming insolvent. We touch on the dollar’s purchasing power, Cullen’s view that time really is money, the role of gold in your portfolio, and why Cullen is such a big proponent of global investing. We wrap up our informative discussion by asking Cullen how he defines success in his life. Tune in to benefit from Cullen’s clever and concise explanation of our modern economic system. Key Points From This Episode: Introducing today’s episode featuring Cullen Roche. [0:00:15] We open our interview with Cullen asking the question, “What is money?” [0:03:50] Exploring where money comes from and the role of banks in ensuring money supply. [0:06:14] The factors that constrain a bank’s lending ability. [0:09:26] Cullen unpacks where the value of money comes from. [0:12:36] Economic constraints posed by decentralized digital currencies. [0:15:08] What central banks are and why they’re such good ideas. [0:20:46] Cullen explains what bank reserves are. [0:25:00] How quantitative easing tries to stimulate the economy. [0:25:45] Why quantitative easing isn’t the same as printing money. [0:30:01] Cullen evaluates the success of quantitative easing as a policy tool. [0:33:19] Whether quantitative easing leads to asset inflation. [0:33:57] The impact that stimulus policies have on inflation. [0:39:38] The relationship between the US Federal Reserve and Treasury. [0:43:04] Why the US government will most likely never go insolvent. [0:47:44] Why low inflation trumps high inflation and how increasing government debt might or might not harm future generations. [0:51:17] Why the dollar’s purchasing power doesn’t reflect the reality of our modern standards of living. [0:55:26] Hear about Cullen’s view that time really is money. [0:59:14] How Cullen sees gold as a hedge against the dollar’s decreasing purchasing power. [1:00:41] Cullen explains why he’s such a big proponent of global investing. [1:05:04] There’s more to life than money; Cullen defines success in his own life. [1:06:48] Read The Transcript: To start with a question that seems basic, but when you dig into it, it’s really not. What is money? Boy. I wish there was a really clean answer. The word money is actually a really messy word. In traditional economics, money is basically any real financial asset or even a real asset that has three basic principles. It’s a store of value, it’s a unit of account, and it’s a medium of exchange. Those are all… In a lot of ways, I find that definition to be more confusing than anything, because those three properties conflict in a lot of ways. I prefer to think of money primarily as a medium of exchange. It is anything that will be widely accepted to buy goods and services from other people in the real economy. In a technologically advanced economy, like the one that most of us exist in, the thing that has the most moneyness, so if you think of money as being on a scale of moneyness, the way I like to think of it, some things have a lot of moneyness and other things have less moneyness. Some things have more moneyness in certain environments than other things, but in your everyday activities, the thing that acts as money or has the highest degree of being accepted as a medium of exchange is bank deposits. Those are the things that we all transfer inside of the private sector as money every single day. You could argue that gold has a certain level of moneyness in that, there are people who will accept gold as a medium of exchange. Gold is a bad form of money generally, because obviously it’s just hard to transport. People generally don’t want to accept gold because it’s more difficult to convert. You can’t walk into a Walmart and use gold to buy goods and services. The most basic, I think the cleanest definition of money is that money is whatever the dominant medium of exchange is within an economy. In today’s economy, that thing is bank deposits and the banking system is the centerpiece of the entire payment system and the way that most of us transact in a modern economy. Where does this money come from? Well, bank deposits come mainly from the expansion of bank balance sheets and the predominant way it happens is through loan creation. When you look at the financial accounting of a loan, it is very simple, basically, that a bank expands its balance sheet, essentially from nothing, it has to have regulatory capital, and there are requirements that limit how much money a bank can create. But in essence, the entire financial system is something that is created from thin air, everything, whether it’s stocks or bonds or bank deposits, and it’s all supported by some sort of real resource or demand for goods and services. That’s what supports the whole thing. But the money that most of us use, the bank deposits, they’re created by loans, loans create deposits, and so when a bank expands their balance sheet, what they’re doing is, they’re creating a deposit for the borrower. The bank has a liability, the deposit, the bank has an asset, the loan, and the borrower has an asset, the deposit, and a liability, the loan. The balance sheet just expands and I don’t want to use crazy weird words but, the economist term for this is endogenous. That, essentially, the money supply grows endogenously from within the banking system, essentially from… theoretically, in general, there will be some supporting resources that help establish this loan that collateralize that loan, but the bank is creating, it’s expanding its balance sheet from nothing. Loans create deposits and when loans are repaid, repayment of a loan destroys deposits, so the balance sheet can grow but it can also contract endogenously. The money supply predominantly is a function of how much are banks willing to lend to people to go buy either, frivolous nonsense on their credit card or the predominant way, or I would argue that the main way that loans and deposits ultimately support the real economy is through the ultimate investment into real goods and services. People will borrow to innovate, people borrow to build homes and all of these things, ultimately… There’s nothing good or bad inherently about debt or the assets and liabilities that they create, but those assets and liabilities can be used to produce things. When they produce things, theoretically, in the long run, our net worth should increase because the value of the assets should remain valuable or increasing over time, even though we might have more liabilities over time, but our assets should increase in value more over time than our liabilities that we’ve created in the past. Ultimately when that happens, the economy and the financial system becomes really supported by the net worth of the underlying real resources that we create through the borrowing process. Can you talk a little bit more about the constraint that a bank would have on lending? Well, typically the real constraint is from a regulatory perspective in that, a lot of us that go through like econ classes are taught that banks are constrained by the amount of reserves that they have, that there’s some sort of money multiplier. This is true to some extent, because reserves make up the asset base of a part of a bank’s balance sheet. But really, I think this puts the cart before the horse, because the reserve system is something that a central bank uses to support its domestic banking system. If there’s a regulatory requirement that healthy banks are not able to meet, the central bank will supply the reserves necessary. It’s improper to think of reserves as being the true constraint on a healthy banking system, because if a bank is healthy and the bank can’t meet some reserve requirement or something like that, the central bank is going to provide those reserves. We saw this actually late last year, there was a lot of concerns about the banking system with a run on the repo market, and really that was just predominantly a shortage of reserves in the financial system, where a lot of the big banks weren’t lending their reserves to other banks. That’s one of the kickers here, is that banks never lend their reserves. They can’t lend their reserves outside of the non-banking system. They can lend them to other banks, but they can’t lend them outside of the banking system. There’s no transmission mechanism by which the central bank creates reserves, and then these reserves somehow go and multiply out into the non-bank financial system. It’s better to think of lending as being constrained really by, is the bank healthy? Is it well capitalized? Are they making prudent loans? Because, ultimately that’s the thing that will constrain banking is, if a bank is profitable and well-run, and they have good reliable borrowers, if they’re well capitalized, there’s nothing constraining them from making just huge, almost endless amounts of loans to people who are going to repay those loans. Banks become constrained when they are poorly capitalized. In a period like 2006, 2007, banks make lots of bad loans to strippers and people who can’t purchase homes and can’t afford all the things that they’re buying, and ultimately, they become poorly capitalized when the asset values decline. That’s what constrains a bank’s ability to lend. But it’s not really, I think, proper to say that the quantity of reserves constrains loans, because if a bank is healthy, the central bank is virtually obligated to provide them with the loans because they created a rule that the banks have to adhere to. A healthy bank is going to get the reserve that it needs if the central bank deems that it is a healthy bank. It puts the cart before the horse to say that reserves constrain loans. What gives money value? I mean, this is another one of those big, big subjective arguments in economics, but I would argue that, I mean, the main thing that gives money value is ultimately whether or not there are goods and services in the economy that people really want. Is there demand for the money, ultimately, because there is demand for the goods and services that exist in an economy? I would argue also that, that’s the core. That’s really the core piece of what gives money value is really what is supporting it, what is the real resource base that’s backing it, but there are other things. I mean, there are important institutional arrangements. For instance, in any developed economy, we have very advanced developed financial systems, very complex technologically based payment systems that they make things very, very convenient for basically using these predominant forms of money within the banking system. Institutions help because institutions basically, they help establish a form of money as being reliable, being something that is not just convenient but also, you have a pretty high level of certainty when you’re using US dollars or Canadian dollars or whatever it is that within that banking system, you trust that money. The money is something that you know that if somebody spent some money fraudulently on your credit card, you know that pretty much you can call your bank and say, “Hey, look, this is fraudulent. You guys got to make this right.” You’re happy to use that form of money because it’s somewhat trustworthy, but also because the government matters a lot. How good are the rules and the regulations that support this? How well does the government actually manage a lot of these institutions and the payment system that exists around all this stuff so that it’s reliable? In a way it’s like public roads. We like to use our own cars. The roads are actually a lot like a banking system and that all the cars that are on the road aren’t made by the government, they’re made by private institutions, but we all travel on this system of highways and roads that are predominantly maintained by the public sector, but we trust those roads because they’re well-regulated, they’re, well, at least fairly well maintained and usable and reliable. The payment system is pretty similar to that. That’s really interesting. It sounds like one of the ways that you’re saying we can attribute value to money is through centralization basically, which makes me think of another question, which is, what do you think about decentralize all of these digital currencies that are popping up? Well, just so much of it is about trust. So much of it is about creating a network effect, a reliable, trustworthy network effect. The interesting thing, I mean, centralized monies like the dollar… Centralization has a lot of benefits. It’s good to have rules and regulations. Going back to the road analogy, there are people who are very, very bad drivers. It benefits all of us to have a certain level of rules and regulation. Obviously, a lot of this stuff could be mismanaged. You could make terrible rules, you could make rules that incentivize bad behavior. Even in the instance of governments, you can argue that the governments can do things that, if the government started creating so many cars on the road, they could make all the roads dysfunctional. You can have bad outcomes from centralized monies, but in general, I think the impetus for centralized monies and governments in general, I think people want a certain degree of goodness to come from public purpose. I think that money that we create and the financial system we create generally adheres to those rules. There’s certainly situations where it can go very bad. There’s certainly plenty to criticize, but in general, centralization works pretty well because you’re supporting all of this by institutions that are to some degree trustworthy and supported by all of us, especially in democratized economies. There’s a certain degree of oversight that I think we all trust to some level and there’s plenty of things to criticize, but it’s worked pretty well over time. With decentralized monies, the really hard part with decentralized monies is, first of all, how decentralized are these things? Because this is the thing that I really struggle with, with a lot of the things like Bitcoin, people argue that they are real forms of money, but ultimately you need two things for a very reliable form of decentralized money. You need a credit system, basically. You need some entity that can basically create these things through credit because ultimately, that’s one of the things. People think that having some static money supply is a good thing when in fact, you want the money supply to be flexible to some degree, you want it to be able to expand and contract as people’s needs grow and contract, and you need a certain degree of credit. I mean, credit grew out of economies because, with population growth and just basic economic growth and more demand for things over time, people want more credit. You need more money in essence, because if you don’t have enough money around then you’re constraining your economy unnecessarily. Because, for instance, if an innovator wants to go out and create a cure for COVID and they just can’t get money, because all the rich people have it or something, you’re holding back your economy in a totally unnecessary way that it constrains it. Credit grew out of that because people realized, basically rich people realized, they could lend some of their money, give that innovator some money and you can have your cake basically and eat it too. It’s one of these things where, with decentralized money, you need a credit based system, which necessarily needs a counterparty, which makes you wonder, “Well, wait a minute, that means some centralized entity has to back the other side of that borrowing so how decentralized is that?” But more importantly, you need stable money. That’s been one of the big things because with lending, it’s very, very difficult to run a payment system and a credit-based system if you don’t have a stable coin. A lot of entities are trying to do this with stable coins in the… and I’ve actually worked with a few that have failed because it’s just, you need such massive economies of scale to create stability inside of a payment system that a lot of people take it for granted, but the fact that you can get $1 every single day reliably, and you just know that that value is stable, people don’t realize it but that is a very, very difficult thing to do. You need, ultimately, some centralized entity with such incredibly huge economies of scale that that sort of stability is very, very hard to replicate. Banks, try to do it with money market funds all the time. They fail. Every time a big panic happens, they need generally a central bank to come in and help create the stability. A lot of these entities are trying to do it with cryptocurrencies and I think finding out that, ultimately, you basically ended up having to pay to something else that’s more reliable. It just so happens that in the modern economy, the dollar is the top of the hierarchy. It’s not only because it’s supported by the biggest income generating entities in the world, but because it’s supported by ultimately the biggest underlying economy in the world and so it’s… I don’t know, I’m very, very open-minded about the idea of decentralized monies, but I have a feeling that the more and more this stuff develops, that as especially as credit systems expand out of this, that they become looking more and more like centralized entities to some degree. This leads me to a very basic question. I just think it’s worth getting your answer. What is a central bank and why does it make sense for a country to have one? Well, the most basic answer is that a central bank is a big clearing house. For instance, the best way to understand what the Fed is, is to really look back at what used to exist, what still does exist actually to some degree is central clearing houses. Before we had the Federal Reserve, banks would basically, they would go to what was called the New York Clearing House. We had a whole bunch of national bank or state based banks in the United States and these guys would all at the end of the day, because the economy was growing so large, you had a lot of this necessity to settle, basically, interbank payments. JP Morgan let’s say would bank in New York and Bank of America was doing some business in New Jersey, at the end of the day, their bankers would go to the New York Clearing House and they would settle up all their payments. These private clearing houses actually work really, really well. The New York Clearing House is still a thing. These private clearing houses work great 99% of the time. What we found in periods like the late 1800s and the early 1900s, that basically when you’d have a financial panic, so let’s say the bankers make a bunch of bad loans like they did in 2006, 2007, what happens is that, in 2008 when JP Morgan and Bank of America go to the clearing house and they meet to settle those payments, there’s going to be 1% of the time where they don’t trust each other, and when they don’t trust each other, they won’t settle anyone’s payments. If all of us bank at JP Morgan and Bank of America, the whole economy grinds to a halt. Not because I did something bad, Cameron didn’t have to do anything bad, Ben didn’t have to do anything bad, but if Bank of America and JP Morgan don’t trust each other, they won’t even settle our payments between each other if we bank at different banks. What that does is it basically turns a garden variety financial panic into a depression. This is what happened in the late 1800s a bunch of times, it happened in 1907. Ultimately, what happened was the federal government came in and basically said, “Look, we could come in and we could create a central clearing house where even in the worst periods, we will come in and using basically the powers of the federal government, we can leverage all of our big institutions and our tax base and everything, and we’re going to support that payment system, even when the private banks don’t trust each other.” 2008 was actually a great example of a time where they did that and it worked perfectly. 2008 was bad, but it would have been if the Fed had let basically the private banks manage all of those interbank payments, it would have been so much worse than it ended up being. That’s the thing, is that, a lot of people think of central banks as these money printing quantitative easing type entities when in reality, the predominant role of a central bank is that right now, the minute we’re talking, they’re settling thousands of payments between just regular people, and they’re helping all of this liquidity just move through the financial system in a seamless manner that we all take for granted and doesn’t really become a problem until you see periods like 2008. But, they’re the machine that is helping to clear things in a very, very efficient way. You could argue, we don’t need central banks 99% of the time, but that 1% of the time that we do is really, really, really important. That’s the primary role of a central bank, is to be just a big public clearing house that through thick and thin, good times and bad, they’re reliably leveraging basically, public resources to make sure that the banking system doesn’t cause a bunch of problems in the real economy Is all that clearing happening with bank reserves? Yeah. The best way to think of reserves is that, reserves are the money… There’s two banking systems in the United States, for instance, or in any central banking system. There is a banking system for the banks, and then there’s a banking system for the rest of us. Banks issue deposits and we use their deposits to settle all of our payments. Banks use the reserve system and the Fed issues all of the reserves and the banks use reserves to settle all of their payments at the end of the day between each other. There’s a two-tier banking system where the banking system for the banks is settled through reserves and the banking system for the rest of us has settled through deposit. Okay. That makes sense. That clearing service that the central bank provides makes a ton of sense, I think that’s pretty intuitive. What’s the Fed trying to accomplish when they engage in quantitative easing? Well, so now we start getting more theoretical into what can the central bank do to impact the real economy through changing things like interest rates or even the supply of those reserves. Because there are all sorts of theoretical and real knock-on effects from all this stuff that the central bank, ultimately, has absolute control of the overnight rate. One of the things that, I think, a lot of people, a lot of economists get wrong is that, when you look at interest rates, overnight interest rates, a lot of people think that low interest rates are some manipulated low number. The reality is that, when the central bank supplies reserves to the banking system, banks can’t lend those reserves outside of the banking system. Reserves, if they don’t earn an interest rate, if there’s no interest on reserves, the banks don’t want to hold these things. They’re just a 0% earning cash drag on the bank. So, if a bank has more reserves than it’s required to hold, it’ll try to lend those reserves to a bank that needs it. What this does in the aggregate, because banks in the aggregate can’t lend out their reserves, it’s like a hot potato, it drives interest rates to zero. You could argue that, basically, any environment where the Fed isn’t pushing interest rates up, the natural rate of interest rates is for it to fall to 0%. Anytime you see an interest rate that is over 0%, that means that the Fed has pushed that interest rate up, somehow. It’s either pulling reserves out of the system or it’s… basically, what they do now is they pay interest on reserves, they incentive banks to hold onto their reserves so that they’re not incentivized to lend them out to other banks. Anytime you see a positive interest rate, it basically means that the central bank has essentially manipulated interest rates higher than where they otherwise would be. With QE and some of these big policies, what they’re trying to do is, they’re trying to impact either interest rates or more theoretical is ideas like the wealth effect of the portfolio rebalancing position where, when the Fed implements QE, what they’re doing is they’re creating reserves. Let’s just use it a really simple example where I sell a T-bond. I hold a, let’s say a 2% yielding treasury bond and I sell it to the central bank because they implement QE. Let’s say, I want liquidity. I need cash right now. I’d rather hold deposits, the central bank creates reserves, uses a bank to create deposits as an intermediary. I get deposits from my bank, I sell my treasury bond to the bank, who on-sells it to the Federal Reserve, and the Federal Reserve essentially takes that treasury bond out of circulation. You could argue now that I have a 0% yielding, super safe asset that is essentially issued by or backed by the government in essence, so I have a lower interest yielding asset, and you could argue that, I might, at some point, have a demand for the income that I’ve lost. I might need to go out and maybe I’ll finance some real investment or I might go out and buy stocks and bonds with it. There’s a lot of arguments over how much all of this stuff is impacting asset inflation and things like that, but that’s the goal of what they’re trying to do. They’re trying to, with a fairly limited tool set, they’re trying to impact interest rates to create all these other knock-on effects that will hopefully stimulate… What they’re really trying to do, they’re really trying to stimulate real investment. They’re trying to get people to go out and build homes and build companies and build factories and do the things that really support the underlying economy and help create a multiplier effect that makes all of this viable in the long run. Is it fair to call QE printing money? I always say that what QE is very similar to is, it’s like basically creating a checking account and swapping it for a savings account, and so when I sold that treasury bond, I had something previously that was 2% yielding that was very similar to a savings account. It was a super safe, pretty liquid 2% yielding savings account. When I sold that thing, I swapped it for a 0% yielding checking account, and so you get into that definition of, what is money again. Was the treasury bond money? Was it money-like? Do I have something with greater moneyness now? Technically, but my net worth didn’t change. Did my propensity to spend change? Probably not. My net worth hasn’t changed. In fact, my income went down. Private sector incomes went down because of QE. I’ve argued that QE it’s in a vacuum, QE is probably a bit dis-inflationary, meaning that it will likely cause inflation over time, the rate of positive inflation to go down a little bit because, basically the government is taking interest income out of the private sector. This is ignoring all the other things that are going on, but I mean, on its own, the Fed just implementing QE outside of the theoretical aspect of a portfolio rebalancing effect or something like that at the basic accounting level, all they’ve done is they’ve taken one super safe asset they’ve swapped it for another, but they’ve taken my income away. And so, do I have more money? Do I have less money? I probably in the long run, I have less money because I’m earning lower interest. I don’t like the term money printing as it pertains to QE, because I just think it’s sloppy in the way that it ignores from the fact that no one’s balance sheet necessarily expanded because of this. In fact, I think the big thing that people miss with QE is that, when the Fed implements QE, they take that treasury bond, they take it out of the private sector. The Fed doesn’t go buy groceries at Walmart and they’re not competing for goods and services so yeah, the Fed has a great big balance sheet but that balance sheet, it might as well be a bunch of bones buried in the backyard. It exists on paper, it doesn’t exist in the real economy. When you look at it from just the private sector perspective, they’ve changed the composition of what we own, but they haven’t necessarily given us more stuff. That’s the kicker with whether you want to call something money printing. A bank loan is more akin to money printing because a bank exists in the private sector, they compete for goods and services and when they’ve created a loan, they’ve expanded the aggregate private sector balance sheet. QE doesn’t necessarily do that. Maybe it does it if you argue that there’s asset inflation, things like that, but at a very base operational level, there’s nothing that is really akin to dumping cash on the street. What about empirically. Has QE been successful as a policy tool? Well, I’ve argued that QE is… Again, the central bank is a bank for banks and their primary job and their primary transmission mechanism is to help banks. They want the payment system to work. They want the clearing houses to function properly every day. When you look back at 2008, 2009, the payment system worked really beautifully. Once the Fed implemented all their big programs and got things supported and all, the banking system worked really, really well. In a sense, QE and all of the Fed’s programs work great because they help bankers, they help banks stay healthy. Does it help the non-bank financial system and the rest of us? Not to the degree that I think a lot of people probably expect, or even theoretically model and mainstream macro. I would argue that, the much more important entity when it comes to the idea of what we would think of as money printing is, what is the Treasury doing? What is the government doing outside of the Fed to help real people? Because that’s where they can make a big difference and that’s where they can expand their balance sheet in a way that, regardless of what the Fed is doing, when the Treasury spends and expands their balance sheet, they’re expanding their balance sheet in a manner that is much more akin to money printing than what the Fed typically does. That’s where the government can help the non-bank financial system in a really big way or the non-banking sector, I should say, in the private sector. They can help primarily through treasury actions and things like with the stimulus that was just passed today, the $600 checks and things like that, that’s money that’s really going to people, and the Treasury is expanding their balance sheet. They’re getting money to people that really need it. QE programs, they don’t have that direct impact on households and the non-banking sector in a way that is broadly beneficial. That was my main criticism of the Fed’s programs in 2008 was that, the financial crisis in 2008 was a household credit crisis. They did lots of things that helped the banking sector. They made banks really healthy, but they didn’t necessarily get to the root of the problem, which was households. We touched on this a bit, but does QE result in asset inflation? I don’t know. Here’s the thing, I get in this argument with people all the time because obviously, if you pull up a chart of the Fed’s balance sheet and the US stock market, or almost any stock market, there’s at least some correlation over long periods of time. I am not an efficient market hypothesis believer, but I do believe that markets are at least efficient enough that they are prone to identify some empirical evidence to justify why people are bidding up asset prices over long periods of time. If you look at places like, for instance, Europe, let’s take a bunch of out of sample examples of QE. In Europe, asset prices were really flat or pretty low throughout all of the post 2010 period. The European Central Bank was doing QE up the wazoo this whole time, and you didn’t have a lot of asset inflation. I mean, you could even cherry pick certain economies, I mean the Greek stock market, total disaster, despite the ECBs huge balance sheet expansion and things like that. Japan was really similar throughout different periods. I mean, you can find evidence where QE doesn’t really seem to have caused a lot of asset inflation and a lot of it is just so theoretical. I would argue that, even in the case of the United States, you’ve had a real underlying, empirical reason for assets to increase, and that’s mainly the fact that all of the big government programs have benefited corporations in a huge way, which has increased corporate profits. For instance, right now, I was arguing earlier this year that the stimulus was going to be a huge boon to corporate profits in the next few years, because ultimately most of the money that they’ve spent, it ends up going to corporations in the end. When you see increasingly, we’re going to have record corporate profits in the United States probably all of next year because of the government’s big spending programs, because most of this money will end up in corporate coffers. When personal savings rates decline next year, which they very likely will, all that money goes right to corporations, and so all of this government spending, ultimately, it trickles basically down to corporations. Do the high valuations and do the booming stock prices make sense? I would argue they do. It’s not just like there was no underlying rationale for all of this. I think the thing that is misleading about it is that, people will argue that money printing just leads to asset inflation and that this is an irrational bubble that has to explode over time. When you look at the empirical facts and you look at the government policies in totality, well, there was QE, but… I mean, for instance this year, the US government has spent, what? We’re going to run a $3 trillion deficit this year, huge numbers. That money is going to corporations in the long run. Whether or not you want to call that money printing or not, the corporate profits are increasing and stock valuations are increasing concurrently. Is it good in the long run? I don’t know, but there’s at least an underlying empirical reason for the asset price inflation that we’ve seen, that isn’t just some fake Fed driven bubble. What about from the inflation perspective when we talked about the treasury printing money with the stimulus, is that a concern? One of the most, I think, disconcerting things about my evolution and education of macroeconomics is that I’ve learned that, nobody knows what the hell causes inflation, which is crazy because there’s lots of theories about it and the general theory that more money chases more goods. We’ve discovered over time that it’s a lot more complex than that. The money supply has increased by any measure is really significantly in the last year or the last 10 years, and especially by any traditional sort of measure. But we haven’t had really high inflation, which was surprising to a lot of people, and I think that what we’re finding out is that a lot of these other things matter a lot more than people believe. Technology trends matter, the demographic trends matter a lot. You have all these big other secular trends that are occurring that make this a lot harder to analyze, then this generalization that more money will chase more goods and therefore you’ll get inflation. My simple answer to what’s going on now is that, in 2008, a lot of people thought that this was going to be hyper-inflationary, that the Fed’s policies were going to cause high inflation, and the big difference between now and then is that, like you said, the Treasury is doing more. That’s the big kicker, is that we just passed a $900 billion stimulus package. That package is bigger than the entire stimulus package that was passed in the financial crisis period and people were arguing that this wasn’t big enough. We’re talking about $900 billion and throwing out these huge numbers like they don’t matter anymore, or at least as it pertains to the Cares Act earlier this year, that thing was over $2 trillion. These are huge, huge numbers. I don’t pretend to know what causes inflation, because I know it’s just so much more complex than anyone and any textbook makes it seem, but I think that the risk management side of me being an investment manager and whatnot, it does make me… When I see these huge numbers, I don’t think that we’re on the verge of a 1970s type of environment where you’re going to have double digit inflation, but boy, I mean, with the political winds changing the way they are and the huge amount of fiscal stimulus and the likelihood that this is going to be the policy approach going forward, will it create inflation? God, I’d be shocked if it doesn’t at least by 2022 get us back to where we were in 2019 on inflation terms and possibly, three, four, 5% inflation. That’s the risk manager in me just saying, “Hey, the common sense of this tells me that there’s a lot of upside risk here,” or at least I shouldn’t say a lot of upside risk, there is upside risk versus the alternative where, are we going to continue to have this perpetual Japanification of the developed economies that leads to just 0% inflation? I think we’re trying really hard to create inflation, and I think that the government is getting better at it for better or worse. Can you talk about the relationship between the Fed and the Treasury, and is the Fed funding the government by buying government debt? I always say, so the Treasury is the entity that enacts fiscal policy, they implement the government spending in essence, and they fund that now by issuing treasury bonds. The central bank is like I said, basically just a big clearing house. They’re the bank for banks. They make sure that the banks keep working and that the inner bank system is working well, so they’re really the head regulatory system and the clearing house for the banks and making sure that the liquidity is always there and that the banking system is always operating well. They are two very different entities and I don’t love the idea of saying that the Fed is funding. A lot of people like to say that the Fed is monetizing the debt. Technically, you could argue that quantitative easing does transform debt, what is technically debt into something that has greater moneyness, that looks more like a bank deposit or that is a bank deposit. But the problem with that is that… Let’s use a really simple example here. Let’s say the Treasury decided to just fund its spending without bonds, let’s say they decided that instead of funding their spending through bond issuance, they decided to just issue cash. The Treasury in the United States makes cash. If we had a law change and they just created cash and when they wanted to spend, they just literally mailed people dollar bills, would you then say that if the Fed implemented QE and they took some of those dollars and then swap them for other dollars, would you say that the Fed financed the Treasury spending? I mean, I wouldn’t because the assets are so similar that it’s negligible, whether or not you needed this other entity to fund your spending. The Treasury has a printing press, so the real cost of their funding is ultimately the rate of inflation. I think that that is the cost of government financing, basically. When you say that the government needs to finance their spending, what you’re really looking at is you’re looking at, what is the cost, the real cost of issuing new money? If the Treasury goes out and they dump $100 trillion on the street, what’s very likely to happen? It’s pretty likely that, that would cause an increase in the rate of inflation. That ultimately is the price that the government pays to finance their spending, because inflation constrains government spending in a very real way. They have to be able to be cognizant of how much inflation is created by their policies. If you had a very high rate of inflation, let’s say 100%, just to be crazy, you could argue that the government is essentially defaulting in a sense, in that, they will necessarily become constrained in their spending because the rate of inflation constrains their spending. The demand for government money has collapsed relative to real goods and resources in that sort of an environment, and so the demand to fund the government spending in that environment has declined. But in today’s environment, when you look at what the Fed is doing with inflation still very low, if the Fed wasn’t doing what they’re doing now, would the rate of inflation be higher? I don’t think so, really. Does it matter that they’re issuing reserves to technically buy treasury bonds and what looks like they’re funding the government? I don’t like the term debt monetization because of that. I think it implies that the Treasury needs the Fed to be able to issue the things that they’re issuing, and I think it’s empirically wrong to argue that the Treasury needs the Federal Reserve to be able to sell their treasury bonds because the demand is there from other entities. You see that in the rate of inflation, in essence, that the rate of inflation is so low that you know there is very, very high demand for government money because the inflation evidence proves it. Whether they fund through bonds or cash or whatever, if the rate of inflation is low, it means that the demand for money is high and that means that the funding sources for government spending are abundant. Whether or not the Fed was doing QE or not, I think that the broader rate of inflation proves that there is more than enough demand for all of the issuance of the money that’s being created at this point in time. Should we be worried about the US government becoming insolvent? Well, insolvent in the sense that, will the money printer break? This is one of those things that… Governments don’t go insolvent household, because the government is essentially… they’re the biggest aggregated sector in the whole economy. They have the highest income stream in the whole economy, basically by definition and so, they have funding sources that are just unlike any other entity. Because they can expand their balance sheet at will basically, they’re not subject to all of the regulatory requirements that the rest of us are basically. Who’s going to deem them insolvent? If the US government created a bunch of money that people, let’s say, just didn’t want to hold or that for some reason, let’s say, they couldn’t or didn’t choose to repay their loan, no one’s going to take that the bankruptcy court or something, no one sues… The federal government doesn’t find itself guilty of defaulting on a loan or something. Again, they’re not going to run out of money because they create the safest money. They create the money that is backed by the largest income stream. Even in a hyper-inflationary environment, there is at least still some demand for government money. But what you see is that, in a very high inflationary environment, the government becomes essentially defaulting on itself through the real rate of inflation and that’s, I think, the thing that a lot of people confuse is that they look at the government, which is a big aggregated sector and they say, “Oh, well, the government has to repay its loans,” or, “The government might go bankrupt.” This is like saying, will the corporate sector repay all of its loans or will the corporate sector go bankrupt? The corporate sector is a big aggregated sector. It doesn’t go insolvent. It doesn’t repay its loans. In fact, over time, just like the aggregated household sector or the aggregated government sector, its loans will expand. Basically, the chart will always look like this over the long-term because corporations are always… there’s more of them, population growth in the household sector means more people, more borrowing, more loans, more deposits, so the money supply always increases over time. I think the same basic thing is true of the government and that at least the nominal amount of government debt will very likely increase over any very long period time because the government is servicing more people, becoming more complex and more intertwined in a lot of the different facets of our ever-changing lives. That means that there’s going to be some growth in the government over the long-term. I don’t know what the right amount of government is or whether the government now is too big or too small or whatever. I’m not really the judge and jury of that, but over any very, very long period at a time, we should expect that the aggregated balance sheets of any sector, we would hope that they will grow. Whether it’s the corporate sector or the household sector or the government sector, you should expect to see some growth in the balance sheets of those entities, just because of basic economic trends over time and the demand increases that will result from just the growth of the population and the growth of the economy over time. If I understood that correctly, the main constraint on government borrowing is the potential for inflation, which is currently low. Is that accurate? I would say that’s exactly right, that the government funds its spending at the cost of inflation, basically. When inflation is very low, it’s arguably evidence that the government has more flexibility with their balance sheet, and when inflation is rising and high, that this constraints government spending. The government needs to be more cognizant of its policies and its spending policies, potentially creating a higher or very high rate of inflation, which people I think to some degree take for granted the fact that inflation is so low. There’s plenty of problems in the economy today. There’s inequality and low growth is worrisome in that maybe we’re not investing enough and you’re doing the things that make the economy healthier in the long run, but a low rate of inflation and a low rate of growth is way, way better than a crazy high inflation. Because a crazy high inflation, it ruins the whole economy. Whereas in an economy like we have today, there are pockets of it that are bad. There are people that are certainly worse off than others, but in aggregate, the economy is doing pretty well over very long periods of time. Whereas a high inflation, it doesn’t just default the government, it defaults the entire domestic economy in real terms, and it ruins the economy for an entire lifetime. Can you talk about how increasing government debt might impact future generations, which is something we hear all the time? Well, people have this tendency to, I think, talk about debt in either good or bad terms. One of the things that is, I think, helpful about looking at all of this from a balance sheet perspective is that, well, debt is just one side of the balance sheet, basically. On the other side of the balance sheet, there’s assets and liabilities. Yeah, when we create debt, we technically create liabilities, but we also create assets. I think the thing that is somewhat lazy about using the term debt the way that we oftentimes do is that, well, what really matters is not just the fact that we created more assets and we created more liabilities, but what did we do with those assets and liabilities? If I go out and I take out a loan and let’s say that I build some world changing technology in factories, and I create thousands of jobs through all this borrowing and the value of my assets explodes over time versus the cost of my liabilities, my net worth explodes also, and so does the net worth of the private sector and the living standards of our society expand. Was my borrowing bad or was it good? It depends. I think, looking at the balance sheets doesn’t really tell us whether or not all of this is good or bad or what the multiplier effect of it was. It’s so much more complex than that. I think it’s just lazy to look at just the liability side and cherry pick one side of the balance sheet and say, ‘Well, we have more debt therefore it’s bad.” I think that’s particularly easy to do with the government, because people I think just, they have a tendency to pretty much always argue that the government is bad or an inefficient spender, which I don’t know, maybe is a pretty safe generalization, but it’s not always and everywhere true. I mean, for instance, the US government has created lots of amazing technologies or at least help to fund and expand a lot of pretty world changing or at least US changing technologies. Is it safe to argue that the government could have a tendency to be incentivized, to spend badly? It’s probably a safe generalization, but it doesn’t necessarily mean that government debt is always in everywhere bad. We talked earlier about money and moneyness and dollars being the thing with the highest moneyness on that spectrum of moneyness. One of the things that we hear now and then is that since the Fed was established in 1913, the purchasing power of dollars has just fallen to the floor. Do you think the Fiat system is destroying our purchasing power? Well, it’s true that the whole financial system is something that we just created it from thin air. This whole financial system that we have today, it’s this weird technology-based thing that we just created from nothing. Yeah, in a world where resources really are scarce, it’s not surprising that there will be a certain level of inflation over time. But, just because, I mean, you see this during COVID where anyone who’s tried to buy, God, virtually anything in the last year has probably run into some supply constraints. There’s obviously no supply constraint on the amount of money that the US government is willing to create at the same time. Is it surprising over time that there is some level of inflation? No. But does this necessarily mean that our living standards are going down? That’s the kicker, if our living standards are increasing and our wages are increasing, well, sure there’s 2% or 3% inflation every year. But if my wages are going up by 2% or 3% every year, and we’re creating all this stuff in the world that is making our lives better off, well, sure, that’s just the price of having created this really convenient technology that we call money. It’s not necessarily bad in that, there hasn’t been like a 90% decline in our living standards since 1913. I think by any objective measure, if you looked at our living standards since 1913, they have exploded. I often talk about how the Bureau of Labor Statistics in the US does this wonderful study, where they show the percentage of household expenditures that are spent on necessities. They use a really simple but useful, I think, definition of necessities as basically food, apparel and housing. As a percentage of our expenditures over time, we spend something like 25% less now on necessities than we did in 1913, which means that we have all this money to spend on other stuff and this is even though housing has gotten a lot more expensive. We have all of the necessities to the point where, actually now, when you talk to the people, you’ll find that when they refer to necessities they’ll say, “Well, but what about college degrees or healthcare?” I’m like, “Well, a hundred years ago, do you know how many people had college degrees or good health care?” Virtually no one, those were luxury goods back a hundred years ago. But today, our living standards have increased so much that now we’re starting to include all of these other things under the definition of necessity where, sure, they might be necessities in today’s environment, but you are objectively better off despite the terrible, horrific money printing of the government over that period. It’s just, I guess, it’s to some degree it’s a subjective argument about, are we better or worse off with our financial system? I would say, yeah, money has been a brilliant, brilliant technology, arguably the most world changing technology that we’ve ever created. Sure, there’s risks to it. If we had a really high inflation, it would make our living standards collapse, but that hasn’t happened and certainly not the United States in the last 100 years. Can you just quickly talk… In your paper, you talk about the ultimate form of wealth being time, can you just briefly touch on the idea that money allows for innovation, which creates more time? Ultimately, when it comes to money, what does money really do for us? Well, money, it won’t necessarily make you happy, but money gives you flexibility. Money is essentially… we’re compensated in basically an hourly wage in a modern economy, and you could argue that, when someone pays you a significant amount, in some sense they are transferring a little sliver of time to you that gives you the flexibility to be able to spend on things that it will now take you less time to go acquire those things. Somebody like Jeff Bezos, who’s just outrageously wealthy, well, Bezos doesn’t have to work another day in his life and he could go out and buy virtually anything. Whereas the rest of us, we would have to work tens of thousands of years to be able to go and buy the things that Jeff Bezos can afford. Money affords us flexibility and money affords us the luxury of being able to basically purchase things that it would otherwise take us a great deal amount of work and time to be able to acquire. My question for you about gold and what are your thoughts about it being a hedge against decreasing dollar purchasing power? I like to think of gold as basically a commodity, I mean, which is right. It’s base level, gold is just a commodity. It has a lot of inputs into real goods and resources. Commodities are an inflation hedge by definition. When the rate of inflation is increasing, you’re going to see the price of commodities increase. Gold is obviously a good inflation hedge in that it’s just a commodity. I think you could argue that people attribute almost like a superior property to gold, because they view it as really the best form of money in that it is the most decentralized form of money. I think there’s a safe haven aspect of gold in people’s minds that the demand for gold is higher because of that function. Yeah, I mean, in any, I think financial system, you guys would preach the same thing about diversification and whatnot, it always benefits to be diversified and that… I’m not a big gold bug or anything, but I own a home and I own a lot of real resources and things that are likely to increase in value if the rate of inflation were to increase. I think that any real resource, any nonfinancial asset is likely to increase in value if the rate of inflation increases it. There’s nothing stupid about being diversified into nonfinancial assets, given if you have a large exposure to financial assets, which most of us probably do by necessity to some degree. What about gold as a replacement for bonds in portfolios considering how low yields are for bonds at the moment? I mean, nothing replaces the certainty of a bond, or you could throw a lot of things in that category, cash and treasury bills and anything that is a fixed income, even if it doesn’t pay income. The thing that is really nice about any stable fixed income type of asset is that, you know what its value is in nominal terms when you need it. Even if the rate of inflation were 10% tomorrow, I know with certainty that my cash, maybe even though it has fallen 10% in real terms, a dollar is worth a dollar tomorrow. That has value in that, it provides certainty for cashflow over time. All of us have this need over time to manage our long-term liabilities, our short-term liabilities with our long-term asset needs. All of us have an asset liability mismatch, is what a financial nerd would call it in that, we have assets that generate income over long periods of time and we have mostly short and medium-term liabilities, and you have to manage that cashflow mismatch to some degree. Golden commodities generally, I mean, unless you’re running a commodity business, they don’t provide cashflow, so gold can’t help you meet your short-term liquidity needs, unless for some reason speculators are bidding it up in value in perpetuity. The problem with gold as a replacement for bonds is that gold could fall in value significantly at a time when you need it to provide you with liquidity. If that’s occurring, then it’s a bad replacement for bonds because that’s the role of bonds, especially in any diversified portfolio, is that they provide you with certainty. You just know what their value is going to be. You know what the value of cash is because it provides you with the ultimate optionality in that you always know what its nominal value is going to be, regardless of what’s happening with inflation or the banking system or the real economy. Is there a place for gold as a store of value in the long-term? I think you could make that argument probably for any commodity in the long run, but they serve a very different function for, I think, portfolio management and financial asset management in the long-term. That’s a great way to think about it. We’re in Canada, as you know, which means that a majority of our portfolio holdings are denominated in other currencies. I just wanted to ask with the macro perspective that you have and all the thinking that you’ve done about currencies, what do you think about foreign currency hedging in equities? Well, I’m a big proponent of global investing. I think that a lot of people have a concentrated domestic currency risks inside of their equity portfolios because they just own nothing but domestic equities. I think that people… Do you need to go out and buy foreign currencies to hedge your currency risks? I don’t necessarily think that, I think that owning a diversified portfolio of global equities is a pretty good way of getting basically a foreign currency hedge in basically a different way than buying the foreign currency explicitly. If you were really worried about inflation in this environment, you wouldn’t want your equity portfolio to be only denominated in domestic equities, you would benefit in the long-term by having some foreign stocks in the portfolio, for instance. You can get foreign currency hedging through holding foreign financial assets in essence. I’m not necessarily against currency hedging, I just… it tends to be, if you’re buying the currencies, first of all, it’s a zero-sum game and it’s ultimately like buying expensive insurance in a portfolio where you could probably get the insurance in a cheaper way that isn’t a zero-sum manner by buying either some other type of financial asset or by owning foreign equities. Great answer. Cullen, this is our last question for you. In reading your paper, Understanding the Modern Monetary System, you talk a bit about the value of wealth and how much value time has in that equation. I’m really curious to your answer to this, which is, how do you define success in your own life? Oh, I mean, that’s the ultimate subjective question. For me, I mean, I own a bunch of chickens and I live in Southern California and in a lot of ways I’ve done more with my life than I ever could have imagined. I’m by no means super wealthy or anything like that, but I have good relationships. I’m lucky to be healthy. It’s funny being in finance because I got into finance because, I’ll never forget this, when I was picking my major, I was at my brother’s graduation, my sophomore year, and I was picking my major, and I think I was a marketing major in the Business School at Georgetown at the time. My uncle was talking to me and he said, “You’ve got to be a finance major, that’s where the money is.” I remember getting into finance because I was thinking, “Oh, this is how I’ll get rich, and I’ll get rich and then I’ll be happy.” Then the more and more my financial career expanded and changed, the more I realized, “Well, God, now I’m making a lot of money and I’m working like a dog and I’m not actually happier.” Yeah, and a lot of things are easier. I mean, don’t get me wrong. Money makes a lot of things easier, but it will not necessarily make you happy. I think at some point I started to realize, all these other things matter so much more. Do you have good relationships? Are you healthy? Do you have good networks and friends and family? To me, sure, would I like to be a billionaire? I guess it’d probably be pretty fun, but I don’t know. A lot of people, I think, the problem with that mentality is I’ve found this over the course of my life too, especially, I’ve had some friends over time that have gotten really, really phenomenally wealthy and sometimes I look at them and I’m like, “Gosh, that sure would be nice.” hen, every once in a while I’ll talk to one of their friends or their wives and they’ll say, “Oh yeah, Dave’s working on Sunday at eight o’clock.” I’m like, “Huh, I haven’t worked since Thursday, that’s pretty… maybe this trade-off, isn’t so bad.” It’s so subjective, but I think that, that’s the one thing that… the trap that a lot of people will fall into is thinking that more money will make everything okay, and if I sacrifice everything for more money, then magically my life will become great. I’ll be Jeff Bezos or somebody, and all my problems will be solved. I think the older you get and the more money you make, the more you realize that money is not really the thing that makes you happy. If you get those two things confused, then I think that that’s a big part of what causes a lot of people’s problems in the world. Subjective question, that was a very insightful answer. Cullen, this has been awesome. We really appreciate you coming on our podcast. I think you cleared up a lot of misunderstandings that just so many people have about how the monetary system works and the role of government and all those different pieces that we covered. We really appreciate you being generous with your time. Yeah. Well, thanks guys. I love the videos. Your channel is awesome. I’ve watched a ton of the videos and they’re really well done. I love the open-mindedness and the education-based perspective that you guys are providing. Even if a lot of what I’m saying is nonsense to people, I always tell people, no one knows all the answers to all this stuff, so there’s little tidbits in everything that, maybe there’s some truth in a lot of the aspects of the things I talked about or not, but the more you learn and the more you soak up, the more you pick up the pieces that are good and the pieces that are bad, and maybe you throw out and over time, you become a little bit smarter and smarter and you figure out a little bit more than hopefully you did before. Oh man, you know this because I sent you the script before I recorded the video and some of our listeners know, but your book and your blog were huge in me gaining an understanding just to be able to communicate the… not even close to your level, but communicate the basics of how all this stuff, basically the QE piece works. I learned all this stuff from other people and just figuring out how it relates to the real financial system and the economy on my own, through my own experiences, and so it’s been just a huge learning process for me. I love teaching people and spreading the wealth, especially because there’s so much, I think misinformation and so much bias in a lot of the narratives that… especially coming from politicians and people that have a really, I think to some degree, intentionally misleading ideology about things that can be very attractive but are very, very damaging in the sense that they’re not consistent with the way that things really work. That has a meaningful impact on people’s living standards and the outcomes of all of our situations in the world. Books From Today’s Episode: Pragmatic Capitalism on Amazon — https://amzn.to/2Ycd3U5 Links From Today’s Episode: Cullen Roche — https://www.pragcap.com/meet-cullen-roche/ Cullen Roche on LinkedIn — https://www.linkedin.com/in/cullenroche/ Cullen Roche on Twitter — https://twitter.com/cullenroche Rational Reminder on iTunes — https://itunes.apple.com/ca/podcast/the-rational-reminder-podcast/id1426530582. Rational Reminder Website — https://rationalreminder.ca/ Orcam Financial Group — https://orcamgroup.com/ ‘Understanding The Monetary System’ — https://papers.ssrn.com/sol3/papers.cfm?abstract_id=1905625 Episode 109 — https://rationalreminder.ca/podcast/109 Share: Facebook Twitter LinkedIn Email CIRO Advisor Report
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