The biggest scam in history?
(Translation of the article originally published in Spanish on June 2nd, 2021)
The “dollar printing machine” is out of control. We are going through an unprecedented global monetary expansion. The U.S., and the world in general, seem convinced that the road to prosperity is reached by putting record levels of money into circulation, but history has given us ample proof that over-inflated currencies end up losing their stability and, therefore, the trust of society.
The stability of the dollar as a global currency is threatened as never before in history. We are entering an era of extreme volatility and systemic risk. How did we get to this point and what can we expect for the near future?
It all began in 1971, when Richard Nixon, the then president of the United States, decided to abandon the gold standard to initiate a purely centralized system of issuing money without backing. Until then, the U.S. could only issue a limited amount of dollars based on its gold reserves. The rest of the world had agreed to use dollars as a global exchange currency, provided they were pegged to gold at a fixed exchange rate. In other words, although the world used U.S. dollars, the fundamental backing of the whole system was a hard asset: gold.
But this system of gold convertibility ended in 1971 and the “FIAT system” or “money by decree” began to operate. FIAT money is legal tender generated by the State and imposed on its citizens just for the fact of living within its borders. Let’s see in very simplified terms how it works…
The emphasis will be on the functioning of the U.S. Federal Reserve (FED), since we are talking about the U.S. dollar, the world’s unit of account. However, with some minor differences, the system works more or less the same everywhere in the world.
The FED is the central bank of the United States. It operates through 12 regional banks that follow the directives of a centralized body called the “Board of Governors”. We are talking about a handful of people who are the ones who really make the important calls in terms of monetary policy in the world.
Many believe that the FED prints “money out of thin air”. Technically, this is not true, since the generation of new money does not take place at the level of the FED but at the level of the banks involved in the process. The key is an instrument called the balance sheet.
Before discussing the balance sheet, please note that the vast majority of circulating dollars are not physical but digital. These dollars are very easily generated through computerized processes at the sole discretion of the FED and its regional banks. So how are digital dollars issued?
Let’s go back to the balance sheet. In simple terms, a balance sheet is a record of the assets (holdings) and liabilities (debts) of an entity at a given point in time. In other words, it is an “x-ray” that shows the state of the entity, comparing what it has versus what it owes.
A company, for example, might have cash, product inventory, accounts receivable, real state, etc. in the list of assets, and salaries, rent, loans received, etc. in the liabilities section. Banks have their own balance sheets. On the assets side, they usually have cash (reserves), loans granted (to be repaid) and financial instruments such as bonds. On the liabilities side, banks might have deposits (money that has to be paid to the depositor on demand) and others.
How does the loan process work? In simple terms, when a borrower is granted a loan, the bank places digital dollars in the borrower’s account and records that transaction on its balance sheet as an asset (the expectation of collecting the amount borrowed) and as a liability (deposit).
Therefore, if each new loan is both an asset and a liability, there would seem to be no restriction on banks lending. Digital dollars magically appear in the borrower’s account and, for the bank, the asset minus the liability remains constant. So what prevents banks from giving unlimited loans? A regulatory tool called a capital requirement, which prevents unlimited increases in their balance sheet, limiting their exposure to excessive risk. Banks must have a certain amount of reserves that will determine the amount of money they can lend.
Central banks are the custodians of commercial banks’ reserves and also have their own balance sheet. In assets, they usually hold government bonds and cash. In liabilities, they have the reserves of the banks that keep their holdings with them (deposits).
What is so special about the balance sheet of a Central Bank? Unlike the rest of the banks, there is no limitation to the size it can reach. The FED (in this case) can expand it without restrictions, buying as many government bonds as it pleases, at whatever price it deems necessary, generating the necessary digital dollars and recording the operation on its infinite balance sheet.
Let’s look at a concrete example. A bank grants a loan and receives, as collateral, the mortgage of a property. Suppose that, at a point in time, the value of all the mortgages fall disproportionately in an extreme market event. It could have happened that the banks did not correctly analyze the risk profile of their clients and decided to grant loans that they really should have avoided. The logical outcome for the banks would be to bear the consequences of their bad decisions and face the loss of capital.
However, what would happen if the FED decided to intervene in the market and buy those mortgages from the banks at the price it thinks is right and get them out of trouble? All it has to do is record the transaction on its balance sheet. There is no limitation. This is precisely what happened during the 2008 financial crisis.
To alleviate the effects of the housing bubble at the time, the FED bought $600 billion in mortgage-backed bonds to artificially maintain the value of mortgages, which would otherwise have collapsed.
The FED intervenes in the system under the slogan of “maintaining stability”, but all it accomplishes are artificial deviations that may bring some relief in the short term, but are devastating in the long term. When capital is not properly placed, the normal thing for the person responsible for that placement would be to assume the effects of her bad decisions, that is, to face the loss of her capital. This is what would happen to any of us individually.
However, it seems that these rules do not apply to banks and those institutions that are “too big to fail”. The FED understands that the fall of the big boys would bring destabilization to the entire system, so it uses its “infinite” firepower to prevent it.
Thus, if there is a “rescuer of last resort”, then the big fish can take a more reckless stance and “gamble” with riskier investments. If it goes well, the profits will be very juicy (the higher the risk, the higher the gain). If it goes wrong, the lifeboat will be there to rescue them.
From this point of view, it is understandable that one of the major criticisms of capitalism is that profits are private and losses are socialized. Because the fact that the FED intervenes by creating money to save the big fish is not without consequences.
The cost of these bailouts is paid by society as a whole, especially by the most vulnerable, who do not understand what is going on but find it harder to make ends meet every day. Capitalism is not bad in itself, but it has many things to improve. This unfair system of money creation and distribution should be at the top of the priorities list.
But let’s go back to 2008 and see what happened from that point on. The following chart shows the expansion of the FED’s balance sheet since the unraveling of the mortgage crisis:
The jump in the size of total assets after the crisis in 2008 is evident. The growth continues in subsequent years and seems to stabilize from 2015 onwards. But the chart only shows us the events until 2017. What happened afterwards?
The expansion of total assets from 2020 is unprecedented. Every increase is new money generation. The latest increase follows a host of measures taken by the FED to “keep the stability” in the system.
The pandemic has had devastating effects on a large part of the population, but it seems that we are not all affected equally. In fact, while the majority suffers, a few benefit from the current context. The problem is that the system is not well designed and is inevitably destined to fail. It’s not an if, it’s a when.
One of the most nefarious effects of unrestrained expansionary monetary policy is the increase in inequality. As more money circulates in the economy, asset prices rise.
Those who are closest to the “printer” are the ones who receive the fresh money first and can use it to purchase more goods and services before the effect of the increase in the money supply is evident in prices. This phenomenon is known as the Cantillon Effect, and explains why, despite the fact that we are going through the most important health crisis of the last century, stock indexes keep rising.
There is also a marked increase in the price of assets that safeguard value, such as real estate. Thus, while it is becoming increasingly difficult for the middle and lower segments to access housing, luxury mansions in The Hamptons are increasing in price by 40% annually. Demand shows no signs of slowing down.
Inflation, which until now only seemed to be evident in asset prices, is now also beginning to manifest itself in consumer goods. Those who will suffer the most from this situation will be people in the lower segments of society.
Given this scenario, I ask myself, is the FED unaware of the devastating long-term effects of its short-term policies? The answer is not widely agreed upon.
There are those who know or assume that printing money out of thin air and injecting it into the system is not without consequences. So, if they know the problems that are generated in the long run, why do they do it?
The problem lies in the incentives. As Warren Buffett’s long-time partner Charlie Munger says, “show me the incentives and I’ll show you the behavior”. Incentives are tremendously important in shaping human behaviors, both individually and collectively.
In theory, the FED and any Central Bank should function as an entity independent of the ruling Government. In practice, we know this is not the case. As much as many deny it, politicians often have their own agenda, different from that of the rest of society.
Politicians’ incentive is to get to power and, once there, to stay, either themselves or their party. Therefore, they have no remorse in making short-term decisions, without really measuring the consequences they will bring in the long term. As Keynes used to say, “in the long run we are all dead”. The problem is that the long term arrives at some point. Our future selves, or even worse, our descendants, are the ones who will pay the price.
Is there a solution in sight? I don’t think it can come from politics. I don’t see there can be a profound change of course in search of fixing the system. Putting an end to monetary expansionism would imply a clean-up of the existing imbalances and would create a major recession both in the short and medium term. It would be very painful for most of society.
The political cost would be very high so, given the prevailing incentives, I don’t think anyone would dare to do it. World politics seems to be convinced that the best way out of the hole is to keep digging. Let the party go on. The hangover will be worse, but that is part of the future. There is so much going on in the present to care about the future.
The solution could come from a much more radical and unexpected change. If only we could return to monetary discipline, without spending more than we have, with a free system that rewards those who make good decisions and punishes those who make mistakes. A system backed on a hard asset, that corrects deviations as soon as they become evident, generating some small natural jumps in the short term, avoiding larger deviations in the long term.
Enters Bitcoin
Bitcoin is a digital currency created in 2008 by an anonymous programmer or group of programmers known as Satoshi Nakamoto. It is a digitally scarce asset that does not require any centralized entity for its operation.
According to the monetary policy established in the code that governs its operation, only 21 million units will ever exist. In addition, the rate of issuance is deflationary, since the issuance of new units decreases as time goes by.
During the first 4 years of the network’s life, 10.5 million Bitcoin or 50% of the total existence were created. Approximately every 4 years, the issuance of new Bitcoin decreases by half. At this point, almost 90% of the total Bitcoin that will ever exist has already been created. It is estimated that 99% of issuance should be reached in 2032, while the remaining 1% would be reached more than 100 years later.
Note the difference between a system whose amount of circulating money depends on the discretionary wills of politicians with their own agendas and interests versus a system whose issuance is defined from day one and guaranteed by laws of mathematics and physics. No centralized body can unilaterally decide changes on the Bitcoin network.
Can we dream of a new monetary system based on the Bitcoin standard? There are reasons to be optimistic. Bitcoin is digital gold. Its design is based on the principles that led gold to be the quintessential store of value for mankind for more than 10,000 years, but significantly improving some of its limitations.
Imagine the implications of having a solid money that maintains its value over time. We would avoid having to spend all our time thinking about what to do with our money, what to invest it in, taking excessive risks that we do not manage to dimension, with the sole purpose of avoiding losing our wealth. That wealth that cost us so much time and effort to generate.
We could avoid falling into the trap of the short term and excessive consumerism. We could go back to thinking about longer time horizons, placing our trust in an asset that would allow us to maintain our purchasing power over time.
At the geopolitical level, the powerful countries could no longer manipulate the exchange rates of the world economy, at the expense of the developing countries. No country would have the excessive and unfair advantage of imposing its own currency as the world’s reserve, affecting with their decisions the entire world population, especially the most vulnerable inhabitants.
The current system, which seems totally normal today, will be seen as illogical and inexplicable in a few decades. We will have the same feeling we have today when we study History and learn that a country could impose a certain religion on its inhabitants. So many people died as a consequence of this aberration.
Bitcoin is probably our greatest opportunity to end a totally unfair system that, in retrospect, will probably be seen as one of the greatest scams perpetrated by the State on its inhabitants. Legal, yes, but not for that reason moral.
