Basic Money Mechanics, banks, the interest rate Fallacy, why Governments cannot be insolvent in their own currencies and Inflation vs Deflation

There are many misconceptions about Central Banks, Governments and the banking system as a whole. The misconceptions are even greater in the general mechanism of money creation and destruction which create incorrect fundamental thinking in investment decisions trapping investors in a dangerous casino-like game of musical chairs.

Disclaimer: This is a quick article I wrote in response to many internet discussions which spread what I believe is misinformation. I won’t dive too deeply to justify my views. This is a very high level overview of my views. Due to time constraints in the real world, I will not be sourcing properly my opinions even though I can if I spend the time. Take this piece as just a blog of my views, which I believe are correct. You(the reader) are ENCOURAGED HEAVILY to dispute me and prove me wrong. But PLEASE do so with sources and links I can easily read to improve and correct my knowledge in this highly complex world of finance. Thank you!

How is money created?

Money is created through the banking system when they extend credit. According to this video when someone wants a “loan” from the bank, that entity essentially issues a debt security which the bank buys and puts it on its asset side of its balance sheet. The money the entity gets are not existing money from anywhere but they are created out of thin air, on the account the entity has created with the bank extending the bank’s liabilities. So, the term bank loan is technically incorrect, as no existing money were lent out. To lend money you have to have money. The lender transfers the money from an existing place, but bank loan money comes from nowhere. The term which is more applicable in this case is credit creation or extension. Credit creation is a swap between current inflation and future deflation. A debtor essentially rents out today’s inflationary impulse and paying it through future sustained deflationary payments on their debt. The net effect after the end of life of one bank “loan”(when it is repaid in full) is deflationary, unless used to generate more income overshadowing the principal + interest payments.

How money is destroyed?

Money destruction or money entering “money heaven”, occurs when said credit is either being repaid or defaulted on. This is a very overlooked aspect of the mechanics of money and banking which is very important for the interest rate fallacy and to understand the current macroeconomic environment we live in. This process can also be called the deflationary payments on debt.

Interest Rate Fallacy

The interest rate fallacy is the position many economists hold that lower interest rates are easy money and higher interest rates are tight money. In fact, the exact opposite is true as evidenced in the developed world since 2008, Japan for at least two decades and in the Great Depression. Lower interest rates are tighter money compared to higher interest rates that are easier money. I will extend the definition a little bit here and add that there exists the risk-free interest rate fallacy. So, when I talk about interest rates, I am specifically talking about the risk-free Government Securities interest rates. It is a completely different discussion when credit risk is involved, as indeed higher credit risk can result to higher interest rates. Still, even in these circumstances, the risk-free interest rate is the floor which credit creation or lending(due to issuance of corporate bonds for example) and can drive even risky bond rates lower like Japanese junk bonds yielding 1% in tight money environment of lower interest rates.

Why Government Debt in its own currency is considered risk-free?

By knowing that technically banks can create money out of thin air, one can easily see that they can buy the risk-free Government debt at any price even if it has a negative yield. Also, regulations typically require banks to hold government debt to match their deposits. If a Government wants money in its own currency, its domestic banking system along with Central Bank contribution can absorb the supply of new government bonds issued. This explains why the US Government did not default on its debt even after several wars which had excessive debt creation due to the urgency of spending in a war, while destroying the real economy at the same time. The way the debt is payed back is through taxes and rolling over the debt by the issuance of new bonds. Every sovereign debt crisis I know(and I have lived through 3 of them myself as a half-Greek citizen) has always involved a foreign currency like the Euro is for Greece or the US Dollar in basically all the emerging markets and many other countries around the world(Venezuela, Argentina some relatively recent examples on top of my head).

What moves interest rates then? Why aren’t they always at 0% since there is no risk?

Disclaimer: This part especially leaves out many variables like Central Bank Policy and services, Government intervention, Foreign Exchange rates, interest rate differentials between countries, derivatives, commodities, Money Market Funds, securities dealers, regulation, offshore banking, warehouse accounting and much more. I told you this blog post is the bigger picture from a very high level in a bank credit extension in the real economy point of view.

Since Government Bond interest rates play a major role in the pricing of new money created through the extension of credit(mortgage rates for example), banks depending on the underlying economic conditions and their current and future expected profitability using their theoretically infinite “money tree”(they are limited by regulation and other balance sheet constraints of what they can do with that money but it’s a topic for another day) can influence the interest rates. I will lay out 3 scenarios of a bank’s playbook which depend on underlying economic conditions. Keep in mind I will not be giving much emphasis on consumer price inflation. Due to debates being mostly about inflation vs deflation, I chose this type of wording to align with the language the internet financial community uses to debate these issues. I will be mostly describing the rate of economic growth not inflation. As even in the deflationary scenario consumer prices can rise, albeit slowly.

Inflationary Scenario

In a booming real economy where profits are high therefore companies and people can afford to pay higher interest rates on their ‘“loans”, banks won’t be buying as much Government Bonds and they will actively sell the ones they have in their balance sheet, in order to drive interest rates higher along with their profit margins since the delinquency rates are low in the entirety of the real economy. In this scenario, credit creation is mostly used to fund new profitable ventures that generate income through real consumer demand for goods and services. By creating these new goods and services, new real world collateral is created so the capacity of the extension of credit is increased, making the public in aggregate able to absorb higher interest rates. Also, unemployment is greatly reduced and job security is also a form of collateral for new credit creation. Asset prices may be flat or slightly rising. This was the state of the capitalist world in the 1950’s, and 1960’s and partly the 70's(This decade is a story in itself I may do an article someday describing it). This is regarded as the Golden Age of Capitalism by some and maybe they are right.

Dis-inflationary scenario

In this scenario, credit creation is shifting from new ventures that generate new goods and services and real world generating income collateral to asset purchases like real estate and increase the consumption of the already existing goods and services. Of course, that doesn’t mean that all productive debt suddenly stops being created, but the rate of asset and financial wealth extension through credit is increased in comparison to productive real world goods and services. Asset prices start rising rapidly since ever lower rates make payments on debt smaller increasing the capacity for higher asset prices. Banks in this scenario see that consumer demand for credit mostly exists for either asset speculation and leveraged consumption beyond one’s income, so bank liabilities are increasing without creating new wealth. In order to keep increasing their profitability, banks need to: 1) Don’t let the party end 2) make the party bigger and bigger. How they do that? They become more accommodative with their credit creation by buying more Government Securities therefore lowering interest rates further along with the unproductive extension of bank liabilities which is generally a gravitative force for interest rates. They have to do that since the rate of actual new wealth creation and therefore quality collateral you could go to war with(excluding government securities) is being reduced all the time. Since they can’t really allow asset prices to fall, they will refinance old “loans” with ever decreasing interest rates to increase the capacity of credit creation their clients can absorb, in order to drown them in even more debt, increasing their profitability and balance sheets. This period is associated with multiple financial bubbles. It usually ends with a mega-bubble which is so big, when it bursts we enter Scenario Number 3. The western world entered this scenario in the early 1980’s and it lasted generally through 2008. The United States is the exception, as the biggest part of its economy hasn’t left this scenario yet, although the lower income classes have already entered the next scenario years ago.

Scenario Number 3 - Deflation

This scenario is associated with the Dark Age of Capitalism. Consumers have spent it all, consumed it all and they have maxed out their credit cards. There are not enough monetary resources to grow the economy anymore. A large part of the private economy, while in the previous scenario they loved their credit cards, their huge houses which were turned into huge ATMs because the price “would never go down” allowing them to afford luxurious vacations, multiple cars, yachts, hookers and cocaine, all non productive assets but mainly consumption and speculation, now find out that they are not able to service their hugely accumulated debts and banks want to foreclose on their collateral. The same story happens with many businesses as well, drowned in debt and unable to pay their bills so the close, bringing even financially prudent people out of work and financially prudent business under stress which may or may not make them completely shut down depending on their counterparties financial position. “So what?” you might say “this is just a normal recession which will be over soon” you are correct. But what happens after that crashing phase if the economy does not ever really recover? If the shock is so large that prior growth projections are nothing but a pipe dream? Where every new “recovery”(reflation) is more disappointing than the last one? When Governments and Central Banks try every possible scheme imaginable to try to generate inflation and recovery but to no avail? Where interest rates are stuck between near zero and negative? The answer is simple. You have entered the Deflation Zone, the Scenario Number 3. What happens here? Banks are no longer the lovely friends which gave us access to a luxurious life, but they have become mafia-like blackmailers which make blackmailing phone calls asking for their money back. The once powerful allies are no longer on our side, they became our enemies. A public outrage occurs, Protests, scandals, suicides, poverty, barter, streets ridled with beggars at an increasing rate, huge unemployment ensues. Governments in all this mess try desperately to stimulate the economy. Central Bankers suddenly make frequent media appearances presented as heroes who will save the day. Prior to this they were famous only in the limited and closed off world of finance, suddenly everyone knows them, media listen religiously to everything they have to say and the public finally have someone else to blame, in addition to politicians and bankers.

What do Banks do?

As banks buy every safe haven asset possible dragging down the interest rates to 0% or even negative, many banks fail as a significant part of their loans turn into Non-Performing and asset prices which were relied upon for a significant part for their credit extension business simply collapse. Many small banks, if they survive, are forced to operate in a very low interest rate environment turning profitability and risk appetite scarce, slowing down the main economic growth machine which is small business. Increasing Government regulation and bailouts, as a response to the crisis, create a very concentrated banking system with a few large banks they can control. A very big part of the population is excluded from credit, since even if demand for loans may increase, the too big to fail banks, in order to survive, become extremely risk averse as they find it way too risky to extend credit to people who may be out of work soon for a tiny 1% interest rate for 30 years. Only high net worth individuals and corporations have access to credit. The rest are facing ever increasing hurdles to credit access. Banks enter survival mode for a prolonged period of time as they explore alternative ways to generate profit significantly affecting the economic growth rate if there is at all. Their stock prices enter prolonged bear markets and if the crisis is big enough they become penny stocks as their share prices fall to 0 then they reverse stock split every few years then the price falls again to zero(Greece).

Non Performing Loans(NPLs)

A significant part of the assets of all the banking system become NPLs. Governments due to the civil unrest and the moral hazard of making more people homeless and more people unemployed due to bankrupt businesses, in order to stop the bleeding, they freeze the process of liquidating the NPLs. While humane and understandable, this creates multiple problems:

1. The borrowers involved are essentially shut off from the bank credit markets, reducing the potential customers for new credit creation so inflation is contained.
2. The NPLs can potentially stay on the banks balance sheets for decades as they are forced to wait for Governments and Central Banks to invent new schemes to resolve the issue only to fail time and time again.
3. This creates a divide between those who lost everything due to foreclosure because somehow they weren’t included in the liquidation protection program and those who benefited from the program.
4. Borrowers who do not have a difficulty repaying their loans back are incentivized to fraudulently claim they cannot pay back potentially increasing further the quantity of NPLs
5. Zombie corporations which add little value to the consumer start to increase in quantity, taking away valuable resources such as land, labor and capital away from new and potentially positive for economic growth ventures.

Note: There exists a potential risk for the United States with the forbearanced loans which may turn into permanent NPLs, throwing the United States into the Deflation Zone in full.

Government stimulus

In all this frustration, where nothing seems to work anymore, governments step up to the plate by spending large amounts of money into the economy. They fund this huge spending with large fiscal deficits made possible by the infinite buying power of the banking system. This should be highly inflationary, common sense would suggest, however many ignore that spending money this way, both inflationary and deflationary impulses are generated.

Inflationary impulses may be generated in a non war economy if spending leads to infrastructure or education that can be used by the private sector to create new goods and services(lasting inflationary pressures) or the newly created bank deposits generated in the broad domestic banking system are used by recipients to raise consumption of existing goods and services. The latter is a temporary inflationary impulse, which is subject to diminishing returns, since the economy doesn’t produce enough goods and services to make consumers interested beyond a certain point. How many Iphones do you need? How much food will you eat?

Also, a key factor which almost everyone ignores is that in this scenario the economy is sick and misaligned with the demands of the consumer, meaning that even if people have money, they find little value on the current goods and services offered by the ever increasing amount of zombie corporations. Monetary resources are exhausted and the ever increasing iron grip of Governments playing savior do not allow the economy to realign itself to consumer demand by creating new goods and services. Stimulus perpetuates this problem as it rewards businessmen with crappy goods and services by allowing them to stay in business wasting valuable resources like land, labor and capital. In general, the size or even mere existence of inflationary impulses generated through government stimulus depends on the alignment of the content of spending with the demands of the private sector.

Deflationary impulses can be variable and structural. Variable deflationary impulses, include the rate of which stimulus money is used to pay down debt which destroys money and is a deflationary force. Also, since the usual background of stimulus is a deflationary crash, a large part of these packages are a form of aid/welfare for the poorest members of our society easing their deflationary pains a bit. These, not only do not generate inflation, but can create a dependency on such payments which traps the recipients on to a welfare trap since these payments usually come with strings attached(i.e. beyond a certain income recipients become ineligible to receive them) limiting the desire and risk appetite of the recipients to improve their financial position putting an additional drag on growth and consumption. Another way stimulus can be used is to directly or indirectly fund companies of certain interests like friends of and family of the current political status quo, limiting competition and economic growth. The demand for credit may also decrease as people already get the cash they want from the government.

These examples of deflationary impulses of government spending vary widely depending on the contents of the spending itself. However, there are some deflationary impulses which happen regardless of the contents of the government spending. As soon as government payments hit the banking system these deflationary impulses happen:

1. By artificially increasing the deposits(liabilities) in the commercial banking system, banks are forced to buy more short term Government Bonds(assets), driving yields lower and bank profitability from new loans lower as well.
2. Since these Government Bonds are considered HQLA(High Quality Liquid Assets) more of them in bank balance sheets act as a deleveraging mechanism which is a deflationary force.

The first one has a more visible direct impact. By artificially lowering interest rates governments reduce the capacity of banks to extend credit to the real economy. Their profitability is reduced. It is harder for the inflationary impulses to overcome this in a sustainable way. The second one is easier though.

Impulses aside, we have to consider the environment these stimulus packages are usually created, which is very deflationary. Since we already are in the Deflation Zone, interest rates are already near zero or even negative, the impact of such stimuli is more likely to be negative. By putting an additional drag on interest rates in this environment, governments completely kill off the appetite of the banking system to extend credit as the whatever reward was left to do so is gone. Also, the underlying economic problem which has nothing to do with numbers but is completely qualitative(the misalignment of the economy with consumer demand)that we face is never fixed using stimulus. It is only an attempt to hide the problem under a rug. It is typical with these periods a massive deleveraging occurs as people prefer to save cash and avoid/pay down debt.

Central Banks

I didn’t really touch on the Central Banks on this article. I find it naïve to believe that they have absolute knowledge and control over the economy and even interest rates, especially knowing that any bank in the world can create money out of thin air like they can. There are key differences from Central Bank money to commercial bank money. Central Banks cannot be the center of the universe in a huge network of thousands(millions?) of banks, real world resources and billions of people. Nevertheless, they are an important piece to this puzzle of finance and macroeconomics and I may do an article someday about them if I get the time.

Closing Remarks and short commentary of the current situation

This article is a very high level overview in the mechanics of money and the potential impact they have on the banking system. Of course, this is very incomplete. I left out many many variables that have an impact of interest rates and our economic lives. In the world of finance, there is always more to a story after all.

The global economy has been growing slowly since the Global Financial Crisis of 2008. This was an inflection point and marked the end of an era. The world is mostly in the deflationary scenario right now, since most leading economies are in that scenario of extremely low rates even in the long end of the curve. The United States is not quite there yet, but when you see QE infinity and stimulus package after stimulus package passing it is very likely it is entering that zone. It depends if long term interest rates can stay sustainably higher than zero and the effect of the stimulus when/if the pandemic ends and how will consumers react to that.