The budget battle that broke the camel’s back

Scholz is scrambling to save face amid approval ratings that have plunged to an unprecedented low of 14%. The SPD’s own approval ratings are similarly abysmal.

Polls of voting intentions show the party now tied with the far-right Alternative for Germany (AfD) at around 16% — a dramatic drop from the SDP’s 26% support in the last election. The FDP faces even bleaker prospects, polling around 3–4%, just below the 5% threshold needed to enter parliament.

While tensions within the coalition were no secret, the breaking point came when a proposal by Lindner leaked. The 18-page document “Turnaround Germany – A Concept for Growth and Generational Justice” suggested cutting financial aid to low-income families and refugees, which panicked the SPD and Greens.

The election of Donald Trump as the next US president has raised fears the US will soon cut its support for Ukraine, forcing Germany to pick up the tab or risk the defeat of Ukrainian forces. Lindner claims he was pressured to agree to another suspension of the debt brake. He refused, afraid of embarrassment by the constitutional court. Scholz floated the possibility of new elections, which Lindner leaked to Bild while parties were still deliberating. This was the final straw for Scholz, who asked for Lindner’s dismissal. 

The economic headwinds Germany has been facing only add to the drama. Budgets crafted on the assumption of GDP growth that never materialized have left government departments strapped. Austerity measures have strained even the nation’s soft power as cultural icons like the Goethe Institute have been forced to close German schools abroad.

Related Reading

Is the German Economy Now Destined to Decline?

The crux of the budgetary deadlock is Germany’s “debt brake,” a constitutional limit capping new debt for structural deficits at 0.35% of GDP. While this debt brake was suspended temporarily during the pandemic and the Ukraine invasion, it has since snapped back into force, severely restricting the government’s freedom of action.

Who stands to gain?

With elections likely in early spring, Germany’s political map could shift drastically. The center-right Christian Democrats (CDU/CSU), currently polling at 33%, are poised to regain power, though their numbers fall short of a parliamentary majority. A coalition with the Greens remains unlikely due to ideological divides, and the SPD’s recent failure makes it a dubious ally. That leaves the CDU/CSU with only a handful of feasible partners — including an intriguing, if controversial, one in the newly-formed Bündnis Sahra Wagenknecht (BSW).

BSW, led by former leftist Sahra Wagenknecht, has captivated voters disillusioned with mainstream parties but unwilling to embrace the far-right AfD. Known for her anti-immigration stance and advocacy for a negotiated settlement with Russia, Wagenknecht is a questionable candidate to offer the CDU/CSU a politically stable alliance. 

It should be noted that AfD came out as the party with the most votes during recent state elections in Thuringia (34.3%, slightly ahead of CDU 33.5%). It missed to reach that goal in Saxony, but only by a hair (34.0% compared to 34.4% for CDU).

Voter discontent in Germany, especially in the former East German states, has led to a surge in support for right-wing AfD. Due to Germany’s history, politicians are very aware of the danger of fascism, but they seem rather helpless in addressing the root causes (increased unemployment in rural areas, social anxiety, xenophobia, feelings of being second-class citizens).

Financial and global implications

The collapse of the German government sends shivers through markets already sensitive to geopolitical risk. Shares of Germany’s iconic automakers — BMW, Mercedes-Benz, Porsche and Volkswagen — have fallen sharply, anticipating the return of Trump-era import tariffs on European goods. With Germany’s political attention diverted inward, “budget sinners” like Italy, France and Spain may find relief, as former members of the hard-currency block, such as Germany, have historically pressured them to meet strict fiscal criteria under the Maastricht Treaty.

So far, little or no spread widening between German and other Euro-area government debt has been observed in reaction to the earthquake in Berlin. While the German 10-year government bond yield stands at 2.4%, France and Spain pay a clear premium at 3.2%, followed by Greece at 3.3% and Italy at 3.7%. Still, Italy (135% debt-to-GDP ratio) and Greece (162%) pay lower interest rates than the UK (98%) and the US (123%). Those yields only make sense if the political will to keep the Euro area together would galvanize politicians into further bailouts of countries should the need arise.

If no stable coalition emerges, Germany faces the prospect of another election, potentially plunging Europe’s largest economy into a period of prolonged instability. A caretaker government may limp along in the interim, but effective governance and ambitious legislative agendas will be on hold.

Internationally, the political crisis could have wide-reaching effects. As Germany becomes preoccupied with its own domestic woes, European allies such as Italy and France may gain breathing room in their own budgetary struggles, potentially facing less scrutiny from Berlin on debt under the Maastricht Treaty. However, any withdrawal from a Trump-led US could leave Europe drifting in the high seas without clear leadership, missing out on a potentially generational opportunity to determine the geopolitical direction of a future Europe unshackled from US dominance.

The views expressed in this article are the author’s own and do not necessarily reflect Fair Observer’s editorial policy.

The post The Collapse of Germany’s Government: An Earthquake With Global Aftershocks appeared first on Fair Observer.

The VIX index, a measure of volatility, reached 65, its third-highest reading in history. Only in 2008, after the demise of Lehman Brothers, and in 2020, during the onslaught of COVID-19, did the index top that number.

A reading of 65 on the VIX is very high. To justify such a high volatility, stock prices would have to move by at least 4% (in either direction) on at least 13 trading days over the following 20 trading days. This would indicate a major economic calamity of global importance, which, to our best knowledge, has not occurred.

What happened?

On Wednesday, July 31, the Bank of Japan raised interest rates to 0.25%, sparking a rally in the yen that caught hedge funds off guard.

The same day, the US central bank hinted at a possible interest rate cut in September. Two days later followed a worse-than-expected US job market report. The unemployment rate reached a 3-year high.

As predicted by futures markets, the probability of a 0.5%-point cut in interest rates by September briefly reached 100%, with some contracts even implying a reduction by 0.75 percentage points. Jeremey Siegel, who lectures on finance at the Wharton School at the University of Pennsylvania, called for an immediate 0.75%-point via cut emergency meeting followed by another 0.75%-point cut in September.

Within a few days, the Japanese currency reversed its weakness and gained 13% compared to the US dollar, causing large losses to the so-called yen carry trade.

A carry trade involves borrowing funds in a low-yielding currency, like the yen, and investing the proceeds in a higher-yielding currency, like the US dollar. Since the summer of 2023, a large difference in interest rates between the US (5.3%) and Japan (-0.1%) attracted plenty of money.

The exact size of the yen carry trade is unknown. Cross-border yen loans reached $1 trillion as of March. Speculative positioning in yen futures at the CME futures exchange in Chicago reached 180,000 contracts at the beginning of July. With each contract being worth ¥12.5 million, a total of ¥2.25 trillion ($15 billion) was thus at stake.

The prospect of rising Japanese interest rates combined with falling US interest rates meant the yen carry trade became less attractive. Higher volatility in the yen/dollar exchange rate led quantitative and trend-following investors to reduce their positions.

Why did the Bank of Japan raise rates?

Around 30% of the Japanese population is aged 65 and older, making Japan the country with the highest share of elderly people globally.

Elderly people are retired and live off their savings or fixed pension payments. Their income usually does not adjust to inflation. Elderly people are hurt by inflation.

Japan had built up a network of 54 nuclear reactors. The Fukushima incident in 2011 led to the shutdown of all 54 reactors, of which only 10 are back in operation today. This has left a wide gap in energy production, leading Japan to import large amounts of fossil fuels, which make up roughly a quarter of Japanese imports.

Fossil fuels are quoted in US dollars. A decline of the Japanese yen thus makes imports more expensive, leading to higher inflation. The further the yen/dollar exchange rate declined, the lower the approval rating of the current government fell.

Throughout May, the Japanese Ministry of Finance intervened in foreign exchange markets with more than $62 billion, which did not help to stop the yen’s slide. Hence the surprise interest rate hike in late July.

After having achieved its goal of stabilizing the yen, the Bank of Japan quickly reverted to damage control by stating it would not raise rates during times of market instability.

What does this mean for investors?

Stock markets quickly recovered from Monday’s shock — the Nikkei Index gained 10% and the S&P 500 around 1%. Volatility receded; while current reading (about 28) is still elevated, it is a far cry from Monday’s panic-driven levels.

Monday’s sell-off can be explained by technical factors. But what about fundamentals? The market value of all US equities amounted to $51 trillion as of December 2023, or nearly twice the US GDP. In the past, this has been considered an “expensive” ratio.

Market breadth, or the number of shares participating in a trend, has narrowed down to a few mega-cap stocks. The weight of the ten largest US companies makes up around one third of the S&P 500, a proportion that has been growing for at least 50 years. The weight of the largest stock compared to the stock in the 75 percentile even exceeds levels seen in 1929.

Microsoft trades at 25 times operating cash flow while NVIDIA is valued at 60 times. Few market observers dispute that US stock valuations are exceptionally high, and therefore vulnerable to setbacks.

But what about the economy?

Market turmoil, if sustained, can feed into the “real” economy. Initial public offerings might get postponed due to a lack of risk appetite. Financial costs for corporations might increase as the risk premium over (presumably risk-free) US Treasury bond yields widens. Leveraged takeovers might fail due to lack of financing.

A recent survey of purchasing managers in the manufacturing sector (ISM) showed many companies reporting a noticeable slowdown in business. On the other hand, the (much more important) service sector painted a more benign picture.

Undoubtedly, employment growth is slowing down, while the rate of unemployment has begun to increase slightly. Consumer confidence is between mediocre and abhorrent. Adjusted for inflation, retail sales declined in 15 out of the past 20 months. While personal disposable incomes are still growing by a low single-digit percentage, little is left after accounting for inflation.

Even the current large fiscal deficit of 6–9% of GDP fails to stimulate the economy; the government sector deficit instead translates into a surplus for the foreign sector (a mirror image of the US trade deficit).

Investors hoping that falling interest rates benefit stocks might be disappointed. Financial markets have anticipated those cuts for years, as evidenced by the negative slope in the yield curve.

Now would be a good time to go through portfolios and ask questions. “Would I buy this entire company at this price?” (the question of valuation) and “Would I be comfortable holding this company if the stock market closed for 10 years?” (question of quality).

Yes, in the long run, stocks go up, thanks to the inflationary bias of our fiat system. In the short- and medium-term, the stock market doesn’t owe you anything.

[Anton Schauble edited this piece.]

The views expressed in this article are the author’s own and do not necessarily reflect Fair Observer’s editorial policy.

The post Japanese Rate Hikes Cause Colossal Losses in World Markets appeared first on Fair Observer.

Mutual funds began in the US a century ago. This financial instrument in 1924 was popular with our parents’ generation. Their advantages include diversification, professional management, affordability, daily liquidity, variety of choices by region, sector, company size or investment style and automatic reinvestment of dividends and capital gains.

However, most mutual funds come with considerable up-front sales charges as well as annual fees, eating into returns over longer periods. Making matters worse, up to 96% of all active US equity funds underperformed their benchmark over a 15-year period, as described in this earlier article. They underperform the market.

The emergence of ETFs

A relatively new type of fund has been cannibalizing mutual funds in recent years. Known as exchange-traded funds (ETFs), the first such fund was launched in Canada in 1990. In 1993, the first ETF was launched in the US. ETFs took time to catch on before growing rapidly in popularity. They seek to track an index, which is typically weighted as per market capitalization, in order to capture the risk and return of a given market. ETFs comprised only 1% of total fund trading in 2000. The crash of the dotcom bubble in 2001 boosted the popularity of ETFs, and a graph on the popular site Investopedia reveals that they have really taken off since 2010. 

Since most mutual funds underperform the market and ETFs are largely so-called passive investment vehicles that replicate the market, why would someone pay higher fees for an inferior performance?

Before we carry on, it is important to understand what active and passive investment means. “Active” describes the process of actively selecting a few stocks, hoping their performance would beat a broad index, like the S&P 500. “Passive”, on the contrary, involves simply replicating the performance of said index. Once funds are invested according to the weights prescribed by the index, the manager can fold his hands and remain passive. 

Why do ETFs perform better and what are the risks?

Why are an increasing number of investors switching to so-called passive investment vehicles? Since there is no need to do any security research, passive ETFs can do without hiring expensive analysts. This allows them to charge much smaller fees and outperform the mutual funds.

The State Street Global Advisors SPDR S&P 500 ETF Trust (symbol “SPY”), with more than $500 billion in assets, charges annual fees of less than a tenth of one per cent, ie <0.1%. By contrast, Capital Group’s “Growth Fund of America,” the largest active US equity mutual fund, carries an expense ratio of 0.63% — more than 6 times as much as “SPY.” In addition, investors in the active fund need to digest a front-load of up to 5.75%.

Unsurprisingly, passive ETF have been cannibalizing active mutual funds over the past years. Conversely, since 2017, US equity mutual funds had only one month of net inflows, and 87 months of outflows.

According to fund analytics firm Morningstar, active US equity funds saw outflows of $290 billion over the past 12 months, while their passive counterparts enjoyed inflows of $320 billion. Passively managed equity vehicles now make up more than 60% of the total funds invested in markets.

As the share of passively managed investment grows, so does their ownership of individual stocks. In some companies, passive investors are already in the majority. Take Central Garden and Pet (symbol “CENT”), for example, where 60% of shares are owned by passive vehicles. Those funds are not interested in the fundamentals of the company such as sales, earnings or dividends. The company might announce terrible results, and passive investors would not sell a single share. It could, theoretically, be approaching bankruptcy, and, as long as the company remains in the index the fund tracks, the fund would not sell. 

Passive investment vehicles are insensitive to price. They are always fully invested. If fresh money comes in, the funds buy no matter what. Regular contributions to retirement accounts (“401k”) lead to a continuous stream of money driving index members share prices regardless of fundamentals.

As more investors become price insensitive, you expect to see more “crazy” price movements, leaving rational investors scratching their head. A rally induced by the recent index inclusion of Super Micro Computer (symbol SMCI) serves as an example. The company’s stock price rose from $284 at the end of 2023 to $1,229 on March 8, 2024, shortly before its inclusion into the S&P 500 Index on March 18. It has since lost around 37% of its value.

Erratic price movements could lead to the impression fundamentals did not matter anymore. Inexperienced investors might be tempted to bet on so-called “momentum” stocks, or worse, options, with quickly eroding time value.

Of course, indiscriminate inflows could reverse. An aging population of investors might want to cash out of stocks, realizing their capital gains. Persistent outflows would lead to selling, with the sellers, again, being insensitive to price. 

So, are ETFs a cure, or rather a curse in disguise?

Low-fee, passive index ETF are the most efficient investment vehicle available to individual investors. For each individual the decision to move into passive ETF is, undoubtedly, rational. However, individual rational behavior doesn’t guarantee a rational outcome in aggregate. For investors as a group, the outcome might be detrimental.

[Fair Observer’s interns, working as a team, edited this piece.]

The views expressed in this article are the author’s own and do not necessarily reflect Fair Observer’s editorial policy.

The post Are ETFs Now Cannibalizing Mutual Funds, and Is That Good? appeared first on Fair Observer.

On March 13, the US House of Representatives passed the “Protecting Americans from Foreign Adversary Controlled Applications Act,” which would ban TikTok completely unless it separates from ByteDance. The Senate passed the bill April 23, and US President Joe Biden signed it into law next day. The act gives ByteDance 270 days to act before the ban goes into effect.

This article reveals possible commercial considerations behind the attempt to ban TikTok.

Since its launch, TikTok has become one of the world’s most popular social media platforms. Its proprietary recommendation algorithms are better than those of alternative apps at connecting content creators with new audiences. Many of TikTok’s users are young, making it more attractive for advertisers than social media with aging userbases, like Facebook.

TikTok cuts into Alphabet and Meta’s bottom line

TikTok’s advertising revenue has seen explosive growth. In the final quarter of 2023, advertising spending on the platform reached $1.2 billion, a growth of 43% compared to the first quarter. 

In 2024, TikTok’s ad revenue is expected to triple to $11 billion. Its video ad revenue could exceed the combined revenue for Meta (formerly Facebook) and YouTube combined by the year 2027. TikTok’s unique approach to integrating advertisements seamlessly into the user experience contrasts sharply with the more intrusive advertising models of traditional social media platforms.

While Alphabet (which owns Google and Youtube) and Meta have long held a duopoly in online advertising, their market share has recently begun to decline. In 2022, for the first time since 2014, their combined market share dipped below 50%, and it was expected to have fallen further to 44.9% by the end of 2023​. This decline is partly due to the innovative strategies of new entrants like TikTok and partly due to external pressures such as privacy changes led by Apple, which have particularly impacted Meta’s ad targeting capabilities.

Meta’s business model depends almost exclusively on ad revenue. In the past year, ad revenue made up 97.5% of sales. In the past, Meta was able to rely on its three billion monthly active users as a moat against competition — roughly one third of the world’s population. Because online businesses are uninhibited by material or geographical boundaries, they can be scaled up indefinitely. Facebook’s meteoric growth in the mid-2008s, crushing its competitor MySpace, proved how this leads to a “winner-takes-all” system, where the dominant site can eliminate any competition. 

However, the moat is not invincible; users might get tired of curating a constant stream of pictures of their pets, kids and food plates.

TikTok captures younger audiences

A significant factor in TikTok’s success is its popularity among millennials and Generation Z. Advertisers highly value these younger users, because they are more likely to spend on consumer goods like clothes, electronics and games and are less likely to have established brand loyalties. Further, they have the most influence over current trends.

Younger users are impatient with ads and likely to scroll away when they realize they are being sold to. However, TikTok employs content-driven advertising that is often indistinguishable from regular user content. This disrupts the user experience to a far lesser degree, offering a level of engagement that traditional platforms are struggling to match.

The advertising industry is seeing a broader shift in spending away from traditional giants towards platforms that offer more engaging and innovative ad experiences. TikTok, with its compelling blend of entertainment and commerce, has become a preferred platform for many brands looking to tap into a younger demographic​. Furthermore, changes in user privacy preferences and the increasing ineffectiveness of conventional ad strategies on platforms like Meta and Instagram have accelerated this shift​.

Threat to US social media landscape

TikTok’s rise in the advertising market is indicative of broader changes in consumer behavior and the digital landscape. As users gravitate towards platforms that offer more authentic and integrated advertising experiences, traditional advertising giants are being forced to rethink their strategies to remain relevant. The future of digital advertising is likely to be dominated by platforms that not only understand the importance of user experience but also continuously innovate to keep pace with changing consumer preferences.

Yet, as users abandon older sites in favor of a disruptive upstart like TikTok, tech giants need to buy more time. It is easy to understand why they would want to eliminate a troublesome adversary.

TikTok’s strategic approach to advertising, combined with its deep understanding of its user base, poses a significant threat to the established order. The ban on TikTok should therefore be seen through the lens of squishing competition rather than concern for its users.

Cui bono?

[Anton Schauble edited this piece.]

The views expressed in this article are the author’s own and do not necessarily reflect Fair Observer’s editorial policy.

The post The TikTok Ban: Unpacking the Battle for Advertising Dollars appeared first on Fair Observer.

Sometimes, we create mind models that, in hindsight, turn out to be completely wrong, even though they made a lot of sense at the time. The geocentric world model, for example. People looked at the sun, saw it rising in the east and setting in the west, and concluded that it must be revolving around the Earth. Later, it dawned upon humanity we got it all wrong. A new narrative emerged — the heliocentric world model. Turns out we are not the center of the universe.

Even though it is a physical thing, you cannot see the center of the solar system in the way that you can see a dog or a bowl of oranges. That is why we must model it, and why a model may sometimes go wrong. We need to marshall the evidence to make sure that our model squares with the best information we have available.

Like the center of the solar system, money and Bitcoin are physical phenomena. They describe the way that physical banks or physical computer systems actually work. Yet, they are not visible, and hence they are hard to understand without a model. I propose a mind model involving the Dutch painter Vincent van Gogh that might help.

Mind model of money

Money, being among the most important things for many, is also one of the least understood. How can mere pieces of paper, backed by nothing, be of such value? You could, for example, purchase a Boeing 747 with pieces of paper.

Things get weirder when you consider that paper money accounts for only a small fraction of the overall amount of money outstanding, estimated to be less than 1%. Most of our money exists in digital form. Bank deposits are the digital liabilities of private banks; they exceed the amount of currency (bills and coins) by a factor of 6. It would therefore be impossible to pay out all deposits in cash.

However, the model of money that we have often consists of handing over our hard-earned cash to a bank where it “works” for us, “earning” interest. Nothing could be further from the truth. Any cash held in the bank’s vault is just dead paper, doing exactly nothing. 

Most of what we think of as “our money” entered the bank in digital form as a wire transfer. And most wire transfers between private banking institutions are settled by moving reserves between various accounts within the same bank, the Federal Reserve System. Before the transaction, the Fed owed money to bank “A”; now, it owes money to bank “B.” Money never left the Federal Reserve; the only thing that changed was an update within its balance sheet, or ledger.

This ledger is not much different from the Rai Stones of Yap Island — large, heavy limestones that served as a marker of who owned what amount of an agreed value. These stones did not move, but everyone remembered who they belonged to at a given time.

Our brain will meet new mind models with initial resistance, especially if they threaten long-held beliefs. “I was wrong all that time” is a hard thing to admit.

Bitcoin as a mind model of money

If fiat money is already difficult to understand, Bitcoin might be even harder. Or perhaps not! There is only a finite number of Bitcoin ever to be mined. No such limit exists in fiat money, which can seemingly be created out of thin air. 

The narrative concludes that Bitcoin must be valuable since it is scarce. It must be a great store of value, and hence it must be a better form of money. Central banks cannot print Bitcoin! The government cannot devalue Bitcoin! Good money drives out bad money, and we will — eventually — transition to Bitcoin. Get educated, get on the train, or have fun staying poor!

Narratives rely on beliefs, and it should come as no surprise that followers of a certain narrative will often congregate in groups or churches. The brain finds comfort in having its narratives confirmed. We like to be surrounded by like-minded individuals. These days, passionate and often strident groups supporting Bitcoin and other cryptocurrencies have seemingly cropped up everywhere online, from Twitter to Reddit and the infamous 4Chan. They preach a gospel in which a few hundred dollars today will turn into millions, as long as you have faith and hold on to your coins.

A Bitcoin fan, or promoter (it’s hard to tell the difference) recently explained: 

“If you want to be a millionaire – you can get one million Satoshis [100 million Satoshis equal 1 Bitcoin] for less than $700 at the moment. Most people will never own one whole Bitcoin in their life. Not just because it’s becoming increasingly more expensive to accumulate one. But also because there simply aren’t enough bitcoin for everyone on the planet, since only 21 million bitcoin will ever exist. There are more than enough Satoshis for everyone, though.”

Here is where Van Gogh comes in. His epic painting Starry Night is estimated to be worth about $100 million. Imagine the artwork was represented by 100 million tokens, offering fractional ownership. One Van Gogh token, let’s call it a VanGoghi, would be worth around 1 dollar. Now, everybody can afford a fraction of Starry Night.

(The example of VanGoghi is purely hypothetical, of course. But fractional ownership of art is a real thing. And, of course, there are reports of improper sales tactics. But that is not our main concern.)

Imagine someone floated the idea that VanGoghis were a new, better form of money. Supply is limited, and value should increase over time. VanGoghis would trade on electronic exchanges, and the Securities Exchange Commission might even approve some exchange traded funds investing in VanGoghis. 

Would you go to a supermarket and purchase an apple for one VanGoghi? If the price was as volatile as Bitcoin, a VanGoghi could be worth as much as one dollar today, but five dollars a couple of months later. Or it might lose 87% of its value within a few hours, as recently seen in Bitcoin. The supermarket had to frequently adjust prices. The friction of buying and selling anything would increase tremendously.

Despite being (potentially) a good store of value, using VanGoghis as a means of exchange would be a terrible idea. The same applies to its use as a unit of account — imagine a corporation trying to do its accounting in VanGoghis.

Here’s why fiat money is good money

Fiat money is not a great store of value. Over long periods of time, it is terrible. Since the inception of the Federal Reserve System in 1913, the US dollar has lost around 97% of its purchasing power. Many other currencies have fared even worse. 

But is this really a problem? Who uses cash as a long-term store of value? There are many options (bonds, stocks, real estate, gold to name a few) that compensate or protect from loss of purchasing power.

Fiat money has its flaws, but it has arguably allowed the creation of unprecedented wealth by enabling frictionless commerce. Yes, there is income and wealth inequality. But is that a function of our monetary system or could it be remedied with appropriate tax policy? Fewer than 2% of Bitcoin addresses control more than 90% of Bitcoin — not exactly screaming “democratization of money.”

A medium can either be a great store of value or a great means of exchange, but not both. That’s why we use fiat money for everyday business, but other options for long-term wealth preservation. A combination of the best of both worlds.

The narrative of Bitcoin, or VanGoghis, initially sounds appealing. Much less so once you lift the veil.

A common narrative of fiat money consists of the view that central banks create inflation by printing too much money. In reality, however, the private sector is responsible for approximately 95% of money creation. 

In fact, money and debt are inevitably linked to each other; you cannot create money without simultaneously creating the same amount of debt. Admittedly, there is a lot of debt, meaning there is a lot of money, too. The narrative “there is too much debt” also implies “there is too much money.” Few people complain about “too much money.”

This is not to say elevated debt levels are not without problems. Money and debt are often in the hands of separate entities or people, resulting in income and wealth inequality, as well as insurmountable debt burdens for some. However, rather than laying blame at the doorstep of our monetary system, income and wealth distribution could be ameliorated by appropriate tax policies.

Fiat money is an accounting mechanism to record who owes whom. Bitcoin is nothing more than a protocol, solving the problem of users spending the same money twice in absence of a trusted central counterparty. However, fiat money is government-sanctioned (legal tender), while cryptocurrency is not. 

Don’t expect governments to give up control over the definition of money without a fight. The narrative of Bitcoin being out of the reach of law enforcement is questionable. Recently, two executives from Binance, the world’s largest cryptocurrency exchange, were detained in Nigeria. The Nigerian government is demanding Binance reveal the top 100 users of Bitcoin in the country, including transaction history. Nigeria accuses Binance of undermining government efforts to stabilize its currency, the naira.

Bitcoin “mixers” like Tornado cash, used to obfuscate the origin of coins, have been banned by the US Treasury. At best, you could be holding “tainted” Bitcoin. Your wallet might then trigger compliance alerts at exchanges once you try to “off-ramp” your coins back into fiat. At worst, your account will be blocked, and your coins frozen.

It is true that, so far, nobody has managed to hack the Bitcoin blockchain. Exchanges, however, have been hacked repeatedly, or even run by malicious actors who suddenly “rug pull” their users.

The dream of “hard” money, miraculously solving all problems of society, is appealing. However, it is just a narrative that you should think about twice before adopting it.

The views expressed in this article are the author’s own and do not necessarily reflect Fair Observer’s editorial policy.

The post How Van Gogh Can Unravel Bitcoin’s Simple Narrative appeared first on Fair Observer.

Let’s take a look at the CBDC critic’s arguments.

“The government wants to control what I spend.”

This claim seems to stem from the potential programmability of CBDC. There are some very limited use cases where this could be possible. In some of these, frankly, it would even be desirable.

Take, for example, the US food stamps program, or SNAP (Supplemental Nutrition Assistance Program). In 2023, about 42 million Americans received financial aid for the purchase of select food items at a cost of $120 billon. To avoid the stigma associated with actual “stamps,” the program often comes in the form of a pre-loaded debit card, or Electronic Benefits Transfer (ETB). Alcohol and tobacco products cannot be purchased with ETC. Imagine the public outcry if US taxpayers were to finance alcohol and tobacco addictions!

Today, governments already control spending; I was unable to buy a t-shirt from the Wikileaks store with my US credit card. In 2022, a Canadian judge froze access to donations for striking truckers. Yet, no CBDC was necessary to enable government control.

One could ask why the government would wait for CBDC to control our spending when it is perfectly able to do so already now.

“The government can make my money go away with a click.”

It might not be a bad thing to be able to create money with an expiration date.

US stimulus checks during COVID were meant to cushion a drop in economic activity. However, rather than spending the additional income, many recipients chose to increase their savings instead. The personal savings ratio jumped from 7 to 32% — the highest level since at least 1960. Consumers reduced their credit card balances by $150 billion.

A reduction in debt does not help boost consumption. It would therefore make sense to require any stimulus checks to be spent within a certain time frame to increase the efficacy of such programs. A programmable CBDC would help achieve this aim. Those “free” CBDC dollars would come with an expiration, just like many gift cards, airline miles or even public transportation tickets. To suggest that this is driven by nefarious intentions is missing the point.

Additionally, stimulus payments could be limited to those with a high propensity to spend — lower-income households. The US CARES Act reduced stimulus payments for those with incomes above a certain threshold. A CBDC could make administration of such limitations less cumbersome.

One area of real concern, however, is the potential for negative interest rates. To combat the threat of deflation, the European Central Bank (ECB) lowered its deposit rate into negative territory from 2014 until 2022. Some commercial banks began charging large deposits negative interest. However, this applied only to bank deposits. Negative interest rates cannot be applied to physical cash. With CBDC, central banks could impose negative interest on currency, too. (From the viewpoint of a central bank, the ability to pass on negative interest rates is an advantage.) It should be pointed out, however, that prolonged deflation is a rare occurrence. This is especially true for fiat monetary systems, which have an inflationary bias by design.

“CBDC is not real money.”

According to the US Code, “US coins and currency (including Federal reserve notes … ) are legal tender for all debts, public charges, taxes, and dues.”

Critics claim that CBDC cannot be legal tender since it is not mentioned in US code. According to this logic, even bank deposits are not “real money,” and wiring monthly payments would not repudiate your obligation towards the mortgage company (unless the company agrees to accept such payments). But why would anyone insist on payment in legal tender only? What would be the purpose? How cumbersome would it be to deliver coins and banknotes, in person or via courier, and then to prove that delivery has successfully occurred?

The relevant section of the US Code was established in 1965. Lawmakers could not have anticipated improvements in payment systems in the following 50 years.

Besides, even if the current statute did exclude CBDC, it would take a simple act of Congress to change it.

As of early 2024, however, there are several noteworthy efforts in the Congress and state legislatures aimed at limiting or preventing the introduction of CBDC. These efforts primarily focus on restricting the Federal Reserve’s ability to develop or issue one.

Republican Senator Ted Cruz, member of the Senate Committee on Commerce, Science, and Transportation, introduced one such bill. This legislation seeks to prohibit the Federal Reserve from developing a direct-to-consumer CBDC, which could, allegedly, be used as a financial surveillance tool by the federal government.

Similarly, Senator Mike Lee, also a Republican, reintroduced legislation aimed at preventing the Federal Reserve from reshaping the US financial sector with the implementation of a CBDC.

In Texas, a Senate Concurrent Resolution expressed opposition to CBDC. In Florida, Governor Ron DeSantis signed a bill prohibiting the use of CBDC in the state, claiming, amusingly, that CBDC would “threaten FinTech innovation.”

Similar legislative efforts are underway in states like Louisiana, Alabama and North Dakota. These bills largely focus on concerns about privacy and government surveillance, as well as the potential for increased control over financial transactions and individual freedoms. The topic of CBDC has become increasingly partisan, with most of the opposition coming from Republican lawmakers. However, no bills other than Florida’s have advanced as significantly in the legislative process.

Advantages of CBDC

CBDC has various advantages over the use of cash, as John Kiff, a former senior financial expert for the International Monetary Fund (IMF), describes. Cash needs to be printed at significant cost due to security requirements. It also requires regular distribution to bank branches and ATMs. Consumers must obtain cash, often paying a withdrawal fee. Cash must be carried in sufficient quantity for payment at points of sale. Businesses need to be equipped with registers, constantly having to restock change while depositing larger bills into vaults. Commercial banks need to sort out damaged banknotes and send them back to the central bank for destruction. At all those stages, physical money needs to be counted.

In many countries, banking customers face significant monthly service fees. Meanwhile, CBDC could be held in a digital wallet, provided by an app for mobile phones, and provided free-of-charge.

CBDC is more than just more efficient. As time goes on, it will become indispensable.

What if you were told that you would never be able to withdraw the money in your bank account? In aggregate, this is true. US deposits at all commercial banks amount to around $17 trillion. There are around $2.3 trillion in currency in circulation, of which an estimated 70% is held abroad, leaving less than $700 billion for domestic purposes. The amount of deposits exceeds the amount of “cash” by a factor of 25.

Related Reading

Money Matters: Revealing Who Is Holding Billions of US Banknotes

Intuitively, we understand the bank does not have all our money in “cash” in its vault. We rely on the assumption not every customer would want to withdraw all the money at once. And that we could, up to certain daily limits, withdraw cash at our pleasure.

You, as a customer, have become an unsecured creditor of a private institution. In other words, from the bank’s perspective, customer deposits are liabilities. When you make a withdrawal, you exchange that unsecured claim against a private institution into a claim against the central bank. Private institutions can go bankrupt; the central bank cannot.

This option of a 1-for-1 exchange into public money is what keeps our entire private monetary system functioning. More than $300 trillion in global monetary claims outstanding are supported by less than $30 trillion in major central bank assets. Thus, 90% of money outstanding is of private origin, consisting in deposits credited by commercial banks to customers, rather than public money like cash or central bank deposits.

Since individual citizens cannot open accounts at the central bank, withdrawing cash is currently their only way to access public money. As the use of cash continues to decline, citizens lose that access. People in a cashless society would not be able to convert any private money into public money. Your bank deposits will remain in the private banking system forever. The “peg” with risk-free public money is gone.

This is an important reason why central banks need to issue digital versions of public money. Money should be a public good. CBDC is necessary to keep it that way.

[Alex Gloy is a member of Digital Currency Think Tank.]

[Anton Schauble edited this piece.]

The views expressed in this article are the author’s own and do not necessarily reflect Fair Observer’s editorial policy.

The post The Truth About Central Bank Digital Currency: It’s Indispensable appeared first on Fair Observer.

How Treasury rates affect other rates

Since US public debt is widely regarded as a “risk-free” asset, it is taken as a baseline for pricing other, riskier debt investments.

Pricing of newly issued corporate bonds is usually expressed as a premium to US Treasuries. For example, if you are a BBB-rated US corporation, you currently would need to pay 1.6 percentage points more than the yield on 10-year US Treasury bonds, currently at 4%. Hence, the corporate bond would yield 5.6%). 

The same applies to non-US governments issuing debt. Recently, the Philippines (rating: BBB+) sold new 5½-year debt. The bonds were priced to yield “T+144bps”, meaning “Treasury yield plus 144 basis points,” or 1.44 percentage points. Lower-rated State of Mongolia (B3, equivalent to B-) had to offer a spread of 4.25 percentage points over Treasuries for a total yield of 8.75%.

The yield premium over Treasuries is also known as the “spread.” Here you will find a table explaining the credit scale used by rating agencies.

The entire world’s debt is priced off Treasury securities. If the yield for Treasuries goes up by one percentage point, most borrowers of US dollars will see their yields increase by the same amount. With more than $300 trillion in global debt outstanding, a one percentage point increase in interest rates would cost borrowers $3 trillion (which is larger than the GDP of all but the top seven nations).

Given their importance, we need to understand how Treasuries are created, traded and treated.

How the sausage is made

Treasury securities are born out of necessity—the need for the US government to raise funds. Since the government spends more than it raises in taxes, any shortfall must be filled by selling debt. For the 2022–23 fiscal year, the deficit amounted to nearly $1.7 trillion.

In addition to plugging the hole torn by deficits, the US government needs to refinance existing debt coming due — which is a lot. An astonishing 85% of Treasury debt issued in 2023 is due within one year or less. This leads to constant refinancing needs. 4-week Treasury bills, for example, need to be refinanced twelve times per year.

Despite the annual fiscal deficit being “only” $1.7 trillion, the gross financing needs for November 2023 alone added up to $2.37 trillion.

To figure out how much debt to issue, the Congressional Budget Office drafts a “Budget and Economic Outlook,” typically each January, and updates it in August. Treasury officials meet quarterly with the Treasury Borrowing Advisory Committee, comprising senior representatives from banks, broker-dealers, hedge funds and insurance companies. The committee then issues a report to the Treasury Secretary with recommendations on debt issuance for the coming quarter, culminating in table with a recommended financing schedule. The Treasury department subsequentlyissues a tentative auction schedule. This way, market participants can anticipate future supply and plan accordingly.

Treasury securities come in three main categories, classified by time to maturity: Treasury Bills (one year or less, namely 4-, 8-, 13-, 17-, 26-, and 52-week), Treasury Notes (2-, 3-, 5-, and 10-year) and Treasury Bonds (20- and 30-year).

The bills do not have a coupon, or interest payment. Instead, are sold at a discount to their face value. For example, a 52-week bill would be issued at 95%, so that the ultimate yield would be 5.26%. All other Treasury securities carry a coupon.

All issues have a fixed rate, except for the 2-year note, which can be issued with either a fixed or variable rate.

In addition, 5-, 10-, and 30-year notes and bonds also come as Treasury Inflation Protected Securities (TIPS). Unlike other Treasury securities, where the principal is fixed, the principal of a TIPS receives an inflation adjustment over time. For example, the latest 5-year TIPS has a coupon of 2.375%. On top of that, the principal gets adjusted for inflation in regular intervals, compensating the owner for the loss of purchasing power. 

How Treasuries are sold

New Treasury securities are sold via auctions. Institutions submit bids, stating which minimum yield they are willing to accept. The Treasury then fills all bids, beginning with the lowest yields, until the entire auction amount is sold (i.e., it uses a Dutch auction). All successful bidders are then awarded the same final yield.

Indirect bidders do not have accounts with the Treasury and must submit their orders through primary dealers, who act as intermediaries.

Primary dealers are a select group of banks and financial institutions that are obligated to bid in Treasury auctions. If no other buyers show up, primary dealers will end up buying the entire auction. In theory, this could amount to $90 billion or more. However, in March 2020, the Federal Reserve introduced a lending program, the so-called “Primary Dealer Credit Facility,” where Primary Dealers can obtain loans against collateral (consisting of the Treasury securities they just bought). The amount of borrowing is unlimited, thereby eliminating the possibility of a failed auction.

This is an important piece of information to understand: US Treasury auctions cannot fail. The Federal Reserve will lend unlimited funds to private sector institutions to absorb any unsold securities. However, the Federal Reserve does not cover any price risk; if interest rates were to rise rapidly, bond prices would decline, creating losses for financial institutions holding them. This effect was seen in March 2023, when Silicon Valley Bank was brought down by losses on Treasury securities and other bonds usually deemed “high quality liquid assets.”

The secondary market

Buying a Treasury security in an auction is also referred to as the primary market. Once a Treasury security has been issued, trading in the secondary market begins. 

Trading volume in the secondary market is impressive. According to the Securities Industry and Financial Markets Association, more than $840 billion worth of Treasury securities were traded daily during November 2023. On busy days, trading volume is likely to exceed $1 trillion, equal to 3% of the total amount outstanding.

On top of that, futures contracts on those bonds are being traded. A futures contract is a trade where the price between buyer and seller is set, but the settlement is made at a specified date some time later. Most futures positions are unwound before settlement.

The average daily volume for the most popular contracts (10-year, 2-year and 5-year) exceeded 13 million in November of 2023. Multiplying the number of contracts traded by their face value of $100,000, the total value of those futures traded amounted to more than $642 billion.

Maintaining this level of market liquidity is important because it makes sure that large buy or sell orders can be absorbed without much impact on price.

The repo market

If you are in a financial pinch and need to borrow money, you may go to a pawn shop. A simple promise to pack back the loan will not convince the store clerk. However, you can use a gold watch as collateral. The store clerk keeps your gold watch until you pay back your loan.

Treasury securities are considered the safest and most liquid investment. This makes Treasuries the perfect collateral for borrowing money.

After the 2008 global financial crisis, unsecured lending (without collateral) all but disappeared. Even banks do not trust each other anymore.

Borrowing money by using Treasury securities is called a repurchase agreement, or short “repo”. In a repo transaction, the borrower agrees to buy back the securities used as collateral at a later date. The repurchase price will be at a slight premium, compensating the lender for lost interest. The time frame for these transactions is usually very short, often overnight.

Here, too, the amounts involved are mind-boggling. In November, the average daily repo financing reached a stunning $5.2 trillion, comprising $4 trillion of Treasury securities.

As if this wasn’t enough, a reverse-repo market exists where the Federal Reserve lends out Treasury securities in exchange for cash, with a peak volume of $2.5 trillion. 

Who owns Treasuries?

“Somebody” needs to own (and keep buying) US federal debt. A look at the the owners of Treasuries reveals that only two out of five groups are price-sensitive: foreign and domestic private institutions. The other three groups are the US government trust funds, the Federal Reserve and foreign official holders — central banks and sovereign wealth funds.

US government trust funds include like the Social Security and Medicare. These funds are “captive” buyers. They are obligated to invest in Treasuries, regardless of the price.

Central banks, including both the Federal Reserve and foreign central banks, are also insensitive to price. They acquire securities for reasons other than profit maximization. Their purchases are motivated by monetary policy (Federal Reserve) or exchange rate policy (foreign central banks).

Foreign entities hold $6.7 trillion worth of Treasury securities, of which foreign official accounts hold more than half. Among the largest holders by country are traditional export countries like Japan ($1 trillion) and China ($0.8 trillion). As most internationally traded commodities and goods are invoiced in US dollars, the exporter ends up with excess dollars. To prevent its exchange rate from appreciating, their central bank then needs to absorb those dollars.

This has important implications; as long as non-US nations produce more goods and services than they consume, they will have positive trade balances, and hence US dollar inflows (that often get absorbed by a central bank). As long as the US consumes more than it produces, a trade deficit implies more money leaving the US than coming in. In other words, the US is exporting Treasury securities. The export of debt is the mirror image of its balance of trade. Financial flows must match flows of goods and services.

According the Polish economist Kalecki, a nation’s economy consists of four sectors: households and corporations (the private sector), the government and the foreign sector.

If the foreign sector has a surplus, domestic sectors must have a deficit. This could be either the government, or the private sector, or both. In the case of the US, the large and growing trade deficit therefore requires a large and growing fiscal deficit.

Only if Congress stepped in and put the brakes on government spending would the fiscal deficit shrink. This, in turn, would force a reduction in the trade deficit. Such a reduction is characteristic of a recession, as US consumers are forced to cut consumption, a lot of which consists of imported goods. 

Foreigners would then cut their purchases of US securities. But now, the need for foreign financing of US debt is reduced since the fiscal deficit was addressed. 

The numbers may seem scarily large, but the Treasury market is far from being at the edge of a cliff.

[Anton Schauble edited this piece.]

The views expressed in this article are the author’s own and do not necessarily reflect Fair Observer’s editorial policy.

The post Trillion Dollar Dilemma: Is the US Treasury Market in Trouble? appeared first on Fair Observer.

Before examining the reasons for this underperformance, it is important to look at the numbers. The average investor achieved annualized returns of 3.6% over 20 years. The Standard and Poor’s 500 (S&P 500 — an index comprising stocks of the 500 largest companies listed on US stock exchanges) achieved annualized returns of 9.5% over the same period. Even bonds, units of debt issued by governments and companies, gave returns of 4.3% over 20 years. 

Generally, investors put their money into both stocks and bonds. A 60/40-ratio of stocks and bonds would have returned 7.4% annually, while a 40/60-mix would have yielded 6.4%. Older investors are risk averse and often favor bonds over stocks because of guaranteed returns. In contrast, stocks can fall dramatically and, at times, lose all value.

With annualized returns of 3.6%, the average investor was able to double his or her money. The 60/40 stock-bond ratio should have led to 4.2 times increase in wealth while a 40/60 mix should have led to 3.4 multiple. Charles-Henry Monchau, the chief investment officer at Swiss Group Syz, estimates 95% of individual investors underperform the market. After fees and commissions, that number might be closer to 100%. Note this means that, except for a tiny percentage, investors almost invariably underperform the market.

In dollar figures, individual investors have left a lot of money on the table. From the end of 2018 to the same time in 2021 the S&P 500 rose by 90%. At year-end 2018, individual investors held equities worth $26.7 trillion. The annualized return figures tell us that individual investors missed out on gains of $3.6 to $5.9 trillion. What is going on?

Underperformance leads to the rise of passive investing

It makes sense that individual investors underperform the market. They do not have the same information as professional and institutional investors. They suffer from information asymmetry. These investors also fear losses, chase market darlings (stocks often discussed at dinner parties and rarely questioned as a good investment), chase hyped-up companies, fail to time the market and make other mistakes that individuals often do when investing or trading alone.

Surprisingly, professional and institutional investors do not outperform the market either. A study by S&P Dow Jones Indices reveals that up to 96% of all active US equity funds underperformed their benchmarks over a 15-year period. Note that only 30-60% of these funds survived over this period. Most underperforming funds simply closed shop. Some merged with others. So, there is a survivorship bias — a type of selection bias that ignores the unsuccessful outcomes of a selection process — to this 96% figure. The real figure is even higher.

So, why are individual and professional investors struggling to beat the market? After all, an index is a mix of companies of varying quality — some are great, some mediocre and some outright bad.

There is a logical problem with the idea of investors beating the market. Very simply, the market is nothing but all the investors buying and selling to each other. For any trade in the market, one investor has to sell to another. For every investor outperforming the market, another has to underperform.

Over the years, passive investors have emerged. These are exchange-traded funds (ETFs) that contain hundreds — sometimes thousands — of stocks or bonds listed on the market. Their basket of stocks or bonds closely follow the performance of the index neither out- nor underperforming the market.

In recent years, passive investing is rising. As a result, the number of market participants who still can under- or outperform is shrinking. According to Bloomberg data, more than 54% of all assets in US equity mutual funds and ETFs are now managed passively.

Who outperforms the market and why?

As most individual and institutional investors are underperforming, who then is outperforming the market? 

Outperformers tend to be hedge funds, activist and quantitative investors, insurance companies, pension funds and conglomerates like Berkshire Hathaway. 

Hedge funds use strategies usually not available to individual investors or mutual funds, such as leverage, arbitrage, combination of long and short positions, derivatives, and algorithmic trading. Activist investors take concentrated positions in companies to force management or strategic changes, which is impossible for individual investors due to lack of size. Unlike hedge funds, mutual funds usually do not take a combative stance towards company boards.

Quantitative investors use mathematical models and computer algorithms to exploit patterns and trends in financial markets. Individual and most institutional investors do not have access to trading technology to enter and resell positions within fractions of a second. Insurance companies and pension funds can afford to ignore short-term market turmoil as their capital is usually of long-term nature. Conglomerates like Berkshire Hathaway get a detailed look into the accounts of a potential takeover target before an acquisition, receiving better information than what individual shareholders obtain via quarterly and annual reports.

Note that this long-term advantage of pension funds might be lost as many outsource management of their assets. According to a BNY Mellon study, 50% of the largest public asset management companies exclusively use external managers. These managers tend to take short-term, not long-term decisions. Furthermore, these institutions often suffer from poor governance. This can have a detrimental impact on their performance.  Compared to their Canadian peers, “American public pension funds are stuffed with politicians, cronies and union hacks” and tend to perform more poorly.

A simpler reason for why it is so hard to beat, or even match, the performance of benchmark indices like the S&P 500 lies in a skewed distribution of returns. The performance of index member companies is not normally distributed (which would follow the bell curve) but has a huge right “fat tail”. Simply put, only a few companies have astonishingly outsized returns. Not owning those few companies automatically leads to underperforming the index.

Between 1995 and 2022, only ten stocks (just 2% of 500 companies) accounted for at least one-fifth of the performance of the S&P 500. In some years, the top ten stocks provided more than 100% of index performance. This means if we exclude these ten stocks, the S&P 500 would have had a negative return. 

Over the first nine months of 2023, the “magnificent seven” — Apple, Amazon, Alphabet, Meta, Microsoft, Nvidia, and Tesla — are up 92%, while the remaining 493 members of the S&P 500 have gained only 3%. Seven out of 500 are tiny odds. And it would not have been sufficient to simply own those stocks — one would have had to own them in the same ratio as the index. Those “magnificent seven” stocks currently command a 28% share of the index. Those who want to match the S&P 500 would have to have the same weighted portfolio. This means, investors would have to heavily invest in technology stocks precisely when the sector commands historically high valuations. 

Only a few winners emerge from the large number of companies listed on the market. Out of 28,114 publicly-listed US companies, the top 25 (less than 0.1%) are responsible for nearly one-third of all shareholder wealth created since 1926. These numbers underline the fact that the odds of picking those few massive outperforming stocks are very slim. Almost invariably, stock picking turns out to be a losing proposition.

Stock indices are simply less risky

Apple went public in December 1980 at a price of $22. Adjusted for stock splits, its initial public offering (IPO) price was $0.10 per share. At today’s price of $179.49, Apple has since gained 179,390%, a 19% annualized return. Yet to get that return, an investor would have had to sit through multiple difficult periods. From 1991 to 1998, Apple’s stock price declined by 83%, from 2000 to 2003 by 82% and from 2007 to 2009 by 61%.

Any potential Apple investor would have had to shrug off negative news headlines, like this one — “The Fall of Steve Jobs” — from Fortune Magazine in 1985. Shortly after this story, Jobs was fired from Apple. He returned 12 years later and led the company to great success. However, it would have taken a brave and stubborn investor to hold on to Apple stock and they would have had to refrain from taking any profits for a long period of time.

Asked which stock investors wished they had bought (in hindsight), most would likely name Apple or Tesla. However, a beverage company, emerging out of bankruptcy in 1988, steals the crown. Formerly known as Hansen Natural, Monster Beverage rose from a split-adjusted price of $0.0062 in 1995 to around $50 today, for a return of more than 800,000%. The annualized gain of 37% for Monster Beverage is almost twice Apple’s 19%.

There is no guarantee that companies can come back from steep declines in stock prices. In such cases, investors’ stubbornness can backfire. The share prices of former market leaders were nearly or completely wiped out. Former stock market darlings such as Nokia (-90%), Palm (-94%), Blackberry (-98%) and Nortel Networks (-100%) are part of a long list of companies that have sunk like lead in water.

In the case of an investment manager, he would have been fired for holding on to Apple or Nokia stock. Holding an ETF saves professional fund managers from the risk of losing their jobs.

Jack Bogle, the founder of investment management company Vanguard, famously exclaimed “Don’t look for the needle in the haystack. Just buy the entire haystack.” The “needles” investors are looking for are the few companies whose shares go on to have an astronomically high performance. The “haystack” is the entire stock index. Vanguard introduced a low-cost index fund in 1976, leading to the success of the ETF. Not only does an index ETF guarantee to closely follow the market but it does so at very low cost. The Vanguard S&P 500 ETF charges 0.03 and even the State Street Global Advisors “SPY” ETF charges 0.09%, a much lower figure than active professional and institutional investors.

What if everyone goes passive?

From a rational perspective it does not make sense to spend millions of dollars on salaries of analysts and portfolio managers if the prospects of outperforming a simple (and cost-efficient) ETF are slim. So what would happen if most investors shifted to passive investing via index-linked vehicles? What if nobody did any research anymore into companies’ fundamentals, balance sheets and products? 

Index members could rely on steady buy orders from automatic investing by pension funds and insurance companies. However, this raises other issues. Would the stock price of a company reflect the fact that it was on the verge of bankruptcy or that it had just invented a cure for cancer? Would the price mechanism of the market still work?

In theory, there must be a maximum share of passively managed money beyond which active investing would become profitable again. But the fundamental conundrum of the market would still remain: for every investor that outperforms there must be another who underperforms the index.

For individual investors, going passive does by no means guarantee investment success. Passive investing simply means no underperformance relative to an index but does not guarantee absolute (positive) performance. It took the technology-heavy Nasdaq Composite 15 years to recuperate losses after the dot-com bubble burst in 2000. Between 1995 and its peak in March 2000, this index rose 800%, only to give back most of its gains by October 2002.

Today, S&P 500 heavyweights such as Apple and Microsoft are valued together at over $5 trillion. They are sporting historically high valuations with their valuations at 28 and 30 times their estimated earnings respectively. The index containing these stocks doesn’t care about the valuations of Apple and Microsoft. The S&P 500 does not care about the future performance of Apple and Microsoft. Passive investing can solve relative underperformance vis-à-vis the market but not guarantee high returns because, like the Nasdaq in 2000 or Wall Street in 1929, the market itself can lose value.

The views expressed in this article are the author’s own and do not necessarily reflect Fair Observer’s editorial policy.

The post How to Invest: Forget the Needle, Buy the Haystack appeared first on Fair Observer.

We might wonder why glass is transparent, given that most other materials seem to stop light in its tracks without any effort. However, this perspective shifts dramatically when you envision an atom magnified to the size of a football stadium. In this atom, the nucleus, resembling a mere pea, resides at the stadium’s center while electrons whiz around the outer stands. The vast expanse in between is empty space. This revelation challenges our perception. Instead of pondering “Why is glass transparent,” we should inquire, “Why do most materials block light?”

A similar thing happens when we talk about money. Most of us think that we understand what money is, because we use it every day. A little bit of science will tell us that matter is really mostly empty space, and that money is really debt. Wow! But leave aside the abstract money that exists in banks’ computers. What about the cash in your wallet — at least we understand how that works, right?

Cash is not where you think it is

Recently, I stumbled upon a piece of information buried within the US Treasury Department’s quarterly “Treasury Bulletin.” The total amount of US currency, encompassing both coins and notes, currently stands at a staggering $2.3 trillion. But what’s really astonishing is that this amounts to a “per capita” figure of $6,998. That’s $6,998 for every man, woman and child in the United States. That ought to mean that, on average, a typical five-person family possesses an astounding $35,000 in cold, hard cash. Not in a bank account, but in the form of tangible currency.

Of course, we must account for other entities holding cash. Around $100 billion is kept in bank vaults. According to a study by JPMorgan, small and medium-sized enterprises (SME) hold, on average, $12,000 in cash. With roughly 33 million SME, the amount of cash can be estimated at $400 billion. Finally, there are around 450,000 ATMs (automated teller machines) in the US, with each holding, on average, around $20,000 in cash, or $9 billion in total. In addition, small amounts of currency will be found in vending machines, parking meters, and organizations receiving cash donations.

Sure. But this still leaves around $1.8 trillion behind — $5,375 per capita. This is hard to believe, since studies have shown that 64% of Americans would have to deplete their savings to cover a $400 emergency expense. So where is all the money?

According to an article published by the Federal Reserve Bank of St. Louis, an estimated 45% of all Federal Reserve Notes (paper cash), worth $1.1 trillion, are held by non-US persons. A study published by the Federal Reserve Bank of Chicago even suggests that more than 60% of all US bills and nearly 80% of $100 bills are held overseas. With $1.88 trillion in $100 bills outstanding, this would total up to $1.5 trillion.

The Federal Reserve makes money from foreign use of US currency

For the Federal Reserve, currency in circulation is a liability. You can conceive of a dollar bill as an interest-free debt note with no end date. Since it never has to be paid back, it is “free” debt. 

Commercial banks have money in accounts at the Federal Reserve, which means the Federal Reserve owes them money. When they withdraw that money as cash, the debt is now represented by paper notes. By offloading its liabilities as currency in this way, the Federal Reserve can then invest its freed-up resources elsewhere. Income earned on such investments is called seigniorage. If invested in short-term Treasury bills, those profits can be described as risk-free.

Where Do New Dollars Come From?

With $2.3 trillion in currency outstanding, assuming the proceeds are invested in 1-month Treasury bills currently yielding 5.5%, the central bank would generate risk-free profits of $126.5 billion per year. This amount is larger than the military budget of all but China and the US itself.

Of those $126.5 billion, $88 billion would be earned thanks to dollar bills held by foreigners. That’s $88 billion the Federal Reserve is earning on safe interest. Foreign investors could have earned that money themselves if they had held Treasury bills instead of cash. So why would they forgo the money and allow the Federal Reserve to make the investments instead?

The answer is that US currency is quite useful.

In some countries, the US dollar is used alongside or even instead of the local currency for everyday transactions. This is usually the consequence of a substantial devaluation and loss of confidence in the local currency.

Ecuador adopted the US dollar as its official currency in the year 2000, following a severe financial crisis. Since then, the US dollar has been the sole legal tender in the country.

In September 2021, El Salvador became the first country in the world to officially adopt Bitcoin as legal tender alongside the US dollar. While Bitcoin is now a recognized currency, the US dollar remains the primary and most widely used currency for daily transactions.

Panama does not have its own national currency; instead, it uses the US dollar exclusively for all transactions.

Due to hyperinflation and the collapse of the Zimbabwean dollar, the US dollar, along with other foreign currencies, such as the South African rand and the euro, has been used for transactions.

In Argentina, lack of trust in local currency has led to strong demand for US dollars, resulting in a 100% premium for US dollar bills in black markets over the official exchange rate.

So, all of these countries make wide use of US currency as a means of exchange and as a store of value, and the Federal Reserve collects the profits.

Digital currency competes with stablecoins

However, this system only works as long as we are still using paper cash. As we shift towards a cashless society, those seigniorage profits will disappear!

This is one of the major reasons why all central banks are keen on introducing “central bank digital currency” (CBDC). Like cash, it would be money issued by a central bank (as opposed to bank deposits, which are money issued by a private institution). In a cashless society, CBDC would be the only way for citizens to get their hands on publicly issued money and for central banks to issue public money to citizens. The ability to continue to generate seigniorage profits depends on the successful introduction (and acceptance) of CBDC.

Here is where private issuers of stablecoins enter the scene. A stablecoin is a digital token that is designed to have a stable value, typically by being pegged to a reserve of assets or through algorithmic mechanisms, but which is neither issued by a central bank nor a commercial bank. Thus, stablecoins are direct competitors to CBDC.

What You Need to Know About Cryptocurrencies

Take Tether, for example. According to its website, Tether has issued almost $83 billion worth of tokens. Assuming the operation is not fraudulent, Tether invests proceeds received in exchange for the issuance of tokens in interest-bearing securities like Treasury bills. $83 billion invested at a yield of 5.5% results in interest income of around $4.5 billion per annum. Since Tether does not pay any interest on tokens issued, this interest income, after subtracting some administrative expenses, is profit. The business of stablecoin issuance is extremely profitable! Seigniorage profits, but privatized.

Since the Federal Reserve remits most of its profits to the US Treasury, seigniorage profits by the US central bank indirectly benefit US taxpayers. Privately-owned stablecoin issuers are eating into the cake of public seigniorage. And there are limited options on how to prevent private issuers from taking a growing share of the cake.

But stablecoins are not as trustworthy or easy to use as cash. So why would anyone forgo risk-free interest income on US Treasury bonds and instead hold a non-yielding stablecoin like Tether?

Stablecoins provide a means for crypto-currency traders to quickly exit the cryptocurrency market without the need to transfer funds back to a traditional bank account. This liquidity is particularly useful for arbitrage opportunities and active trading. In traditional banking and brokerage, proceeds from a sale are not immediately available for another trade, as settlement of funds does not take place until a few business days later.

95% of Tether, to the extent that we can tell, is held outside the US. Tether is likely gaining popularity in countries with failing local currencies for the same reasons we cited above for the use of US paper money abroad.  For a person living in Argentina, unable to access dollars at the official exchange rate of 350 pesos to one dollar, and faced with a black market rate of 725 pesos, the remote possibility of a stablecoin issuer becoming insolvent pales in comparison with the certainty of 113% inflation in local currency.

From a regulatory perspective, stablecoin issuers are accepting deposits while lacking a banking license. Therefore, they cannot call themselves banks, and the deposits they hold are not covered by any deposit insurance scheme. The lack of transparency and high risk of fraud set stablecoin issuers apart from highly regulated commercial banks.

But what if a stablecoin issuer did act like a legitimate bank? If it were a member of the Federal Reserve System and deposited its proceeds into an account with the Federal Reserve Bank, the existence of funds would be easily verifiable. Moreover, since the central bank cannot go bankrupt, there would be no default risk!

Custodia Bank of Wyoming, a US state with crypto-friendly legislation, has tried for years to do exactly that by becoming a member of the Federal Reserve System. The Federal Reserve, however, recently denied Custodia Bank’s application as the firm’s “novel business model and proposed focus on crypto-assets presented significant safety and soundness risks”.

Seigniorage profits are substantial, especially if most holders reside outside the country of the issuing institution. The prospect of virtually risk-free gains will continue to attract privately owned stablecoin issuers. Central banks will try to prevent those private issuers from eating into their share of profits. Perhaps users will only stop flocking to stablecoins after a good proportion of issuers run into financial troubles, fall victim to theft from insiders, get hacked or see their peg to the underlying currency fail. Central banks probably wouldn’t shed many tears if that happened.

[Anton Schauble edited this piece.]

The views expressed in this article are the author’s own and do not necessarily reflect Fair Observer’s editorial policy.

The post Revealing Who Is Holding Billions of US Banknotes appeared first on Fair Observer.

Despite its importance, very few could answer even the most basic questions about money: Where does it come from? How much money actually is there?

If I asked you how much money you own, you could likely determine the answer with a few clicks by checking your account balances. Store owners are aware of the dollars in their cash registers and in the bank. Any bank knows exactly how many dollars (or any other currency) are on its balance sheet. The government knows. The number of total dollars in circulation, then, should be a known quantity.

Here is an experiment you can do right now: google the question, “How many dollars exist in the world?” You will be puzzled by the result: a wide range of different figures. For example, Wikipedia will tell you there are $2.1 trillion in circulation, while the Federal Reserve Bank lists $20.8 trillion as the monetary base just of the US. The Financial Accounts of the US mention $95 trillion in outstanding public and private debt—to which we can add more than $80 trillion in hidden debt identified by the Bank for International Settlements, bringing the total figure for American debt to over $175 trillion. Surprisingly, the exact total number of dollars in existence remains unknown.

The lack of a definitive figure stems from varying definitions of what qualifies as money. Consider the unused portion of your credit card limit—does it fall under the category of money? Similarly, when two non-US banks engage in a cross-currency swap agreement involving US dollars, booked as potential liabilities off of the balance sheets, should that be considered money? These examples highlight the complexities and uncertainties surrounding the precise determination of the total amount of money in circulation.

What is money?

Money exists in diverse forms and exhibits varying characteristics. For instance, for a car dealer, the primary concern would not be the specific form of payment a customer uses to purchase a car. Whether the customer pays with a suitcase full of cash (money laundering concerns aside), obtains financing from a bank, or secures a loan or lease from the manufacturer’s in-house financing arm, the main objective, from the dealer’s point of view, would be completing the sale.

In the first scenario, the customer uses money created by the central bank, which is commonly referred to as public money.

In the second case, the customer relies on money created by the private banking sector, known as private money.

The third example involves the in-house financing arm bundling customer loans and selling them to investors in the form of collateralized car loan obligations. This practice exemplifies money creation by the shadow banking sector. (The term “shadow banking” refers to financial activities that fulfill similar functions to traditional banking but take place outside the scope of traditional banking institutions.)

These examples demonstrate the varied sources and mechanisms that create money, encompassing public money issued by central banks, private money generated by commercial banks, and even forms of money creation within the shadow banking sector.

In all three examples, debt plays a significant role as a method of payment. In our fiat monetary system, the creation of money is tied to the creation of an equivalent amount of debt. In other words, when new money is brought into existence, an accompanying debt is simultaneously created.

This means that one person’s savings represent another person’s debt. As a result, the total amount of money in circulation must match the overall amount of outstanding debt. This explains why, when searching for the number of dollars in existence online, it is common to encounter search results mentioning “debt.”

The functioning of our monetary system can indeed be unintuitive. It can be challenging to grasp the notion that money we hold in our bank accounts represents someone else’s debt and that when we transfer money, we are essentially passing on IOUs.

This lack of awareness or disbelief about the nature of money is not uncommon. Many people may view money as a tangible and independent entity without recognizing its interconnectedness with debt.

Where do the dollars come from?

I spoke about institutions that create money. “Isn’t it the government that creates money?” you might ask. The reality is not so simple.

A country’s central bank creates money in physical (notes, coins) and digital form (deposits credited to its clients, which are other banks). Both forms constitute a liability for the central bank. By examining its liabilities, the total amount of money created can be determined. In the case of the Federal Reserve, the US central bank, this amount currently stands at approximately $8.25 trillion.

Of the over $175 trillion of debt in the economy, the vast majority has not been created by the central bank but rather by the private sector. The US central bank accounts for less than 5% of total money outstanding. However, despite its small contribution, the central bank is often held responsible for the entire amount outstanding, despite this amount being 20 times greater than its own creation.

Central banks face criticism for their perceived role in “printing” vast sums of money seemingly out of thin air. However, as previously mentioned, their direct impact on the total amount of money in circulation is relatively small compared to the contributions of the private sector.

Instead of solely focusing on central banks, it can be valuable to recognize and appreciate the functioning of our monetary system. This system, despite not being backed by any physical commodity like gold, has been operational for several decades. The longevity and resilience highlight the system’s ability to facilitate economic transactions, support economic growth and maintain relative stability.

Why do we need private banks?

Money, as a medium of exchange, is a public good. However, private sector banks are permitted to create money, under strict regulations, through the issuance of loans. Why should the private sector be allowed to participate in money creation?

The reason lies in the nature of lending and the risk of individual loans. It is not feasible for average citizens to lend significant amounts of money directly to strangers for purchases like cars or homes. It would be impossible for individuals to assess creditworthiness and risk. Banks, with the help of equity buffers and deposit insurance, take care of that risk. This enables your neighbor to finance his house without you having to worry about his creditworthiness causing sleepless nights.

In theory, it is conceivable for central banks to undertake the lending function. However, central banks primarily have a public mandate to ensure monetary stability and implement monetary policy. Determining the creditworthiness of individual borrowers on a local level would require a vast network of branch offices, which could divert resources and focus away from the central bank’s core responsibilities.

Private banks not only perform risk transformation, by shifting credit risk from individual depositors onto the bank, but also maturity transformation. This means that while banks provide longer-term loans to borrowers, depositors have the flexibility to access their savings daily. This maturity transformation allows banks to match longer-term loans they make with shorter-term deposits, ensuring the smooth functioning of the financial system.

Economic growth requires the expansion of debt

Most big-ticket items, like cars as mentioned in the earlier example, are financed rather than paid for in cash. As a result, availability and accessibility of credit play a vital role in facilitating car sales and driving economic activity.

A credit contraction, in which credit institutions tighten lending standards, leads to fewer loans and therefore economic contraction.

As the expansion of debt often outpaces economic output, debt service levels may eventually become overwhelming. This situation can result in borrowers being unable to meet their debt obligations, forcing banks to write off loans and thus triggering a recession. In cases where loan losses exceed safety buffers, banks may face the risk of closure. Fortunately, depositors can rely on deposit insurance schemes within certain limits, which is crucial to instill trust in private institutions despite the possibility of insolvency.

In addition to deposit insurance, trust in private institutions is also bolstered by the possibility of converting bank deposits, representing a claim against a private institution, into cash, which carries no risk of bankruptcy. However, this feature can trigger bank runs once the trust in a particular bank has been shattered.

The role of cash

Public money, in the form of cash, serves as a critical mechanism to maintain the uniform value of dollars, regardless of their issuer. Prior to the establishment of the Federal Reserve Bank System, a dollar note issued by a bank in Connecticut, for example, would be cashed at a discount to its face value when presented in New York City. Only the introduction of a central bank ensured full fungibility of dollars regardless of their origin or issuing entity.

Bank deposits can be thought of as stablecoins, with deposit insurance and convertibility into cash functioning as the mechanism guaranteeing the 1-for-1 peg.

As we transition towards a cashless society, the role of public money (cash) as the anchor of our monetary system is undergoing a transformation. Currently, cash serves as the only means through which individuals can access public money, as only banks are permitted to hold accounts with the Federal Reserve.

This is where Central Bank Digital Currency (CBDC) comes in. With the eventual retirement of physical forms of money, CBDC will emerge as the sole means for central banks to directly engage with individuals.

CBDC can be thought of as tokenized cash, representing a digital form of central bank-issued currency. It retains the characteristics of cash in terms of being a liability of the central bank, ensuring its stability and reliability.

Keeping seigniorage alive

Central banks benefit from cash in circulation as cash represents interest-free debt, providing them with a significant source of income from investing proceeds in interest-bearing securities, resulting in profits known as seigniorage.

The US Federal Reserve, for example, has around $2.3 trillion of currency in circulation. If these funds were invested at a hypothetical interest rate of 5%, the annual return would amount to $115 billion, a sum greater than the military budget of any country other than the US and China.

With the disappearance of physical cash, the traditional source of such profits would cease to exist. However, the introduction of Central Bank Digital Currency (CBDC) presents an opportunity to sustain and continue generating seigniorage profits. Furthermore, public money is vital to support increasing sums of private money outstanding. The introduction of CBDC should therefore be welcomed.

A debt-based monetary system is a feature, not a bug

The current monetary system frequently faces criticism for lacking tangible backing and enabling unlimited issuance. In contrast, assets like gold and Bitcoin are seen as different because they do not represent any counterparty’s obligation. However, while some proponents applaud this aspect, it can be viewed as a drawback rather than a desirable feature.

The absence of counterparty risk and limited issuance in assets like gold and Bitcoin can lead to a phenomenon known as hoarding. This hoarding behavior is reminiscent of medieval kings sitting on vast treasure chests filled with gold, rendering the gold inert and unavailable for circulation within the economy. Consequently, this results in a restricted monetary base in circulation, which hampers economic growth.

A fiat monetary system possesses the unique feature of allowing for the simultaneous creation of savings and debt, enabling economic growth even in the presence of accumulating savings. This characteristic is a significant advantage of such a system.

The potential drawback of a fiat monetary system lies in the temptation to create excessive debt or money, which can lead to devaluation. This factor renders fiat money less reliable as a store of value, while it represents an excellent medium of exchange.

The stability and functionality of a fiat monetary system relies on individuals’ willingness to hold their savings in fiat currency. While it is impossible for everyone to convert fiat into tangible assets, individuals still have the freedom to make such choices.

Despite its drawbacks, a fiat monetary system remains preferable to a system based solely on hard assets, which would create deflationary pressures and possible economic depression. The dynamic nature of a fiat system allows for central banks to make adjustments in money supply to accommodate economic needs.

[Anton Schauble edited this piece.]

The views expressed in this article are the author’s own and do not necessarily reflect Fair Observer’s editorial policy.

The post Where Do New Dollars Come From? appeared first on Fair Observer.

The debt ceiling in the United States originated from the need to control government spending and ensure fiscal responsibility. Initially, Congress had to authorize each new batch of debt issued, a cumbersome process that was modified with the passage of the Second Liberty Bond Act of 1917. This act established an aggregate amount, or debt ceiling, to govern the total debt to be issued. Since World War II, the debt ceiling has been adjusted over 100 times to accommodate the country’s evolving financial needs.

The concept of a debt ceiling, however, itself poses logical inconsistencies. All federal government spending is already authorized by Congress, making it contradictory to prevent the Treasury Department from raising the necessary debt to fund these authorized expenditures. In other words, Congress forbids spending which it has already mandated. Reaching the debt limit forces the government to choose between not fulfilling previously agreed obligations or defaulting on existing debt service. Either of these would be a violation of obligations established by law, and would therefore have severe implications for the US economy.

Implications of reaching the limit

Reaching the debt ceiling carries significant implications for the US economy. It can lead to a government shutdown, disrupt essential services, and even result in default on financial obligations, jeopardizing the nation’s creditworthiness. Credit rating agencies closely monitor debt ceiling debates. If they were to downgrade the federal government’s credit rating, this would increase borrowing costs and undermine investor confidence. Uncertainty surrounding the debt ceiling, even if it is not eventually reached, also introduces volatility into financial markets and can impact global economic stability.

An Outstanding Deep Dive Into the American Economy

Government default entails the non-payment of interest or principal on its obligations. This triggers a credit event that has far-reaching consequences. Individuals and institutions relying on government funds would not receive payments. Credit default swaps (CDSs)—insurance contracts taken out against credit events—would be triggered, potentially causing financial difficulties for institutions which have written CDSs. Rating agencies would downgrade the US credit rating, impacting other borrowers, and Treasury securities would no longer serve as acceptable collateral for institutional borrowing, leading to a collapse of credit availability, choking the economy and leading to a severe contraction.

Rating agencies such as Fitch and Standard & Poor’s have expressed concerns about the United States’ credit rating, despite the recent agreement on the debt ceiling. A potential downgrade could have implications not only for the US but also for all other borrowers whose credit rating is usually influenced by the sovereign rating. With the US bond market dominating global markets, the loss of the anchor role of US Treasuries, which form a substantial part of institutional portfolios worldwide, could create disarray in international bond markets.

Partisan shenanigans and a borrowing spree

The debt ceiling has become a contentious political issue in recent decades, with both major parties sharing responsibility for substantial increases in outstanding debt. The threat of a debt default has often been used as a bargaining tool in political negotiations. However, neither party wants to bear the blame for driving the country into a crisis, resulting in a risky game of chicken in which each party attempts to see who will budge first and agree to concessions favorable to the other party’s spending policy. This raises questions about whether the debate really revolves around the debt itself. The recent deal, featuring a suspension of the debt limit, essentially provides the Treasury the freedom to borrow as much money as needed until January 2025—a carte blanche.

The government’s account at the Federal Reserve, the Treasury General Account (TGA), has almost been depleted. It will have to be replenished to 600 billion US dollars (it peaked at 1.8 trillion US dollars during the pandemic). Those funds will have to be raised by raising additional debt—on top of money needed to fund the current federal fiscal deficit of around 2 trillion dollars. As I mentioned in a previous article, it is not apparent who would buy that amount of Treasury securities. The Federal Reserve might be forced to reverse its plan to slowly shrink its balance sheet, having to absorb additional government debt.

Who Will Buy America’s Debt Now?

After borrowing 726 billion dollars during the second quarter of 2023, the Treasury Department expects to raise another 733 billion dollars in the following quarter. Total government debt is hence guaranteed to continue rising at a fast pace. Having briefly been arrested at 31.4 trillion dollars (the amount of the debt ceiling), federal debt is expected to exceed 50 trillion dollars by 2033. The exponential growth of government debt is going to continue unabated.

The spending bill includes some mild cuts of non-military discretionary spending in 2024, and a limit of all discretionary spending in 2025. Military spending, however, will increase further, to 886 billion US dollars in 2024, and 895 billion in 2025, a 23% increase over the amount spent in 2022.

The bill’s drafters found other devices to cut costs. 20 billion dollars originally awarded to the IRS (Internal Revenue Service) to fight tax evasion will be clawed back. The bill imposes new requirements for adults to maintain access to food stamps. It also ends the freeze on student loan repayments. In short: money taken from the poor is being given to the military and to people crafting “innovative” tax returns.

Hidden under the surface-level negotiations was a fight over permit reform. Local governments had the ability to block interstate pipelines and electricity lines by dragging out the permitting process. Alternative energy companies need new transmission lines to transport energy produced by wind and solar farms towards population centers near the coasts. Fossil fuel companies need pipelines to move abundant natural gas from sparsely populated areas with shale reservoirs towards the big cities or harbors for export. In the end, the Mountain Valley Pipeline, bringing natural gas from the Marcellus shale fields in West Virginia to Virginia, made it into the bill, securing Senator Joe Manchin’s vote.

A proposal to end recurring debt ceiling drama

US lawmakers recognize the insanity of recurring debt ceiling debates, especially since it is a question of funding spending that has already been authorized by Congress once.

One option contemplates a bureaucratic rather than a legislative solution. This would involve the Treasury Department disregarding the debt ceiling and continuing to issue debt. The perspective finds support in the 14th Amendment of the US Constitution, which states that “the validity of the public debt of the United States, authorized by law…shall not be questioned.” However, pursuing such a unilateral move could result in a legal dispute and potentially generate still more uncertainty.

Another suggestion entails the Treasury minting a platinum coin with a denomination of 1 trillion US dollars, as it is legally permitted to do. This coin would then be deposited with the Federal Reserve in exchange for a credit of 1 trillion dollars. However, Treasury Secretary Yellen has dismissed this idea, noting that the Federal Reserve is unlikely to agree to such a proposal.

It is worth noting that the US government has in fact experienced instances of default in the past. Esteemed Wall Street veteran Jim Grant argues that a default can occur through a unilateral change in payment terms, resulting in a diminished financial obligation, such as forced currency redenomination. Two events over the past century align with this definition. Firstly, the devaluation of the dollar relative to gold under US President Roosevelt in 1933, when the gold price was raised from $20.67 to $35 per ounce. Secondly, the “temporary” suspension, which has since become permanent, of the dollar’s convertibility into gold by US President Nixon in 1971.

In reality, persistent inflation can be viewed as another form of default, albeit spread out over many years. Over time, the US dollar has lost approximately 97% of its purchasing power since the establishment of the Federal Reserve in 1913. While the dollar remains an effective medium of exchange, it has proven to be a poor long-term store of value due to the erosion of its purchasing power through inflation.

If spending is not controlled, the government will find one way or another of making ends meet, and all too often it is the consumer who foots the bill.

[Anton Schauble edited this piece.]

The views expressed in this article are the author’s own and do not necessarily reflect Fair Observer’s editorial policy.

The post What You Need to Know About the Debt Ceiling appeared first on Fair Observer.

What is money?

Money is defined as a medium that fulfills at least three conditions:

1. Medium of exchange. Instead of bartering chicken against wheelbarrows, we can use the money for intermediation, which reduces friction and facilitates trade.
2. Store of value. Money should not be perishable. Ice cream would be a terrible store of value. Same for air since air is abundant. Gold is a good store of value.
3. Unit of account. A collector of classic cars might boast about the number of vehicles he owns, but it might not mean much to a farmer who measures his wealth in acres of land. However, most can relate to the value of things expressed in dollars.

Before the advent of paper money, people used gold coins as a medium of exchange. Unlike paper money, which is just ink on paper, a gold coin has tangible value and is easily understood. However, carrying around heavy coins was inconvenient and risky. The introduction of paper money was a game-changer as it provided a lightweight and convenient alternative to gold coins. In 1971, the gold standard was abandoned, and paper money became detached from its physical backing. Today, money is merely a social construct, and its value is based on our collective agreement. Despite being intangible, it is a powerful tool that enables trade and economic growth.

The rise of electronic banking has brought about the concept of digital money, which takes the abstraction of money to a whole new level. While we traditionally associate money with its physical representation as cash, the truth is that most of the money exists purely in digital form, represented by strings of zeros and ones stored on computer servers. In fact, only a tiny fraction of the money supply in the United States is in the form of physical cash, with estimates suggesting that only around 1-2% is available domestically. The sheer scale of digital money is staggering, with the total amount outstanding in the US amounting to a staggering $93 trillion, compared to just $2.3 trillion in physical cash circulation.

Pokémon Theory of Money

To illustrate how our monetary system works, let’s use an analogy with Pokémon cards. Pokémon trading cards were first introduced in 1996 in Japan and have since been sold more than 43 billion times worldwide. Let’s assume all Pokémon cards are equally common and different designs equally distributed. While the production cost of each card is just a few cents, they are sold to the public for $1, much like how our paper currency is printed at a very low cost but has a much higher face value. These cards have almost zero material value, being made of cardboard and ink, just like our dollar bills. In this analogy, the company that produces the Pokémon cards represents the central bank, whose role is to serve the public by supplying currency. The central bank manages the production of cards so that the market isn’t flooded with them, which would cause the value of each card to plummet. Instead, they aim to produce enough cards for new players to accumulate, while maintaining the overall value of each card.

Pokémon exist in the digital world, too. Players can collect Pokémon through an electronic game by either finding them by chance or completing in-game tasks. Motivated by the game’s popularity, certain private companies have entered into a license agreement with the CPC (“Central Pokémon Company”) to produce digital Pokémon. These companies function like commercial banks, creating only digital representations of the Pokémon. However, players can still exchange their digital Pokémon for real cards if they wish. Private banks hold a certain stash of physical cards in their vaults for this purpose.

Some players wish to borrow digital Pokémon for business purposes. The creation of those Pokémon happens via double-entry in the bank’s books – as an asset and a liability. The bank records Pokémon on loan to the customer as an asset. Simultaneously, the bank records the same Pokémon as a liability since it was also credited to the customer’s online wallet. The customer can now either exchange his Pokémon into a real card or send it from his account to other players in digital form.

Private banks create additional digital Pokémon out of “thin air” with a keystroke on a computer. Most players do not understand this feature, wrongly believing the bank was dependent on other players depositing their Pokémon cards first.

As a result, digital Pokémon exist in two forms – as an asset and as a liability – each complementing the other like yin and yang.

No money without debt

This is exactly how our monetary system works. It is impossible to create money without creating the same amount of debt at the same time. This has various important implications:

1. Growing the amount of money available requires growth of debt.
2. For someone to save, someone else must go deeper into debt.
3. Your savings are only as good as the corresponding debt.

What does that mean for your money in the bank?

Your bank deposit – what we call “money” in the bank, represents a liability for the bank. In case the bank becomes insolvent, you are only entitled to what is left over after liquidation. Which in many cases would be little. Therefore, deposits are usually guaranteed by some form of insurance ($250,000 per account in the US).

Players know that they can individually exchange their digital Pokémon into real cards at any time. They are (mostly) aware that, in aggregate, not enough real cards exist in case every player tries to exchange at once.

The bank keeps a limited stash of real cards on hand based on estimates of average customer requests for exchange. In case of larger exchange requests, the bank orders a shipment of additional Pokémon cards from the CPC, which arrives in armored trucks. The bank pays for the shipment by having the amount deducted from its account with the CPC.

Social media accelerates bank runs

A bank run can occur when customers rush to exchange their digital Pokémon into real cards simultaneously. In such a situation, the bank might not have enough real cards to honor all requests, leading to potential losses for customers. Customers with deposits below the insurance limit need not worry as they are protected by some form of insurance, such as the FDIC in the US, which insures deposits up to $250,000 per account.

In the event of rumors regarding a troubled bank, customers with large deposits might withdraw funds immediately and transfer them to a supposedly safer financial institution or purchase government-issued securities. Failing to withdraw large deposits could result in financial losses due to lack of insurance coverage. There are almost no negative consequences to withdrawing immediately, while there could be a considerable downside in not doing so. This asymmetry is what often leads to a dangerous and self-fulfilling acceleration of bank runs.

In recent bank failures, such as with Silicon Valley Bank and First Republic Bank, large deposits have been covered even when they exceeded the insurance limit, despite no obligation to do so. While this is a benefit for customers, it weakens the insurance fund, and surviving banks might have to pay higher insurance fees, which they could pass on to their customers.

Deposit insurance guarantees the “peg”

The Deposit Insurance Fund (DIF) of the Federal Deposit Insurance Corporation (FDIC) had $128 billion of assets at the end of 2022. Insured deposits amounted to $10 trillion compared to total deposits of $17 trillion. The DIF covers 1.3% of insured and 0.75% of total deposits.

Think of a bank deposit as a stablecoin, with the FDIC guaranteeing the “peg” (making sure the exchange ratio of 1:1 from bank deposits into central bank-issued cash holds). In a bank run, that “peg” gets challenged.

As more US regional banks are running into financial trouble, the cost of making depositors whole rises. A significant decline in assets of the DIF could cause savers to question the “peg” even for insured deposits, which would trigger a bank run on institutions previously deemed safe.

Act now to stop the spread of the banking crisis

To prevent the situation from getting out of control, policymakers must act, and soon. One solution would be to guarantee all deposits regardless of size. This should stop the deposit bleeding at regional banks. However, insurance fees would have to be increased.

A further spread of the banking crisis would make it necessary to cut interest rates, drastically. This could help reduce banks’ losses on fixed-income securities on the asset side and relieve funding stress on the liability side.

Capital markets are already betting on significant cuts in interest rates. The Fed Funds Rate, the US central bank’s main refinancing rate, currently has a target range of 5-5.25%. Futures markets see this rate in a range of 4-4.25% by the end of the year, with further cuts to 2.75-3.00% by the end of next year.

Large rate cuts could undermine the ability of the Federal Reserve to combat inflation. The central bank might not be able to maintain the stability of both the financial system and the value of money. If forced to choose, it is likely that the survival of the system is more important than tolerating higher inflation.

The views expressed in this article are the author’s own and do not necessarily reflect Fair Observer’s editorial policy.

The post The Pokémon Theory of Money and How to Stop Bank Runs appeared first on Fair Observer.

• $12 trillion is owned by US private investors such as mutual funds, pension funds, banks, and insurance companies.
• $6 trillion is held by the Federal Reserve, the US central bank.
• $7 trillion is owed to US agencies and trusts, such as the Social Security Trust Fund, the Military Retirement Fund and the Medicare Fund.
• $7 trillion has been purchased by foreign holders, with 50% owned by foreign official accounts, i.e. central banks, and 50% by foreign private investors.

Many investors have suffered substantial losses from holdings of long-term US government bonds. As interest rates rose, the prices of existing bonds with lower coupons had to drop in order to make them competitive with newer bonds issued with higher coupons.

The price of too many “high-quality” assets

After the Global Financial Crisis of 2007-08, regulators forced banks to increase their holdings of so-called high-quality liquid assets. These were debt instruments issued by the US government and government-sponsored entities (GSE). 

Banks duly raised their bond holdings from around $1 trillion in 2008-09 to almost $5 trillion in 2022. As interest rates rose, unrealized losses reached $620 billion in the fourth quarter of 2022, eating into banks’ capital. This directly led to the undercapitalization and collapse of Silicon Valley Bank, the 16th largest bank in the US, in March 2023.

Given recent events, it is doubtful that banks or insurance companies will be willing to absorb large amounts of government debt.

The Federal Reserve is, by far, the largest holder of US government debt, with $8.4 trillion. As stated earlier, $6 trillion is US government debt. Another $2.4 trillion is debt issued by government sponsored entities (GSEs) like Fannie Mae, Freddie Mac, and Ginnie Mae. Legally, GSE debt isn’t government debt. In reality, the government backs GSEs and, therefore, this is US government debt too. In any case, as interest rates rose, prices of existing bonds declined, causing over $1 trillion in unrealized losses for the US central bank. Those losses exceed its paid-in capital ($35 billion) by more than 30 times.

Interestingly, the Federal Reserve treats its capital deficiency as an asset. The US central bank usually generates large profits, most of which are transferred to the US Treasury. If the Federal Reserve incurs a loss, it would have no profits to remit to the Treasury. It would accumulate what is known as a “deferred asset.” The deferred asset must be reduced to zero before any further transfers to the Treasury can be made.

While the central bank cannot become insolvent, its credibility could still suffer. The Federal Reserve already owns a large share of outstanding government debt. Private investors could question if the prices of such bonds reflected free market forces or whether they were artificially propped up by intervention from one large, price-insensitive buyer.

The balance sheet of the Bank of Japan (BOJ), for example, now exceeds 120% of the GDP. It owns more than half of all Japanese Government Bonds (JGB) outstanding. As a result, trading in JGBs has dried up. In October 2022, 10-year JGBs, supposedly among the most liquid bonds, did not register a single trade for four consecutive days.

Theoretically, there is no limit to how many government bonds central banks can own. However, they must consider practical issues such as market domination, impact on credibility and liquidity of government bonds when making their purchases.

Apart from the Federal Reserve, another large holder of US government debt is the Social Security Trust Fund. It owns almost $3 trillion of US debt. Since 2021, payouts from the fund have exceeded its income. As per current estimates, the fund will be depleted by the year 2034. This will transform the fund from a buyer to a seller of Treasury securities.

Foreign Central Banks Are Reluctant to Buy More US Treasuries

As of January 2023, foreign investors own $7.4 trillion of Treasury securities. This represents 23.6% of US government debt.

Among foreign holders, official accounts (central banks, sovereign wealth funds and supra-national organizations) and private investors (corporations, investment funds and individuals) held approximately $3.7 trillion each. 

It is important to note that foreign central banks have not added to their holdings of Treasury securities over the past ten years. In fact, they have now become net sellers. Since June 2021, they have reduced their holdings by $564 billion. This reduction has occurred largely because Japanese and Chinese central banks have sold over $200 billion of US Treasury securities.

Over 80% of the reduction in Japanese holdings occurred in the three-month period from August to October 2022. This coincided with a pronounced weakness in the exchange rate of the Japanese yen, which reached 150 yen per US dollar. If Japan had bought more US treasury securities, it would have released more yen in the market. This increase in the supply of yen would have caused a further fall in the value of the Japanese currency. Therefore, the Japanese Ministry of Finance had no option but to sell US Treasury holdings to raise dollars and then sell these dollars to buy yen. This operation supported the price of the Japanese yen and stopped it from falling further.

Despite growing US-China tensions, the Chinese central bank remains the second-largest foreign holder of US Treasury securities. Now, it has no reason to keep financing US fiscal deficits and, by implication, American military spending. Beijing and Washington are now increasingly hostile to each other and the prospects of a military confrontation have been rising in recent months.

In contrast, the holdings of other countries are not as large as their Asian counterparts. The UK owns $129 billion, Belgium $111 billion and Canada $86 billion. They continue to purchase US securities but cannot fill the gap left by Japan and China.

Over the past two decades, private foreign investors have increased their holdings from a mere $424 billion to $3.7 trillion. This increase occurred because these investors were looking for better returns. Government bonds in Europe and Japan were offering negative yields. Banks and insurance companies purchased US Treasury securities instead.

Norinchukin Bank, a Japanese cooperative for agriculture, fishing, and forestry, once accounted for 23% of purchases of all US and European collateralized loan obligations (CLO). As Europe and Japan begin to raise interest rates, investors like Norinchukin Bank no longer have to put all their money into US Treasury securities.

Along with relatively higher interest rates, the strength of the dollar attracted private foreign investors. A strong US dollar helped improve returns for foreign investors over the past 15 years. However, since September 2022, the Dollar Index has lost around 13% of its value. A weaker dollar is eating into returns for foreign investors. Therefore, they are more likely to sell US Treasury securities.

There is another development hurting the US dollar. According to recent announcements, foreign nations are moving away from using the US dollar as the settlement currency for international trade. This makes large holdings of dollars unnecessary, adding further downward pressure on the currency.

Another $19 Trillion in Additional Debt on the Horizon

While the current debt is already high, future debt will be even higher. The Congressional Budget Office (CBO) projects US government spending to increase over the next ten years from $6 trillion to $10 trillion dollars. Of the $3.7 trillion increase during this period, only $533 billion is discretionary spending. The majority of increased spending will be mandatory such as Medicaid, Medicare, Social Security and interest payments on US debt. 

The annual fiscal deficit is forecasted to double from $1.3 trillion to $2.7 trillion by 2033. This will increase American debt from $27 trillion to $46 trillion. Someone will have to absorb an additional $19 trillion in debt. The US government raises money by levying tax and issuing debt. The US Treasury Department sells securities through auctions by the so-called Primary Dealers. These are large US and international financial institutions. The yield (i.e. return) and the price of the debt depends on investor demand. 

Despite the seemingly open market nature of these auctions, they are designed not to fail. Primary Dealers are required to submit bids in case of a lack of investor demand. Since 2008, Primary Dealers can borrow money from the Federal Reserve through the so-called Primary Dealer Credit Facility (PDCF). This means that the central bank can effectively finance government debt under the disguise of loans to Primary Dealers.

The most likely outcome of PDCF is an ever-increasing share of government debt held by the central bank. This raises another important question: Can the central bank simply write down its holdings of government bonds, so as to lower government debt? 

Technically, the Federal Reserve could do so. But this would worry other investors if the largest holder of the US debt writes down its value, or worse still, declares it to be zero. This action also would create a large hole in the balance sheet of the Federal Reserve. A big chunk of its assets would evaporate. 

The central bank’s liabilities represent public money—currency in circulation and bank reserves. After a write down, its corresponding assets would not cover those liabilities. This would undermine public confidence in money, leading to potentially destabilizing consequences, including an economic meltdown. With constantly ballooning debt, it is clear that the US is entering tricky waters in the 2020s.

The views expressed in this article are the author’s own and do not necessarily reflect Fair Observer’s editorial policy.

The post Who Will Buy America’s Debt Now? appeared first on Fair Observer.

Further,  the price of crude oil—around $80 per barrel, or 42 gallons (159 liters)—makes it one of the cheapest liquids ($1.90 per gallon, 50.3 cents per liter). A liter of San Pellegrino or Coca-Cola costs around $2, four times as much as crude oil. Olive oil costs around $13, vodka $4, a Canon printer black ink $270, Dom Perignon Brut $346, nail polish $777, and Chanel Perfume No.5 $1,173.

Do We Still Need Fossil Fuels?

Despite being relatively and absolutely cheap, significant increases in oil prices regularly wreck economic growth and lead to inflation, as seen in the aftermath of the Russian invasion of Ukraine.

A graphic from 2016 visualizes the comparative size advantage of the global oil market to all other raw materials. Since then, the oil price has risen from $50 to $80 per barrel, and global annual consumption has increased from 94 to 102 million barrels a day. This has resulted in a demand for oil worth $8 billion per day, or roughly $3 trillion annually.

The US consumes roughly 20 million barrels per day (mbpd) and produces around 12.5 mbpd. That leaves 90 mbpd of consumption for the rest of the world. Crude oil, like most commodities, is priced in US dollars. When a non-US country wants to import oil, it first needs to acquire dollars to pay for it. Depending on exchange rates, countries can find themselves paying more for the same amount of oil.  Currently, global oil consumption creates a demand for US dollars amounting to $7 billion a day, or $2.6 trillion per year. 

Oil exporting countries cannot simply sell the dollars they receive into local currency. Saudi Arabia, for example, had a current account surplus in the third quarter of 2022 of $47.3 billion. Selling those dollars in exchange for Saudi Riyal would lead to a dramatic reduction in the amount of Riyal in circulation, thus pushing up its value. This would threaten to break the currency peg to the US dollar, which has been fixed at 3.75 Riyal per dollar since 1986. Most local currencies of net exporting nations are simply too small to be able to absorb massive dollar inflows.

What to Do with all the Dollars

The dollar proceeds from oil exports continue to pile up. Non-US countries call them foreign exchange reserves, and they are usually seen as positive. However, for the US, this is worrying. Currently, the country is approaching a $1 trillion per year trade deficit. When more money is exiting the US than entering, and imports exceed exports, the trade deficit must expand. 

Until the US resolves its trade deficit, it will continue to export its debt. Its trade partners, in the aggregate, will be forced to purchase treasury securities rather than goods and services. “Foreign official institutions” (for example, central banks and sovereign wealth funds) have amassed nearly $4 trillion in US government debt. Private foreign entities accumulated another $3.5 trillion. The “net international investment position” (NIIP) of the US- which measures the difference between a nation’s stock of foreign assets and a foreigner’s stock of that nation’s assets-  has declined to more than negative $16 trillion, from a mere $2 trillion in 2006.

A negative NIIP means more dividends and interest payments flowing to foreign nations. It is not a coincidence the Swiss National Bank is among the largest shareholders of some US corporations, as mentioned in this article.

Non-US countries are effectively financing the US’ fiscal and trade deficits by purchasing large amounts of debt issued by the Department of Treasury. A large fiscal deficit, in turn, allows the US to spend as much money on its military budget than the next ten countries combined. To put it bluntly, some countries pay for the bombs being dropped on the heads of their constituents.

The Problem with Current Account Deficits

Normally, a country with large current account deficits will soon find its currency under pressure. In a system of freely floating exchange rates, import prices would rise, volume would reduce, and exports would boost due to heightened competition. The trade deficit would therefore shrink.

The longer a country runs a current account deficit, the greater the likelihood of a debt crisis. Many non-US countries rely on dollar-denominated debt for funding. A decline in local currency makes those dollars more expensive to service, often making debt restructuring necessary.

In the case of the US, this does not happen, as it has virtually no debt in foreign currency, and can always “print” more of its own currency to repay foreign debt. Due to the status of the dollar as the world’s reserve currency and “involuntary” accumulation, the normal exchange rate mechanism does not work. The US can keep running current account (and fiscal) deficits with impunity.

According to the Kalecki Profit Equation, named after the Polish economist Michal Kalecki, the sum of all flows of the three sectors of an economy (government, private and foreign) must balance to zero. A government running a fiscal deficit will cause a surplus to pop up in either the private sector (households and corporations) or the foreign sector (as a surplus from the viewpoint of foreign countries), or a combination of both. 

Consequently, a foreign sector surplus (as in the case from the US viewpoint) must create a negative US government sector balance (a fiscal deficit). If the government tried to run a balanced budget, the negative sector balance would appear in the private sector, with households being forced to dissave or go deeper into debt, while corporations’ profits would disappear.

Repercussions of Dollar Overvaluation 

The more dollars non-US countries accumulate, the more it appreciates in value. This, in turn, means US consumers pay less for imported goods than they would otherwise, and foreign purchasers, in contrast, overpay. This also translates into a higher standard of living for US residents and a lower one abroad. 

A growing US fiscal deficit implies a growing trade deficit. Under President Reagan’s administration, it was common to hear economists refer to the twin deficits, as both the fiscal and trade deficits grew considerably. Abroad, this means that workers are forced to produce goods for US consumers in exchange for fiat money. This comes at the detriment of US workers, as production moves to lower-cost countries, thanks in part to an overvalued dollar. Since the 1980s, employment in the US manufacturing sector has declined from almost 20 million to 13 million today. This, in turn, allowed China to become the world’s leading manufacturer.

Oil Price as a Threat to Dollar Dominance

The flow and foreign accumulation of dollars depend mainly on two things: the price of oil and the willingness of oil exporters to invoice in dollars.

Lower oil prices equal fewer dollars, which means less recycling of those so-called petrodollars. Cheap oil, therefore, is against US interests and must be kept off the market. It is not a surprise the US has tossed some of the (potentially) largest oil producers, like Russia, Iran, Iraq, and Venezuela, with either war or heavy economic sanctions (Venezuela has the largest proven oil reserves in the world, amounting to almost 300 billion barrels). 

Military adventures in the Middle East have been misunderstood as a fight for oil; in actuality, the purpose has been to suppress supply. A few select nations (e.g. Saudi Arabia) are “allowed” to enjoy full production, albeit in exchange for large orders for US weapons manufacturers and a promise to not sell oil in any other currency than dollars.

Proponents of selling oil in euros (such as Saddam Hussein, former President of Iraq) or against a gold-backed pan-African currency (Muammar Gaddafi, former leader of Libya) have been removed.

Threat from Energy Transition to Alternatives 

Given that the dollar’s status as an international reserve currency depends on oil, it should not come as a surprise that the US is vehemently opposed to any form of alternative energy.

President Reagan famously removed solar panels from the White House that had been installed by former President Jimmy Carter in 1979. The panels ended up in a museum in China, the world’s leading producer of solar energy modules (75% world market share), cells (85%), and wafers (97%).

In 2017, legislators in the state of Wyoming, which generates 90% of its energy from coal,  introduced a bill to prevent Wyoming utilities from selling electricity generated by wind or solar farms. In 2021, the same state tabled a bill that would ban the sale of electric vehicles by the year 2035. 

Texas banned government agencies from doing business with financial firms that won’t invest in fossil fuels and firearms. The state also banned several asset management firms like UBS, Credit Suisse, and Blackrock for violating ESG (Environmental, Social, and Governance) guidelines. The Teacher Retirement System of Texas, with $183 billion of assets under management, is among the top five public pension systems in the US. The US has spent enormous funds to become energy independent and a net exporter of energy. But though renewable energy is growing fast, it will take even longer for the country- once considered the leader in science and innovation- to cut its overreliance on fossil fuels. 

In today’s global commerce, fossil fuels offer less value and more unfavorable terms of trade, of the kinds often found in emerging economies. Former Saudi oil minister Sheik Yamani famously said, “the Stone Age did not end for lack of stone, and the Oil Age will end long before the world runs out of oil.” As the sun sets on the Oil Age, the days of the dollar as the anchor of the international monetary system seem numbered.

[Naveed Ahsan edited this article.]

The views expressed in this article are the author’s own and do not necessarily reflect Fair Observer’s editorial policy.

The post Oil Now Makes Our Dollar-Based Global Economy Inflammable appeared first on Fair Observer.

Let us examine the potential culprits one by one.

The Federal Reserve

In an interview with YouTube channel Blockworks Macro, Chris Whalen, an investment banker and author, puts the blame for SVB’s failure at the footsteps of the Federal Reserve, the US central bank. He argues that long periods of near-zero interest rates forced management to venture into longer-dated securities to find acceptable yields without compromising the quality of assets. The speed of subsequent increases in rates, the fastest of the past six cycles, led to steep losses on longer-duration bonds. 

While this is certainly true, it is doubtful a central bank should take individual positioning into consideration when deciding on its monetary policy. Unfortunately, rising interest rates usually create casualties, especially after long periods of low rates. Should the fight against inflation, which affects every individual, trump the wish to protect certain institutions against financial harm?

Whalen predicted that the Federal Reserve would cut interest rates in an emergency meeting before financial markets open on Monday morning or face the risk of contagion. Whether that happens or not, it seems Whalen is not entirely right in blaming the Fed for SVB’s collapse.

The Management

Over the past ten years, client funds at SVB grew almost tenfold from $38 billion in 2012 to $375 billion in 2022. Inflows in 2021 alone amounted to $137 billion. From a bank’s perspective, client money inflows represent an increase in liabilities. The bank has to do a corresponding transaction on the asset side of its balance sheet, preferably earning an interest rate higher than the one owed to its clients.

During the period of largest inflows, yields in securities considered risk-free, such as 3-months Treasury Bills, ranged between 0.02% and 0.16%. Management could have chosen to relax standards for loan approvals in order to increase lending to customers. This would have been a recipe for increased credit losses in the future. Low interest rates forced management to venture into bonds with longer maturities in order to achieve acceptable yields on their assets.

Despite such pressures, management does not seem to be able to escape entirely scot-free. Moody’s has severely downgraded SVB, citing “significant interest rate and asset liability management risks and weak governance.” In hindsight, purchasing hedges against a rise in interest rates would have been beneficial. However, those hedges would have eaten further into margins. Management could be forgiven for dismissing the necessity of hedging after experiencing a decade of interest rates below 2.5%. Yet it is worth investigating shortcomings in governance.

The Customers

Social media are rife with comments demanding “no taxpayer bailout for rich clients” or blaming customers for not being aware of the $250,000 limit of Federal Deposit Insurance Fund (FDIC) insurance per account. Many of SVB’s clients were start-ups in the technology and healthcare sectors. Their deposits at SVB often consisted of capital raised from venture capital firms—money intended to carry them through the first loss-making years. These funds are needed for payroll, rent and other current expenses. Losing them would most likely result in the start-up closing down and laying off all employees.

A bank customer should not be required to study the bank’s balance sheet or be familiar with implications of monetary policy decisions on duration risk. During the 2008-09 financial crisis, the FDIC managed to protect all depositors of almost 500 failed banks without using a single tax-payer dollar. The same is expected at SVB, especially given the losses incurred seem manageable in relation to its assets.

The Rating Agencies and the Regulators

A news article by Reuters titled “Silicon Valley Bank’s demise began with downgrade threat” describes how an imminent downgrade in credit ratings by Moody’s derailed a plan by SVB to raise $1.75 billion in fresh capital. For legal reasons, investors need to be made aware of significant developments when purchasing newly issued securities. While the news of a looming downgrade certainly scared off any potential investors, it would be unfair to blame rating agencies for the demise of the bank.

Following the 2008-09 crisis, banking supervision has become stricter. Bankers regularly complain how stringent regulation hampers their operations. “Where Were The Regulators When SVB Crashed” asks the The Wall Street Journal. The article raises valid questions yet it is important to note that regulations require banks to hold a certain percentage of assets in so-called “High Quality Liquid Assets.” These can be quickly turned into cash if depositors want to withdraw funds, which is exactly what SVB did. Its losses did not stem from bad credits or investments in low quality assets, but from unrealized losses on high-quality bonds.

Regulations cannot foresee every business decision any bank might take. Banking is already one of the most regulated industries and more regulations do not seem to be the answer.

The Crypto Bros and the Short Sellers

Bitcoin advocates were quick to celebrate the demise of SVB as a sign the current fiat money system was about to collapse. Meanwhile, Circle Internet Financial, the issuer of stablecoin USDC, confirmed having $3.3 billion out of $40 billion dollars of its reserves stuck at SVB. This revelation led to turmoil in the market of stablecoins, with USDC breaking its $1 peg. It is not without irony that crypto still depends on traditional banking—the system it seeks to liberate its followers from—only to get caught with funds in said system, leading to a bank run on its stablecoin.

Stablecoin reserves are hard to manage since withdrawal could be required in a short period of time. Many banks refuse deposits from stable coin operators for exactly this reason apart from legal considerations.

As usual, short sellers are blamed for driving down the stock price of a failed company. However, short sellers analyze companies in depth and are well informed. Rising short interest (number of shares sold short) is often an indication of trouble brewing. According to an online service, as of February 15, around 6% of SVB shares outstanding were sold short. This is only a slightly elevated figure. If short sellers had any impact on SVB’s share price, it would have been relatively minor.

SVB was Unique

The business model of banking is to borrow short (at low rates) and to lend long (at higher rates). Otherwise, there is no way to accept deposits and make a profit. Net interest margins are slim. It would not make sense to run a bank without leverage. The business model has inherent risks, but those risks are not to be borne by depositors. The depositors themselves are a risk, should they decide to withdraw funds all at once. This is discouraged via the FDIC’s deposit insurance, which has worked very well in the past.

The combination of rapid deposit growth during a low-yield period, lack of lending opportunities, high share of non-insured deposits, and rapidly rising interest rates led to an unfortunate shortfall in risk-bearing capital. Calls on start-ups to withdraw their funds were individually rational, but they led, in aggregate, to a bank run and the irrational outcome of the bank being closed.

Containing contagion is important: the stock prices of other regional banks have suffered. Investors are now concerned about unrealized losses on long-duration bonds at other institutions too. In order to prevent increasing mistrust becoming a self-fulfilling prophecy, the Federal Reserve might be forced to stop the fire from spreading by lowering rates or lending against collateral. The fight against inflation might have to take a backseat.

The views expressed in this article are the author’s own and do not necessarily reflect Fair Observer’s editorial policy.

The post Who Broke the Silicon Valley Bank and What Now appeared first on Fair Observer.

A previous article by Fair Observer, “Is The Gold Standard Alive or Dead,” came to the conclusion that a gold standard would be unworkable due to its deflationary bias.  Deflationary bias in terms of gold represents large disadvantages. For example, if a nation backs its currency with the stock of gold, it is faced with the following problem: the above-ground stock of gold is around 200,000 tonnes, while mining produces only about 3,500 tonnes per year. This means that the stock of gold increases by only 1.75% a year. That low growth rate directly dictates the rate at which the money supply in that economy can grow. This would simply not be enough to accommodate population growth and productivity, resulting in a decline in the overall prices of goods and services. So why are central banks, who are surely aware of these limitations to the gold standard, frantically accumulating gold?

A survey by the 2022 Gold Reserves studied 56 central banks, and provided very interesting insights. When asked which topics they considered relevant for “reserve management decisions”, respondents named “low / negative interest rates” as the number one item (chosen by 91% of respondents), followed by inflation (88%) and geopolitical instability (84%). The fact that “low / negative interest rates” was ranked so highly as an influencer of monetary policy is somewhat ironic, since interest rates are typically controlled by central banks themselves. 

Is the Gold Standard Now Alive or Dead?

The same could be said about inflation, although many experts attribute the 2022 inflationary surge to the unprecedented fiscal stimuli alloted in response to COVID-19, as well as the persisting supply chain bottlenecks that occurred when countries went into lockdown. When analyzing the survey results concerning factors relevant to the decision of whether or not to hold gold, two common answers by central banks raise eyebrows: (1) “anticipation of changes in the international monetary system” (which 20% of respondents deemed “somewhat relevant”), and (2) as “part of de-dollarization policy” (which 9% of respondents deemed “somewhat relevant”). While these statistics may seem negligible, their responses  are actually quite revolutionary. 

These insights most likely came from central banks in developing countries, and are an expression of concern regarding the stability of our current international monetary system, which is currently dominated by the US dollar. The severe economic sanctions placed on Russia in response to its invasion of Ukraine have rendered its dollar reserves useless, a fact which has not gone unnoticed by other countries. As a result, many developing countries are now questioning the continued use of US dollars as reserves.

When asked about the reasons for increasing their gold reserves, 39% stated that they did so “as a buffer against balance of payment crises”, while 34% (up from 13% in 2021) claimed their increases in gold serve as a “backstop for the domestic financial system”.

A balance of payment crisis is a common occurrence in developing nations, when import costs, to be paid in dollars, exceed the value of export profits over an extended period of time, leading to an overall shortage of dollars.

But can gold really be used as a “backstop for the domestic financial system”?

Is the Reckless Swiss National Bank Endangering Its Independence?

Can gold really jumpstart the economy?

In case of a breakdown of the international monetary system, the primary concern of most governments will be to prevent the collapse of the domestic banking system, as it would lead to widespread economic depression and civil unrest. Commercial banks will be largely insolvent if this occurs, due to devastating credit losses. Central banks would have to extend fresh loans to reliquefy commercial banks, which they could potentially accomplish with gold reserves.

But is there enough gold to back all currency? The answer is surprisingly simple; yes, there is technically always enough gold – it just depends on the price. However, it also depends on what is defined as “money”.

For example, the current outstanding value of US currency (dollar bills and coins) is about $2.3 trillion. The US government also owns 261.4 million ounces of gold. At the current price of $1,875 per ounce, US gold reserves are worth approximately $490 billion. In order to back all outstanding currency with gold reserves, the price of gold would have to reach $8,800 per ounce, roughly five times higher than it is today.

If gold were to cover all money created by the Federal Reserve (which is equal to its current liability of $8.4 trillion) the price of gold  would have to be upwards of $32,000 per ounce (nearly eighteen times the current price of gold).

If you add to that sum the $17.7 trillion in US bank deposits, the correlating price of gold required would come close to $100,000 per ounce, a practically inconceivable amount compared to today. Furthermore, the widest measure of money in the US, total credit market debt outstanding, has accrued a hefty $92 trillion, which would require a gold price of more than $350,000 per ounce to be fully insured. 

The Reality of Bank Deposits

A bank deposit is a digital token. You cannot take it home. Traditional bank deposits are not issued by a central bank – they are conducted by commercial banks. The moment you walk into a bank and deposit cash, you exchange a central bank’s liability against the liability of a commercial bank. Your counterparty has changed, unbeknown to most.

Bank deposits cannot, in aggregate, be converted into central bank-issued currency, since, as we saw above, the amount of bank deposits ($17.7 trillion) exceeds the amount of available currency ($2.3 trillion) by a factor of eight.

Bank deposits are supposed to match central bank-issued money one-to-one, but with certain limits. In the US, bank deposits are “insured” by the Federal Deposit Insurance Corporation (FDIC) for up to $250,000 per account. According to the FDIC’s 2021 annual report, the Deposit Insurance Fund (DIF) had assets of $124 billion, or 0.7% of all US bank deposits, a mere drop in the ocean of the $17.7 trillion that Americans have deposited into commercial banks – deposits they will eventually want back. Most people think of bank deposits as “money”, when in fact, they are nothing but stablecoin (with a very questionable stabilization mechanism).

Central Banks and the Potential of Digital Currency

A functioning monetary system is crucial for any society, so central banks have contingency plans for all kinds of calamities. Bundesbank, the German central bank, had hidden an entire set of alternate bank notes worth 15 billion deutsche mark (approximately $7.5 billion) in the basement of a house camouflaged as a residential villa in the suburbs of Frankfurt. Bank notes with a new design were ready to be exchanged overnight in case the existing ones had been rendered unusable. The list of potential threats included poisoning, nuclear contamination or attempts to derail the economy by mass introduction of counterfeit bank notes.

According to the CBDC tracker, a website which monitors the status of Central Bank Digital Currency (CBDC) projects across the globe, all major central banks are either in the beginning stages of research or piloting for the introduction of a retail CBDC. The advantages of a retail CBDC for the average user are not immediately clear, but become more evident with further research. 

Most of what we call “money” is digital already. Instant settlement options are being offered by private sector companies (such as Venmo, Zelle, and Cash App), which offer currency for users to trade and distribute that is not backed by a central bank. The massive popularity of these apps have effectively cut time and costs of cross-border transactions across the globe. 

However, a retail CBDC would have one major advantage: being able to offer central bank-issued money directly to users. Currently, the only way for citizens to get access to central bank-issued money is by obtaining cash via a commercial bank. Having a CBDC would allow  central banks in crisis to credit users with new currency, enabling them to bypass commercial banks completely. 

However, for this method to be effective, users would need to establish digital wallets and be comfortable using them. The introduction of CBDC has the potential to resolve many monetary inconveniences. Central banks with gold reserves would be able to offer both partial or full gold-backing for their digital currency. However, countries lacking in gold would not be able to participate in a gold-backed monetary system, and may have to back their currencies with other items, such as government-owned land or the rights to raw materials to be mined in the future.

While unprecedented, combining a 5,000-year store of value (gold) with modern technology (digital currency) could turn out to be just the tool the world needs to reset its monetary system. Once confidence in the novel CBDC system has been established, gold backing could be gradually removed, and the cycle of credit-based monetary expansion could begin anew.

Gold is the anathema to a fiat-based monetary system. Record gold purchases by central banks are a red flag regarding the stability of our current monetary system. When central banks embrace gold, it is an indicator that they are losing trust in the current system. 

This phenomenon was seen previously during the financial crisis of 2008, when commercial banks refused to lend each other money on an unsecured basis. Central banks lacking in gold reserves have good reason to increase their holdings, as it could help them establish their own digital currencies and avoid future financial ruin. Historically, central banks tend to prepare for the worst. Will the combination of gold reserves and digital currency be enough to bail us out? We can only wait and see. [Hannah Gage edited this piece]

The views expressed in this article are the author’s own and do not necessarily reflect Fair Observer’s editorial policy.

The post The Great Gold Rush: Central Banks in Frenzy appeared first on Fair Observer.

Alan Greenspan, former chairman of the Federal Reserve Bank, in a 2016 interview stated “If we went back to the gold standard as it existed prior to 1913 it would be fun. Remember that the period 1873 to 1913 was one of the most progressive periods economically that we have had in the United States.”

Current chairman Jerome Powell, however, does not think a return to the gold standard would be a good idea. Economist John Maynard Keynes famously referred to gold as a “barbarous relic,” which was no longer needed as a backing for currency.

Is the Reckless Swiss National Bank Endangering Its Independence?

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What is a gold standard and why is gold valuable?

A gold standard is a monetary system where a country’s currency has its value linked to gold. This can be done directly, by setting a fixed price of gold to the dollar, or indirectly, by other currencies setting a fixed price in relation to the dollar, thereby linking indirectly to gold. One could imagine a full gold standard, where 100% of paper money issued must be backed by gold. Another option is a partial backing, covering only a fraction of money supply that is backed by gold. Under the Bretton Woods currency system, only non-US official holders of dollars (i.e. central banks) were able to exchange dollars into gold at the fixed price of $35 per ounce. Private ownership of gold in the US was outlawed under President Franklin Delano Roosevelt in 1933. President Ford legalized gold ownership in 1974.

The amount of above-ground gold is limited (estimated around 200,000 tonnes). The amount of gold contained in ores has been declining as most rich deposits have been exploited. The average grade of gold mines has fallen to 1 to 5 grams per ton. Large amounts of energy are needed (to crush and transport rock, for example), limiting how much gold can be economically mined. Over the past decade, annual mining output ranged from 2,800–3,600 tonnes, adding less than two percent annually to the stock of gold available.

Pros and cons of a gold standard

The idea behind a gold standard is to ensure a stable currency that is the bedrock of a well-functioning economy. A currency collapse impoverishes large sections of the population. This could lead to political extremism, and, ultimately, threaten democracy. Historians point out how hyperinflation in Germany led to the rise of Nazis.

There are several advantages to a gold standard, which are as follows:

1. Linking the growth of money supply to the growth of gold stocks would keep inflation in check, thereby ensuring monetary stability.
   
2. Government spending would be limited to the amount of tax receipts. Any deficit financing via debt issuance would require additional gold.
   
3. Central banks would be immune from political pressure as the amount of money in circulation is determined by gold.

However, there are considerable drawbacks, which are as follows:

1. Under a gold standard, growth of money in circulation would be severely restricted and could suffocate economic growth.
   
2. Fixed supply of money would be deflationary, and most likely lead to a period of depression with bankruptcies and high unemployment.
   
3. The expansion of money supply would depend on successful gold mining operations and continued investment in exploration of new deposits.
   
4. Gold standards in the past might only have worked because the stock of existing gold was much lower. So an increase in the stock of gold was possible. The 46% growth rate of gold stock between 1900 and 1909 would be impossible to repeat today.
   
5. Policy makers would be unable to respond to economic shocks.
   
6. Not all countries have equal access to gold for lack of gold mines or existing reserves.
   
7. International trade deficits, if settled in gold, would, over time, lead to a depletion of gold reserves, leading to a balance of payments crisis coupled with the inability to pay for critical imports.
   
8. In the (unlikely) event that the amount of gold available would allow for additional debt to be issued, who would be entitled to do so? The government? Banks? Households? Who would decide on who has access to fresh debt?

The problem with a gold standard

In August 1971, US President Richard Nixon “temporarily” suspended the convertibility of the US dollar into gold, effectively ending the gold standard. Since then, the total amount of US dollar debt outstanding has increased from $1.6 billion to $92 trillion — an annual expansion rate of 8%. During the same time, gross domestic product (GDP) has grown from $1.1 billion to $25.7 trillion, an annual increase of 5.8%. Debt, synonymous with “money,” is growing faster than GDP.

Most economic activity is dependent on the availability of credit. An increase of average 30-year mortgage rates in the US from 2.7% at the end of 2020 to over 7% in October 2022 has led to a decrease in existing home sales from 6.5 million to 4.1 million, a 36% reduction. Potential homeowners without access to debt would have to accumulate the entire purchase price through savings for an “all-cash” deal, which would exclude most people from being able to afford a home in their lifetime.

Proponents often counter that a gold standard could be flexible, with adjustments of the amount of gold backing (downwards) or the price of gold (upwards, hence devaluing the currency) as necessary. But how would that be different from the current system? A flexible gold standard would let imbalances accumulate over time, require large adjustments, introduce speculation, financial friction, and potentially unintended consequences. The cure could turn out to be worse than the disease.

The current monetary system is unsustainable

The current fiat monetary system seems unsustainable in the long run, for mathematical reasons. 

First, it is impossible to create money without simultaneously creating an equal amount of debt. The current system is “damned” to increase debt continuously to enable the economy to grow. Given positive interest rates, debt with interest owed is an exponential function (interest on interest in subsequent periods), which is a problem in a world of finite resources.

Second, the marginal utility of debt has decreased as debt levels increased. Since 2007, US GDP increased by $11 trillion, while the amount of debt outstanding grew by $40 trillion. In other words, an additional dollar of debt generates only 27 cents of additional GDP. Interest on debt is owed annually (and increases the debt pile), while GDP resets on January 1^st to zero. It gets harder and harder to generate additional GDP with additional debt.

Third, the amount of interest due on rising debt levels is reaching dangerous levels. According to the Institute of International Finance (IIF), the global ratio of debt to GDP stands at 343%. If we (generously) assume an interest rate of three percent, more than 10% of GDP is siphoned off the economy for interest payments – every year. This does not even include repayment of principal.

Is return to the gold standard inevitable?

Would a crisis or collapse in the current system open the way for a return to the gold standard? Central banks, while denying gold had any monetary function, still hold more than 36,000 tonnes of gold valued at more than $2 trillion at current market prices ($1,838 per ounce; 1 metric tonne = 32,150.75 troy ounces). Central banks reduced their gold holdings from 1968 to 2008. Interestingly, gold sales ceased after the “Great Financial Crisis” of 2008/9, and central banks began purchasing between 250 and 750 tonnes annually.

Over the past two decades, purchases have been led by countries mostly outside the Organisation for Economic Co-operation and Development (OECD ), led by Russia (1,875 tonnes), China (1,447 tonnes), India (428 tonnes), Turkey (373 tonnes) and Kazakhstan (324 tonnes).

In absolute terms, the largest holders of gold are the US (8,133 tonnes), Germany (3,355 tonnes), the International Monetary Fund (IMF), (2,814 tonnes), Italy (2,452 tonnes) and France (2,437 tonnes), mostly “old world” countries. Members of the euro-area, including the European Central Bank (ECB ), hold a combined 10,771 tonnes. But none of those countries are adding to their holdings, since doing so could signal to markets a dwindling confidence in their own currencies. Emerging market economies have, in absolute terms and relative to GDP, to catch up to developed ones.

The advantage of gold holdings is evident: in a currency crisis, a central bank could arbitrarily set a (dramatically increased) gold price, thereby realizing a large revaluation gain on existing gold holdings. Euro-area central banks could, for example, by raising the price of gold ten-fold, generate a book gain of roughly 6 trillion euros. In a recent interview, Klaas Knot, Governor of the Central Bank of the Netherlands, suggested gold revaluation as a tool to remedy any solvency crisis.

As a bonus, gold revaluation would lead to windfall profits at private owners, potentially providing consumers with a boost in otherwise dire economic circumstances. According to reports, German citizens privately hold more gold than the Bundesbank, Germany’s central bank.

For the US, the outcome is less clear. Data on private ownership of gold in the US is not available. The Federal Reserve, unbeknown to most, does not own any gold. The Gold Reserve Act of 1934 required it to transfer all of its gold to the Treasury. In exchange, the Fed received a “non-redeemable gold certificate,” valued at the “statuary” gold price of $42.22 per ounce, a fraction of today’s market price ($1,838 per ounce). The Fed is “owed” 261 million ounces, but only at the book value of $11 billion, due to the mandatory gold price of $42.22.More than 75% of US gold is actually controlled by the military, as it is stored at West Point and Fort Knox.

The European Central Bank (ECB), on the other hand, values its gold at market prices (currently worth around EUR 600 billion, about $633 billion), listing it above all other assets. The ECB is free to sell or buy gold in the market.

The Federal Reserve cannot sell any gold since it does not own any. It might also have difficulties buying gold at market prices since this would, due to the above-mentioned mandatory gold price of $42.22, create an immediate loss on the position.

The Fed’s hands are tied regarding gold. As the issuer of the world’s reserve currency, demonetizing gold was necessary for the dollar to replace gold as prime reserve asset for central banks around the world.

This reveals a fundamental rift across the Atlantic Ocean: European central bankers are, albeit covertly, gold-friendly, the Federal Reserve is not. The former is ready to use gold as a tool to recapitalize its central bank (and subsequently commercial banks), while the latter is not.

In case of a break-down of the current monetary system, an international conference (akin to Bretton Woods) would unlikely be able to agree on a common position on the role of gold. This would signify the end of the dollar as the world’s reserve currency. In the ensuing turmoil, market participants would value currencies issued by central banks with sufficient gold holdings. Central banks will not revert to a gold standard, given before mentioned disadvantages, but use their revalued holdings to restore confidence in the continued use of paper currencies.

The views expressed in this article are the author’s own and do not necessarily reflect Fair Observer’s editorial policy.

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How to lose 1/6th of GDP

The loss is almost entirely due to foreign investments. Around half of the losses of $74 billion (CHF 70 billion) came from fixed income securities. As global bond prices fell, so did the value of these securities. Another $57 billion (CHF 54 billion) came from losses in equities, among them many US technology stocks. The loss wiped out almost three quarters of the bank’s equity. How did we get here?

In March 2009, the SNB began to purchase euros to stop the rise of the Swiss franc. The mission failed, as the euro continued to fall against the Swiss franc (from 1.46 to 1.26). Within two years, investments in foreign currency mushroomed from $50 billion (CHF 47 billion) to $216 billion (CHF 204 billion) by the end of 2010. That year, the SNB lost $27 billion (CHF 26 billion) on foreign investments. Early that year, newspapers such as Neue Zürcher Zeitung der SNB warned of “concentrated risks” and “harsh losses” due to outsized positions in foreign currency.

Doubling down

On September 6, 2011, the SNB announced that it would “set minimum exchange rate at CHF 1.20 per euro” as “the current massive overvaluation of the Swiss franc poses an acute threat to the Swiss economy and carries the risk of a deflationary development”. It announced, “With immediate effect, it will no longer tolerate a EUR/CHF exchange rate below the minimum rate of CHF 1.20. The SNB will enforce this minimum rate with the utmost determination and is prepared to buy foreign currency in unlimited quantities”.

Foreign exchange markets are characterized by enormous trading volumes. An average of $7.5 trillion are traded per day. This number is ten times larger than the annual Swiss GDP. Central banks have attempted many times to influence exchange rates. Most attempts have failed. To be fair, some succeeded such as the 1985 Plaza Accord to weaken the dollar and the 1987 Louvre Accord to stop its decline. Note that successful attempts always involved multiple central banks.

Unfortunately, the SNB took its decision unilaterally, without help from the European Central Bank (ECB). The ECB released a statement it had “taken note of this decision, which has been taken by the Swiss National Bank under its responsibility”. This is central banker speak for “good luck – you are on your own”.

The Swiss franc’s share of world currency reserves is less than 3%. It was pure hubris to think the SNB could manipulate the exchange rate of the Swiss franc given how much larger the euro (20%) and US dollar (60%) happen to be.

Did SNB contribute to negative German yields?

For the SNB, a dilemma presented itself: what to do with all the euros purchased? Remember, this was in the middle of the euro crisis. Greek government bonds were yielding over 20% but they were risky. Losing money on such bonds would have looked terrible. Therefore, German government bonds were the go-to solution. This helped drive German government bond yields even lower, increasing the spread to “peripheral” sovereign issuers — the so-called PIIGS; Portugal, Italy, Ireland, Greece, Spain.

Understandably, the ECB was not particularly happy about Swiss purchases of German government bonds. And it led to another problem: acquiring German government bonds at negative yields would effectively be a transfer of wealth from the Swiss to the German taxpayer.

This forced the SNB to venture into other currencies still offering positive yields, like the US dollar, and, by extension, US stocks. At the end of 2021, its holdings exceeded $11 billion in Apple, $9 billion in Microsoft, $5 billion in Amazon and $3 billion each in Tesla, Alphabet A (formerly Google), Alphabet B and Meta (formerly Facebook). In total, the SNB owned 2,719 different US stocks worth $166 billion, a sum of $19,000 per Swiss inhabitant. Among earlier holdings were also 1.8 million shares of Valeant, a healthcare company that turned out to be an accounting fraud, which subsequently saw its stock price fall from over $260 to below $10.

Should a central bank invest in foreign assets?

A central bank generates seigniorage gains by pushing zero-yielding currency into circulation while investing the proceeds in assets, usually bonds, carrying a positive return. If your counterparty is domestic, the transfer of assets stays “within the country.” Some income is being transferred from those domestic counterparts to the central bank. The central bank makes a profit, pays salaries, and transfers the rest to the government. It’s a kind of tax.

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But if you do the same with non-domestic counterparties you are “taxing” other countries’ citizens. US shares purchased by the SNB are not available to other investors or, if they are, then only at a higher price. Perhaps the SNB even contributed to the bubble in technology stocks. Because the SNB was forced to invest its euros and dollars it became what is called a price-insensitive buyer. It had to buy something with the money printed. Price-insensitive participants distort market prices. When an individual distorts markets, he will go to jail. Central bankers face no such consequences.

Negative effects on large-scale purchases of foreign currency are not limited to the asset side of the balance sheet. For every euro, dollar or yen purchased, the SNB sold a corresponding amount of Swiss franc, thereby increasing the amount in circulation dramatically. Such a move, if left unsterilized, can provide the kindling for inflation driven by monetary expansion.

SNB meets Waterloo, causing chaos in markets and billions of losses

Despite massive interventions the SNB was unable to prevent the Swiss franc from strengthening against the euro. By the end of 2014, its foreign currency investments had mushroomed to $540 billion (510 billion CHF), or 76% of GDP. On January 15, 2015, the SNB had to give up its 1.20 CHF/EUR exchange rate barrier it had vowed to defend with “utmost determination”.

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The announcement occurred during European trading hours (10:30am CET) on a Thursday. The Swiss currency briefly shot up by a staggering 40% against the euro. Postfinance (Swiss postal bank) had to suspend foreign currency trading for its customers. Swiss stocks fell the most in 25 years. Shares of Julius Baer lost 23% on rumors of currency losses. FXCM, the largest US retail FX broker, needed a $300 million cash infusion after customers were unable to repay losses incurred. Citigroup, Deutsche Bank and Barclays lost a combined $400 million. Everest Capital, a hedge fund, lost virtually all its $830 million as it had bet on the Swiss franc to weaken. Homeowners in Austria, Poland and Hungary were thrown into financial trouble as they had taken out mortgages in Swiss francs to benefit from low interest rates. Swiss franc-denominated loans accounted for 15% to 35% of total mortgages in those countries.

Could not wait for the weekend

Market-moving decisions are usually released on weekends, when all financial markets are closed, allowing investors enough time to analyze the news. Publishing a dramatic decision in the middle of a trading day is highly unusual and unprofessional. What could have convinced the SNB to do so, nevertheless? The weekend was only one day away. Why couldn’t the release wait, given the mayhem it was bound to cause?

The most likely explanation is that the imminent publication had leaked. Swiss franc futures contracts traded in Chicago show a suspicious burst of activity 39 minutes before the announcement. On the following Monday, Christine Lagarde, then the managing director of the International Monetary Fund, mentioned that “very few people were informed of the move ahead of time. My understanding is that very, very, very few people were informed ahead of anything.” It seems that some of those people used inside information for personal gain. Once a leak occurred, rumors would have started flying, and the SNB would have been asked to comment. This would have forced their hand to immediately release the fateful statement.

“Poor advertisement for Swiss reliability” titled a story in The Financial Times. The entire episode does not shine a good light on the SNB. In addition, no lessons seem to have been learned, as the balance sheet continued to grow after this debacle. At the end of 2021, the SNB’s balance sheet exceeded $1.1 trillion (CHF 1.05 trillion), equal to 144% of GDP. Foreign currency investments of around 130% of GDP, and 30% in foreign stocks, can hardly be described as prudent. In terms of balance sheet size relative to GDP the SNB exceeds the Bank of Japan (129%), the European Central Bank (67%), the US Federal Reserve (34%) and the People’s Bank of China (32%).A large balance sheet relative to the GDP limits potential future moves in case of economic or monetary turmoil. It also amplifies losses. The SNB’s mandate is to “act in accordance with the interests of the country as a whole. Its primary goal is to ensure price stability.” Engaging in failed currency and balance sheet adventures on a massive scale seems contradictory to its mandate. The supervisory board of the SNB should put an end to this casino mentality, or risk losing the independence of the Swiss central bank.

The views expressed in this article are the author’s own and do not necessarily reflect Fair Observer’s editorial policy.

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