1:51

We

2:00

tried so hard to do this

2:02

in person, but that's

2:05

the way of the world. We couldn't get you here

2:07

in Bedford, and I couldn't get to you. But

2:09

Danny has been pressuring me for a long time. He's

2:11

like, get Macquarie out on the show. He's

2:13

brilliant. And I was like, I know he's brilliant.

2:16

I follow him. So

2:18

we want to get into a few things with you today. We want to talk

2:20

about credit ratings, because

2:22

we had a downgrade this week. So we want to get into that. But

2:25

we also want to get your take

2:28

on money creation, because we've

2:30

had various people on the show talking about it. We've had

2:32

Jeff Snyder on. We've had Lynn Alden. We've

2:35

even had them together debating

2:38

the whole subject. And then morons

2:40

like me sit in the middle going, I've got no

2:42

idea who's telling me the truth

2:45

here. So I think I want to start

2:47

there. Can you talk to me about money creation?

2:50

What are the truths? What are the myths? Whoa,

2:53

that's quite a question. Let's see if I can

2:55

disentangle that. So the answer

2:57

is there are

2:59

a lot of different forms of fiat money.

3:03

And there are two main forms. One

3:05

is the money that we use, namely

3:09

the private sector, households,

3:12

corporations. That's

3:14

what you would refer to as potentially

3:17

inflationary form of money, or real

3:19

economy money, as I would call it. And

3:22

then there is another form of money, which

3:24

is the result of our mysterious mucky

3:26

lodges with the

3:29

financialization of our economy. And

3:31

that's a financial form of money.

3:33

It's money for banks. Those are

3:35

bank reserves. Bank

3:37

reserves are

3:39

often associated, correctly so,

3:42

with monetary expansion from

3:44

central banks. So when a central bank

3:46

does quantity-divising, for example, it

3:48

creates bank reserves. It expands

3:50

its balance sheet, and it gives commercial

3:52

banks more financial

3:55

money. And this is the main distinction

3:57

that people should understand.

3:59

use and there is money the

4:02

financial system uses. And

4:04

those two things might interact, but

4:07

they have to be separated in order to really understand

4:09

how money is created. Okay, so

4:11

can you explain in those scenarios how it

4:13

is actually created?

4:15

Okay, so let's start from the

4:17

thing that people call more often money

4:20

creation, which is quality

4:23

easing or central bank

4:25

balance sheet expansion. That's what

4:27

people refer the most as printing

4:29

money, right? While we speak that

4:32

is printing money that is printing

4:34

a financial form of money, bank reserves.

4:37

And how that works is, well, the

4:39

central bank wants to buy bonds.

4:41

So they from the liability

4:44

side of their balance sheet, they expand

4:46

it, they print digitally new

4:48

bank reserves, they can do that.

4:51

And they take these bank reserves and go and

4:53

buy bonds from the private sector.

4:56

It might be a primary dealer, it might be a

4:58

bank, it might be a pension fund, but they

5:00

take it away from the private sector. By

5:03

doing that,

5:04

what happens is that the private sector overall

5:07

has less bonds available and

5:09

banks are given in exchange

5:12

bank reserves. So the bank reserves that

5:15

are created on the liability side of the

5:17

central bank end up on

5:19

the asset side of the banking system.

5:22

And there are a few ways how this might happen.

5:25

Maybe if the central bank buys bonds directly

5:27

from the bank, it's easy to understand. The

5:30

bank had a bond before, now it hasn't

5:32

sold it to the central bank and instead it has bank

5:35

reserves. There might be more different

5:37

and difficult steps where,

5:40

yeah, the central bank is buying bonds

5:42

from a pension fund that might be slightly

5:44

different. But at the end of the day,

5:46

for the system overall, you have

5:48

reduced the amount of bonds available and you have

5:50

injected more bank reserves in the system. This

5:53

is often called money printing and

5:56

it is a form of money printing. It's printing

5:58

bank reserves.

5:59

real question we need to tackle here is, what the

6:02

hell are bank reserves in the first place? So

6:04

what are these, right?

6:06

Okay, so my advantage point, hopefully

6:09

I understood a bit more about these works, is

6:11

I have worked for a

6:13

European, a global bank actually, and

6:16

also in their Treasury Department, which means I have

6:18

been the recipient of

6:21

quantitative easing exercises. I

6:23

was the guy I was taking bonds away

6:25

from when the European Central Bank

6:27

or the Federal Reserve was doing quantitative easing. I

6:29

was the guy getting the bank reserves. So what do

6:32

I do with them? What are they? So

6:35

bank reserves basically fulfill two

6:38

main roles for a bank.

6:40

The first is they allow

6:42

banks to settle transactions with each other.

6:45

So if Danny is banking with Peter, Danny

6:47

is banking at JP Morgan, Peter is banking at Wells

6:50

Fargo, they make a bunch of transactions

6:52

during the day, JP Morgan at the end of

6:54

the day needs to settle a balance

6:56

with Wells Fargo. Okay, it might be a positive

6:58

and negative balance. The way they settle with

7:00

each other is they give reserves to

7:02

each other. They pay each other in bank reserves.

7:05

First function, just the payment settlement

7:07

mechanism. Second function,

7:10

it's a,

7:12

let's say a regulatory liquidity function.

7:16

So we have imposed rules on our system

7:18

for which banks must own a bunch of liquid

7:21

assets on their balance sheet. Because if Peter

7:23

wants to take away his money from a bank, as we have seen

7:25

in March, we better make sure that the

7:27

bank has enough liquid assets to serve

7:29

Peter, or we have a problem, especially

7:32

if there are more Peter going there at once all

7:34

of a sudden, right? So bank reserves serve

7:37

that function because they can easily

7:40

be translated into, let's

7:42

say, deliverable cash that Peter can bring

7:44

home, right? They can serve that function. They're

7:46

a liquid asset, basically, or

7:48

considered to be so by the Federal Reserve and

7:51

the ECB. So then banks, all these

7:53

reserves,

7:54

they regularly look fine. They make

7:56

some yields on them, depending

7:58

on where is the range. that the central

8:00

bank sets on them and

8:02

that's it. This is it.

8:05

There is no other thing

8:07

that a bank can do with reserves if

8:10

not settling a transaction against another

8:12

bank. Well, it might be that you

8:14

know they are buying a bond from another bank. They're

8:16

making a repo transaction with another bank.

8:19

So they pay other banks with bank reserves. Each

8:22

chartered bank as a bank reserves,

8:25

let's say, an account at the Fed

8:27

so they can take these reserves in and deposit

8:30

them in the Fed. Only banks

8:33

have these accounts. I don't

8:35

have a reserves account either. You neither. A

8:37

pension fund doesn't have a reserve account

8:39

at the Fed so it's literally only

8:42

money for banks. They can settle with each other. And

8:45

now comes the key thing.

8:47

Banks don't use reserves

8:49

to make loans. Jeez,

8:52

this is the most misunderstood

8:54

concept in modern finance. A

8:56

reserve is an asset for a bank.

8:59

Remember, reserves are created as

9:01

a liability from the central bank. They end up

9:03

as an asset for a commercial bank. When

9:06

a commercial bank makes a loan,

9:08

it's not like transforming or multiplying

9:11

the existing amount of reserves.

9:14

When a bank makes a loan, and then

9:16

we're moving to the second step, creation of real economy

9:19

money, a bank expands

9:21

its balance sheet. It creates the new

9:23

money by lending. We can cover

9:25

this as a bit more complicated, but reserves are

9:28

not used to lend money. Also,

9:30

because I don't have a reserve account, you

9:32

don't have a reserve account, nobody else says.

9:35

There is no direct channel

9:37

for this financial form of money to enter

9:39

the real economy. There is no way. Okay,

9:42

so no, I think I understand it. So it's really just a tool

9:44

for the banks to be able to continue

9:47

on their normal day to day business with each other.

9:50

How do they get themselves in a position where they

9:52

need these reserves?

9:53

So I've talked about,

9:56

let's say the entire banking

9:58

system. role, but

10:00

each bank works differently. A

10:03

certain bank might have more

10:05

needs to settle transaction with each other

10:07

overnight. A bank might have a certain preference

10:10

to all the less reserves or more reserves on their

10:12

balance sheet. Maybe they're more prone to risk

10:15

or less prone to risks. So

10:17

effectively, the distribution

10:20

of reserves amongst each bank

10:23

is different depending on the preference of risk

10:25

and liquidity that a certain bank has. So

10:27

it might be that one bank is

10:30

running scarce on reserves. Okay,

10:32

so they need to beat them up. They need to find

10:34

these reserves somewhere. So they will go in

10:36

the repo market, try to post some of

10:39

the collateral they own, let's say they own treasuries.

10:41

They post more treasuries, they go to other banks

10:44

and they say, hey guys, you have more reserves. Can you lend

10:46

them to me?

10:47

Right? And so they operate with each other and they

10:49

try to move around these reserves in the system, depending

10:52

on their personal preference. Important

10:55

thing, at emergency,

10:58

the federal reserve can always,

11:01

as we have seen during the banking turmoil in March,

11:03

the federal reserve can

11:05

always produce new reserves

11:08

to make sure that the entire banking system or

11:10

the fragile parts of the banking system kind

11:12

of hold together. So what happened in March is

11:14

a couple of banks acted a bit like cowboys.

11:17

They didn't really do the risk management, right?

11:19

And therefore all of a sudden they

11:21

found this value of this collateral, treasuries

11:24

that they were told were super

11:26

safe and stable, especially if you

11:28

had interest rate risk, but they didn't hedge.

11:31

All of a sudden they found the value of this collateral down

11:33

by 30,

11:35

40%. Depositor said, well, I want my money

11:37

out all at once. And

11:41

at that point,

11:42

you need to be able to transform

11:45

this collateral back into reserves,

11:47

into liquidity, basically, to serve

11:49

the service, your deposit outflows. That

11:52

single bank is an urgent need

11:54

of these reserves, right? Of this funding,

11:57

basically.

11:58

Well, the problem is that the haircut. That's where massive.

12:01

This collateral had gone down 40% at some point. So

12:04

you can try to do that, but you will destroy your

12:06

capital. You will basically deplete

12:08

your equity very quickly, and you will default.

12:10

It's basically a liquidity spiraling crisis.

12:13

What happens? The Federal Reserve shows up

12:15

and says, well,

12:17

to us, Federal Reserve,

12:20

that collateral is worth 100 cents on the dollar.

12:22

We don't care whether it's marked at 60 by the

12:24

market. To us, it's worth 100.

12:27

So you post that collateral to the Fed,

12:30

and the Fed says, here is your bank reserves,

12:32

here is your funding, please service

12:34

your deposit outflows. So the Federal

12:37

Reserve, in that case, serves as the

12:39

lender of last resort for

12:42

financial money.

12:43

For that financial form of money, bank reserves,

12:45

the Federal Reserve, or the ECB, can

12:48

always act as the lender of

12:50

last resort for domestic banks.

12:53

So this is always on the demand

12:55

side from the bank. They are solving an issue

12:57

for the banks. But does it ever become that

12:59

the Federal Reserve wants

13:02

to force the banks to have more liquidity? Can

13:04

they force assets onto them? Or does it always

13:07

just directionally come from the banks? Actually,

13:09

it's the bank reserves that, it's the

13:12

Federal Reserve, sorry, that decides

13:15

the aggregate level of bank reserves in

13:17

the system or can influence it the most. So

13:20

if they do QE, they're expanding

13:22

the level of

13:23

reserves in the system. They're taking away bonds,

13:25

and they're giving more reserves to banks. If

13:28

they're doing these collateral lending programs,

13:30

like in March, they're doing the same. They're saying

13:32

to banks, lend these bonds to us, we'll

13:34

create new bank reserves. They're expanding,

13:36

basically, the amount of bank reserves in the system. When

13:39

they do QT,

13:40

quantitative tightening, normally

13:42

the

13:43

amount of reserves goes down. So they're

13:45

trying to drain the amount of reserves

13:47

from the system. The European

13:49

Central Bank had a program called TLTRO,

13:53

targeted long-term refinancing

13:56

operations, I think. So basically, it's a lot

13:58

of words to say. A, European

14:01

banks, here is a very cheap

14:03

loan for you.

14:04

You're going to post some collateral to us

14:07

exactly like the Fed did. We're going to lend you

14:09

money very cheaply at negative interest

14:11

rates. European bank got a

14:13

loan from the ECB for four

14:15

years at negative interest rates.

14:18

And the idea was, here is your cheap funding. Try

14:20

and do something with it, please. Sustain the

14:22

economy. I mean, please do something with

14:24

it.

14:27

When they

14:28

changed the terms and conditions

14:30

on this TFT RO, banks

14:32

all of a sudden didn't find appealing to renew

14:35

this funding. So the funding compressed and the

14:37

amount of reserves in the system compressed

14:39

too. So it's really up to the central bank

14:42

generally to decide what is the amount

14:44

of reserves in the system, more or less.

14:47

Right. Okay. And so in a time

14:49

where the economy looks like it's struggling,

14:52

they might want to expand the balance sheets to

14:55

stimulate the banks, to stimulate the economy.

14:57

And eventually they want to QT because

14:59

if the economy

15:02

is a bit too, I mean, is

15:04

QT one of

15:06

the reasons to actually just,

15:08

is the goal eventually not to have huge reserves?

15:10

You are leading me to where I want

15:13

to go. And I'm going to bring Japan into

15:15

the mix now. I mean, I love global market. Come on, Japan.

15:18

It's all over the place.

15:19

So you're telling me, and

15:22

this is how central banks think, by the way,

15:24

and that's I, because of the distinction

15:26

between real economy money and financial money,

15:28

that yet we have to draw, but we will. What

15:31

I'm about to say is the way central banks think,

15:34

but it's not correct. So central banks

15:36

think

15:37

that by injecting more reserves

15:40

into banks,

15:41

banks will somehow

15:43

lend more. They will sustain economic

15:46

growth more. That's the thinking, right? You do

15:48

QE, you print money,

15:50

quote unquote, financial form of money,

15:53

and then from there, banks will act more

15:55

aggressively. They will take more risks. They will

15:57

support economic recovery. This is the thinking.

15:59

Right. Let's go back to Japan. Let's

16:03

do that. Around 1990s

16:06

after the real estate bubble burst in

16:08

Japan

16:09

the real estate bubble burst

16:12

Japanese households are you know hit very

16:15

hard. They were chasing the dream

16:17

the imperial palace of Tokyo in 1989

16:19

was valued more than the

16:21

entire state of California.

16:24

This is the level that we reached back in Japan

16:26

in 1989. OK. The Bank of Japan

16:28

raised interest rates the leveraging

16:31

happened the real estate bubble burst

16:34

the so-called balance balance sheet recession

16:37

unfold. That meant that

16:39

the Bank of Japan cut interest rates aggressively

16:41

back to 0 percent. It has effectively

16:43

never moved since then and

16:46

started later on quantitative easing. And

16:48

the idea was 0

16:49

percent interest rates quantitative

16:52

easing access to credit

16:54

will be as cheap as it can ever be.

16:57

Banks will have more bank reserves and

16:59

they will

17:00

multiply quote unquote these bank

17:03

reserves by lending them to people and

17:05

we will restart the economy. There

17:08

is a chart that I posted on the macro compass

17:10

a couple of times which is incredible. It's

17:12

from the B.I.S.

17:14

and it shows

17:16

between 1995 and 2000 the

17:18

amount of bank reserves in the system in Japan

17:20

went through the roof. They did quantitative

17:22

easing monetary expansion. So

17:25

they took bank reserves at Japanese banks and

17:27

the amount of bank loans went

17:30

down during the same amount of

17:32

years. So you're like what. They

17:34

not only didn't

17:36

lend these reserves they didn't multiply

17:39

these reserves. I mean there were more reserves in

17:41

the system and less loans. Is it because the

17:43

demand isn't there for the loans. So it's very

17:45

simple.

17:46

Banks don't lend reserves

17:48

to make a loan. The bank

17:51

looks at three things.

17:54

Do I have a credit worthy

17:56

borrower that has a

17:58

demand for loan in the first place.

17:59

place. If there is no demand, the bank

18:02

cannot shove you with credit. You need to

18:04

show up and ask for credit first. So

18:06

you need a credit worthy borrower. First

18:09

condition. Second condition,

18:12

you need loan yields, the money

18:14

you make on these loans basically, to be

18:16

good enough to reward you against the risk.

18:19

If you bring down interest rates

18:21

at 0% and you look at banks, they're actually

18:23

less likely on the margin to make loans because

18:25

they're going to take risk on you and they're not going to make

18:28

much money out of it.

18:30

And the third condition

18:32

is return on equity.

18:33

So regulators that touch a certain capital,

18:36

they ask banks to retain capital against

18:38

the risk they're taking. And of

18:41

course, if regulation says you need to retain a lot

18:43

of equity against that loan, banks might be disincentivized

18:45

to lend. They might look for other ways

18:48

to generate return on equity.

18:50

Those are the three conditions. If you give bank, right,

18:53

banks, a hundred million reserves, one

18:55

billion reserves, one gazillion reserves,

18:58

but those three conditions are not met. Banks

19:01

are not going to lend. And

19:04

that's exactly what happened in Japan

19:06

between 1995 and 2020. And this direct connection that

19:11

mainstream economics wants to draw between the

19:13

amount of bank reserves in the system and

19:17

lending stimulating the economy

19:19

doesn't exist. There is no direct pipe

19:22

for bank reserves to fill and

19:24

go into the real economy.

19:26

So what do bank reserves actually do then? And

19:29

is there any winners and losers created

19:31

by expanding the bank's

19:34

balance sheets?

19:35

Well, sorry, the reserves. Yeah, it's

19:37

a very good question because there is a theory

19:39

called the portfolio rebalancing

19:42

theory. So I've been there

19:44

firsthand. Let me tell you what's

19:46

true and what's not true about it. So

19:49

the portfolio rebalancing theory works

19:51

as follows. You're

19:53

a bank.

19:55

Regulation forces you to own

19:58

liquid assets on your balance sheet. So you must. own 15%

20:02

about 15% of your entire balance

20:04

sheet in what the regulator says

20:07

it's liquid assets. And to make it

20:09

simple, it's mostly treasury bonds, mortgage

20:11

backed securities,

20:13

some corporate bonds and bank

20:15

reserves.

20:16

That's it. Equities are not deemed to be

20:18

liquid. Other

20:20

commodities, Bitcoin, they're by the regulator,

20:23

not deemed to be liquid. You

20:25

have to look at basically bonds and reserves. Now

20:28

say we do QE, Peter, and the

20:30

central bank is taking the bonds away from me. I'm a

20:33

bank and they're giving me more reserves.

20:35

They're skewing the composition of my portfolio

20:38

forcefully without my consent. They're

20:41

skewing it towards more reserves and

20:43

less bonds. And

20:45

you know, reserves make less money than bonds. Bonds

20:49

might have interest rate risk embedded in it,

20:51

credit spreads embedded in it in the case of corporate.

20:55

So I as a bank want to own liquid

20:57

assets, but I also want to make some money on this liquid

20:59

buffer. It's 15% of my balance sheet. I

21:01

mean, I'm supposed to try and make some money on that

21:05

portion, right? So if you force

21:07

on me to have more reserves and more

21:09

reserves and more reserves, there might be a point

21:12

where I might ask myself, where do

21:14

I want to rebalance my portfolio

21:17

back to bonds?

21:19

So that means that I will try and

21:21

get these reserves, get rid of these reserves,

21:24

give it to other banks, you know, just you take

21:26

it. I don't want it anymore. Remember, it's a closed system.

21:28

You cannot delete reserves. You can only pass

21:30

them away like a hot boiling potato. But

21:33

maybe there is a competition to do that, to pass

21:35

away these reserves and instead rebalance

21:38

your portfolio back to corporate bonds, for example,

21:40

or mortgage-backed securities.

21:42

If everybody tries to do that at the same

21:44

time, what you will have is that credit

21:47

spreads will

21:48

compress. So corporate

21:51

credit spreads and mortgage-backed securities spreads,

21:53

they will compress. The portfolio rebalancing

21:55

theory proceeds further and says, if

21:58

I'm a pension fund or an equity investor and I

21:59

see that credit spreads are compressing,

22:02

or maybe I want to own more equities. It's a good

22:04

environment, right, because credit spreads are tight

22:06

and everything is good and volatility is low, so I'm

22:09

going to buy more equities and so on

22:11

and so forth. So the portfolio rebalancing

22:13

effect basically says that by doing QE and

22:15

flooding the system with reserves, as long

22:17

as the volatility remains compressed, banks

22:20

will be incentivized to rebalance

22:23

back their portfolio towards more credit risk and

22:25

that will lead other investors to be

22:27

more risk seeking in the cycle. This

22:30

is the truth,

22:31

the true part, the wrong

22:33

part now. It doesn't really

22:36

make any sense. Can I just ask a quick question before we go on to the next

22:38

part? Of course, of course. So as

22:41

a commercial bank, you can't buy bond

22:44

like treasuries from the treasury with

22:46

bank reserves? As

22:48

a primary dealer, you can. I see.

22:51

So

22:51

let me put it like this. A primary dealer

22:54

can settle in auction with reserves.

22:56

A bank treasury

22:58

can participate in auction and

23:00

also settle the purchases with reserves directly.

23:03

So the answer is yes, they can.

23:05

So why would they not do that as a way of rebalancing

23:07

rather than going to other commercial banks?

23:10

That's one way to do it as well. The problem

23:12

is that the treasury is issuing new bonds, but

23:14

don't forget if QE is going on, the federal

23:17

reserve is buying these bonds away. So as

23:20

a system overall, the federal reserve is

23:22

taking the bonds off the system. You

23:24

might go through auction and buy them, but then you'll

23:26

have the federal reserve buy them from you in

23:28

secondary markets anyway. I see.

23:31

You see my point? So the federal reserve is crowding out

23:33

basically the system by taking away these

23:35

bonds. That's why QE takes away the

23:37

collateral from the system and

23:40

puts the reserves on the balance sheet of banks.

23:43

And at some point, these banks might

23:45

be incentivized to feel a bit more risk

23:48

prone. This is the true part

23:50

of it. The wrong part of it is the following.

23:53

Let's say you're a European guy. It's

23:55

easier to explain. Okay. So you are a European

23:58

bank treasury and the European bank.

23:59

and Central Bank is running QE and it's taking

24:02

the bonds away from you, it's flooding you with reserves.

24:05

At some point you won't like all your liquid

24:08

assets and reserves and you want to buy some freaking

24:10

bonds. Okay. Uh, good. I

24:13

want some risk. I want some Greece. Let

24:15

me buy some Greek bonds, some Portuguese

24:17

bonds, some Italian bonds.

24:21

The limits, the risk limits,

24:24

my risk preference that the risk manager

24:26

sets, it's not going to change

24:29

because the central bank is doing

24:31

QE. They are not going to allow me to

24:33

be reckless on risk because

24:36

I have more bank reserves. That's not how a risk

24:38

manager thinks. So there are limits and

24:40

constraints, let's say to how much this portfolio

24:42

rebalancing effect might work. But to answer

24:45

Peter's question, this is one of the ways

24:47

or second round effects that printing

24:50

financial money or bank reserves might

24:53

actually unfold with when it comes

24:55

to direct link between bank reserves

24:58

and lending bank reserves and

24:59

inflation bank reserves and

25:01

stimulating economic growth and making

25:04

the economy run hot.

25:06

There is no direct link between the two.

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27:51

How is a normal Joe

27:53

meant to understand all this fuckery when

27:55

he just wants to go to work, get

27:58

paid, maybe have a holiday once a

27:59

year. It feels like all this

28:02

financial fuckery goes on in the background. How's he

28:04

meant to understand what he's meant to do? That's

28:06

a very valid question, Peter. I don't know what to say

28:09

apart from

28:10

I hope that with the work I am doing

28:13

and other people are doing on this topic, it's

28:15

become a bit more accessible, a

28:17

bit more democratized. I hope

28:21

that's all I can say. But look, I always wonder,

28:23

like a friend of mine

28:26

is a mathematician and a

28:28

PhD and she went into

28:31

finance and then she's

28:33

modeling stuff for a pension

28:35

fund. And she asked me sometime, what

28:38

the heck? This is all a bunch of

28:40

convention and machineries

28:42

you guys are doing. But in reality, it's

28:45

really the principles are very simple,

28:47

but we are trying to really make this overly

28:50

complicated, aren't we? And yeah,

28:53

to a mind of a mathematician, which thinks in reading

28:55

processes and steps,

28:57

this is really the case. Also in my mind, by the way, I'm not

28:59

a mathematician, but this is really overly complicated.

29:02

Well, this is the best explanation I've had

29:04

of this side of money creation that

29:07

I've heard so far. Tell

29:09

me about the real

29:11

money creation. Okay, let's do that. Now

29:13

comes the fun. A

29:15

few of the listeners here might think,

29:18

God, is this guy nuts? But I'll

29:20

try to

29:22

explain where I come from. So

29:26

there are two ways that

29:29

Peter, Danny and I and you at

29:31

home

29:32

can get more money to spend,

29:34

more real economy money,

29:37

inflationary money to spend. There are

29:39

really two ways.

29:40

The first is hear me

29:42

out

29:43

the government runs deficits.

29:46

What? So think about it. The

29:49

government of the United States

29:52

is the basically the issuer

29:54

of the dollar. You can think of it like

29:57

a thousand years ago, it will be like the King.

29:59

The king coins and

30:02

says, this is the currency in my kingdom.

30:04

And let's assume it's the dollar. OK, now we

30:06

don't have kings anymore. We have a democracy. But

30:09

the government of the United States has the same power

30:12

to issue the dollars.

30:13

OK, good. Now the government says,

30:17

I want to send the checkset home

30:20

to Peter. That's what the government did, by the way,

30:22

in 2020, 2021. So

30:25

what happens then? Mechanically, what happens then?

30:28

Well,

30:29

the government has a balance sheet, assets

30:31

and liabilities. And

30:33

it says, well, I want to print

30:35

dollars because I have the power to do so. I

30:37

am the guy that basically decides

30:40

whether dollars are worth dollars. So let me print

30:42

them, OK? And I'm going to make deficits.

30:45

What's a deficit? It's a negative equity.

30:47

You spend more than you have. Basically,

30:49

you're drawing down, you're blowing a hole in

30:51

your equity structure. Good. So

30:55

on the liability side, we're going to mark minus

30:57

deficit spending. And it's the government

31:00

spending money. They decide, so good. They

31:02

send the check at Peter. Awesome.

31:05

So Peter has more bank

31:07

deposits,

31:09

spendable bank deposits. I mean, Peter

31:11

can just spend it on a computer or

31:13

on going to the theater or whatever. He

31:16

can spend it in the real economy, right? This

31:18

is new money that Peter didn't have before.

31:22

Most importantly,

31:24

Peter doesn't have a liability attached to this

31:26

money. It's not like somebody told Peter,

31:28

you have a mortgage to repay. You have a debt

31:31

attached to this. You just have new money. It's a check in

31:33

your mailbox. You open it, you cash it, you're

31:35

done. So Peter has new money,

31:37

new bank deposits. And on

31:39

the liability side, Peter is richer. He

31:41

has a higher equity at this point.

31:44

He has more money, very simple, no liability attached

31:46

to it.

31:47

Good. And when you do that across the whole country,

31:49

there's a massive increase in? It's

31:52

a lot of money. Real money. Real

31:54

money being put. I'm going to get there.

31:57

What does that mean and why people always under-rest.

31:59

meet the power of fiscal deficits

32:02

when it comes to inflation. It's much

32:04

more powerful than bank reserves,

32:07

but we're going to get there if you bear with me for a second

32:09

more. So then, well,

32:11

what happens? There are more bank deposits in the

32:14

system, right? And so Peter has deposited

32:16

money at JP Morgan. I don't know the bank. So

32:19

the bank now has more bank deposits, right?

32:21

They have more deposits than before. Peter has

32:24

deposited them. So a deposit

32:26

is a liability for a bank. Liabilities

32:29

goes up. That's deposits. What

32:31

goes up on the banking side is

32:34

asset side is reserves.

32:36

And now we come to the point where the government

32:38

has to issue bonds.

32:41

That's again, something we decided the king

32:43

a thousand years ago, didn't have to issue

32:45

bonds guys. But okay. Now we say

32:47

that amongst the 3000 machellages we

32:50

use, we cannot run a negative

32:52

treasury general account at the Fed. We

32:54

cannot have a negative equity at the

32:56

government and so on and so forth. We have a thousands

32:58

of these rules. The government

33:01

of the United States says they cannot have more than a certain

33:03

amount of debt, the debt

33:05

limit, right? Or that

33:07

ceiling, that ceiling. So then we have

33:09

this political circus every

33:12

X years where we have to raise the

33:14

self-imposed ceiling. So we have a lot of these self-imposed

33:17

structures, right? One of it is

33:19

that the government must issue bonds to

33:21

fund its spending. Well, they do the issue

33:23

bonds. Banks have more reserves.

33:26

Remember at the end of this exercise,

33:27

they just show up, exchange the reserves for bonds

33:31

and we are done. And

33:32

this is the process. The most important part

33:34

is Peter has more money. He

33:36

can spend the money. This is not

33:38

bank reserves in the financial plumbing

33:41

system, repo, reverse repo

33:43

and complicated stuff. This is Peter with a

33:45

check in his, in his mailbox, which can go

33:47

and spend it. And when you do $5 trillion

33:50

of debt, all at once, like the

33:53

United States did between early 2020 and mid of 2021. Well,

33:55

guess what? It's a lot

33:58

more money.

33:59

to be spent,

34:01

and can you expand the supply

34:03

of services, the supply of goods as

34:05

rapidly

34:07

as the demand goes up? No, you can't. That's $5 trillion.

34:09

It's too much. So what's the release

34:12

valve? It's inflation. One

34:15

method to print real economy money

34:17

and to destroy it, it's

34:19

fiscal deficits and fiscal surpluses,

34:21

because if I am taxing Peter more,

34:24

I can do the opposite exercise. I

34:26

am destroying Peter's wealth. I'm

34:28

taking Peter's ability to create money

34:31

through his income, his work, whatever, and

34:33

I'm saying, Peter, I'm sorry, let's cancel that money.

34:36

I'm going to tax you more. So I'm destroying

34:39

money, and I'm slowing down the economy very

34:41

rapidly. With deficits, you do the opposite.

34:43

You print real economy money.

34:46

So could you argue that reducing

34:48

taxes

34:49

would drive inflation? Yes, I

34:51

can argue that. I can even, and I'm

34:54

going to post an article next week. I can stand up for that inflation.

34:57

I am posting an article next week on

35:00

the macro compass where I will show that

35:03

most of the difference in GDP

35:06

between the United States and Europe,

35:09

between 2013 and 2019, can be

35:13

explained by the difference

35:15

in fiscal stance between the US and

35:17

Europe. So Europe run

35:20

austerity programs, basically, between 2013

35:22

and 2019. That was the result of, yeah, we need to pay

35:27

down that. We need to reduce our

35:29

fiscal deficits. We need to tighten the screws

35:32

and tax the system more and balance

35:34

our budgets and so on and so forth. The

35:36

United States did less than that. They

35:39

mostly did deficits between 2013 and 2019. If you take the

35:41

difference between

35:44

the US fiscal stance, lose

35:46

deficits in Europe, and

35:48

you basically plot that against

35:50

the difference in GDP,

35:52

you'll see that most of the GDP overperformance

35:55

of the US,

35:56

most of the nominal GDP overperformance

35:59

to come back to Europe either.

35:59

So it's real and inflation on top

36:02

of it. It's due to the fact that

36:04

the United States is printing more money

36:07

than Europe did. Europe was trying to destroy

36:09

money by taxing the system

36:11

more by doing austerity. Well, why do

36:13

austerity then? Is

36:16

it because, well, my

36:18

assumption is one of the reasons

36:20

for austerity is that money

36:24

printing itself in the real economy

36:26

has a, it's

36:30

an unfair system that creates a wider

36:33

wealth disparity eventually. I mean,

36:35

we know inflation disproportionately

36:38

affects the poorest the most. I've

36:41

referred to Ovik Roy's article. He said even at 2% inflation

36:44

has a, over multiple years,

36:47

has a catastrophic effect on the poorest. So

36:49

my assumption, even though the austerity

36:52

by the conservative government seemed to actually attack the

36:54

poorest, ultimately it was for

36:56

balance in the economy to ensure

36:59

that we didn't have this disparity. Look,

37:03

austerity in Europe is basically

37:05

in the DNA of most Northern

37:08

European countries.

37:10

It comes from a school of economics

37:12

that actually dictates this kind

37:14

of thinking. And it also comes from historical experiences.

37:17

I mean, if you think about the Weimar Republic in

37:19

Germany, for instance, Germany doesn't have a good relationship

37:22

with fiscal spending and inflation, I can

37:24

tell you. So they are

37:26

wired to think that

37:29

government debt is bad. It's terrible.

37:32

We should reduce deficits. We should cut down debt. The

37:34

interesting part of this is

37:37

that in all AAA

37:39

rated countries left

37:41

in the world,

37:43

Denmark, Germany, Netherlands,

37:46

Norway, Australia,

37:48

I'm going top of my head now. In all

37:51

of them,

37:52

government debt to GDP is very low. Private

37:57

debt to GDP is extremely

37:59

high.

38:01

So what did we do? We basically said

38:03

the government doesn't want to create

38:06

new money for the private sector. It doesn't

38:09

want to cut taxes. It doesn't want to do checks

38:11

and send them over to Peter.

38:12

In Switzerland, that doesn't happen. They have a balanced

38:15

budget or a surplus every year.

38:17

Well, what then? How does

38:19

the private sector get this lifeblood

38:21

of credit and new money that

38:23

other parts of the world get through government

38:26

spending? Well, they get it through private credit.

38:30

Households and corporations in Switzerland

38:32

borrow up to their nose. And the same

38:35

is in Australia. And the same is in New Zealand.

38:37

And the same is in all other

38:39

AAA countries, as I just mentioned, that

38:41

have a low government debt to GDP. They

38:44

use the private sector to lever up.

38:46

So they create money. They create leverage.

38:49

They create credit

38:51

through mortgages, for example.

38:53

They create that wealth through the housing market.

38:55

And this is more risky, actually, because

38:58

it drives stronger imbalances

39:00

in the system that government debt

39:02

drives. So the second

39:04

form of real economy money printing

39:07

is

39:09

private sector credit or leverage.

39:12

Bank lending is one way to get access to it.

39:14

But now we also have capital markets to

39:16

do leverage and to do credit. So if you

39:18

take the simple form, bank lending, basically

39:21

when a bank makes a mortgage, you can think it

39:23

this way. So Peter wants to buy a house,

39:26

shows up at a bank, doesn't have the money to

39:28

buy a house, doesn't have the cash to buy a house. But

39:30

it has a job. It has a good job.

39:33

And the bank feels like it's a credit worthy

39:35

borrower.

39:36

OK, good.

39:37

So the bank is going to lend money. It's going to make

39:39

a mortgage. So Peter doesn't have the money.

39:42

But Peter gets

39:45

a credit, a mortgage, 500,000 euro,

39:47

whatever he needs.

39:49

He buys the house from the seller.

39:52

The seller

39:53

had a house, now has 500,000 euro

39:57

that he got from the proceeds of the sale. It

40:00

deposits the money in the banking system.

40:03

And what happened?

40:04

Peter has a house that he didn't

40:07

have before with money that he didn't have

40:09

before.

40:10

A new loan is created,

40:12

a

40:13

credit is created, a mortgage is

40:15

created, new asset for a bank,

40:18

and also a new bank deposit is

40:20

created, which is the 500,000 euro that the seller of the

40:23

house didn't have before. And now it has,

40:25

and it deposits at the bank. Bank

40:28

lending creates new money.

40:31

It gives Peter the ability to buy

40:33

an asset with newly created

40:35

money that Peter didn't have before.

40:37

It's a new loan,

40:39

and the seller now has new bank deposits,

40:42

new spendable money. The seller

40:44

can spend it on whatever he wants now, that 500,000 euro. And

40:47

so when banks make loans, they are increasing

40:50

credit and leverage in the system. They are blowing

40:53

up their balance sheet, both on the assets

40:55

and on the liability side. If everybody,

40:58

the flip side of it is more private sector

41:00

debt. Peter has a new asset,

41:02

that's a house, but he also has 500,000 freaking

41:05

euros of debt to pay back.

41:07

And if everybody does the same year

41:10

over year over again, you'll have the situation

41:13

that many AAA countries have,

41:15

private sector debt gets very elevated.

41:18

But that's a more healthy way of

41:20

growing the economy. We

41:23

can debate about that. So let me put it like

41:25

this. The government spends money. If

41:29

I'm credit worthy, and I'm borrowing, I can pay it

41:31

back. It means I'm

41:34

creating something of value in the economy that leads

41:36

to me having the money to be able to pay that back. Therefore,

41:39

you're increasing the economy through

41:41

prosperity rather than through

41:44

just stimmy checks and printing. So that's

41:46

an excellent point in the sense that the

41:48

government isn't really the best allocator

41:51

of resources historically. So when the

41:53

government does deficits, they are

41:56

unilaterally, without asking for

41:58

your consent, they are unilaterally. unilaterally

42:01

deciding where to allocate newly

42:03

created money. I mean, it's that spending goes

42:05

to

42:06

where? To you know,

42:09

whatever, agriculture subsidies,

42:11

cutting taxes, whatever,

42:13

they are deciding unilaterally they are allocating

42:16

newly created money. Peter, you're right.

42:19

To create money through private sector

42:21

credit, you need a willing borrower

42:23

to start with, as we discussed this

42:25

before, it's not like the bank can make you a mortgage

42:27

if you don't ask for one. You have to show up

42:30

there, you have to have a productive intention

42:32

behind this creation of credit, right? You

42:34

need to want to do something with the new money. Buy

42:37

a house, invest in your company, do

42:39

something,

42:39

right? That's already the first

42:41

filter for the productivity

42:43

of this. And

42:45

in general, the private sector might be

42:47

deemed to be a bit better and more efficient

42:50

at allocating new money than the government

42:52

is. The flip side of it.

42:56

The government limit

43:00

to fund quote unquote

43:02

its deficits and its increasingly

43:05

high levels of debt, it's only

43:07

inflation and reckless spending. If

43:09

you don't get inflation, massive

43:12

and sustained inflation, if the populace

43:15

doesn't lose their trust in the currency,

43:17

you're fine. Look at Japan. Japan

43:19

has been doing this for over 30 years and

43:22

not much happens there. The only limitation

43:24

is inflation, really. If you do too much, you

43:27

go over the edge, then people start to

43:29

wonder whether that is sustainable or not. But

43:32

that's a limitation that you can try and manage around.

43:34

If you're Peter and you are indebted privately

43:37

up to your nose and you have an economic

43:39

downturn and you lose your job and

43:42

companies start making less earnings and they start

43:44

firing people, you cannot

43:46

print money to repay your mortgage.

43:49

You need to find a way to generate income, right?

43:51

So the inherent fragility,

43:54

let's say, potential fragility in

43:56

that leverage when things get bad

43:58

is higher.

43:59

than it is in government debt, let me put it

44:02

like that. So the productivity is higher

44:04

as well, but the risk of private

44:06

sector leverage are generally higher if there is an economic

44:08

downturn.

44:10

And so is that disparity

44:12

exacerbated by the fact that if

44:14

I borrow 500,000 euros to buy a

44:17

house because I can, I have the opportunity

44:19

of lots of people are doing that. And

44:21

even despite the fact that they are creating,

44:24

they're being productive in the economy, it is

44:28

still leading to higher prices. And

44:30

for those who maybe you are lower on

44:32

the economic ladder, everything's

44:35

being pushed further and further away from them. Whereas

44:37

if you had a system which was say fully reserved,

44:40

or let's talk about what the Bitcoiners

44:42

talk about, the value of the

44:44

money itself becomes worth more as

44:47

a unit. And therefore, even

44:49

if they can't afford to buy a house, the growth of the economy

44:51

at least means the asset, the Bitcoin

44:53

they own becomes worth more. Am I seeing

44:55

that right? So you are describing,

44:59

so basically we so far defined the two

45:01

forms of money that we can print in

45:03

our fiat system. We have financial form of money

45:06

and we have real economy form of money. The

45:08

real economy form of money is credit.

45:10

It's either government debt or government

45:12

credit or private sector debt or

45:14

private sector credit. Okay,

45:16

so we are talking about a fully elastic

45:19

credit system. That's what we have today.

45:22

So today we can always create new credit. We

45:24

don't have anything that really

45:26

pins the value

45:29

of these dollars that we create.

45:31

It used to be gold where we tried the gold

45:34

standard, but today we don't really have that, right?

45:37

We can create new credit and it's only really an accident,

45:40

the deleveraging episode,

45:42

inflation, something like that, that

45:44

makes people wonder about the sustainability of the

45:46

system. But otherwise the system doesn't have

45:48

any inherent limits, any strict

45:51

limitations. It's a fully elastic credit

45:53

system. There

45:55

are advantages and disadvantages with the system. The

45:57

advantages are

45:59

if you use it well.

45:59

being fully elastic,

46:03

during downturns you can

46:05

anticyclically expand your

46:08

credit. So you can stimulate the economy when the

46:10

economy needs it, right? And you

46:12

can also create credit for productive

46:14

purposes. This is a bit utopistic

46:17

because we don't do neither of that. We

46:19

tend to

46:21

run on animal spirits so

46:23

we stimulate when the economy is already

46:25

running hot.

46:27

Today the US government is running

46:29

an annualized one trillion

46:31

dollars deficit so it's literally printing

46:34

new money for the private sector with inflation

46:37

not yet fully contained and they've been doing

46:40

that for six months still so we tend

46:42

to stimulate

46:43

well sometimes we run with animal spirits

46:46

we are not anti-sick, right? Well

46:48

most of the times we run with animal spirits

46:51

but in principle if you use the system anticyclically

46:54

it's a useful tool right you can expand credit

46:56

when you need it the most and you can contract when you

46:58

need the least.

46:59

The downside is

47:01

expanding credit generally

47:04

if you don't do it for productive purposes but

47:06

you do it for increasing house prices,

47:09

increasing asset prices it will

47:11

lead to disparity because

47:14

credit is easily accessible from

47:16

people that have collateral from people that already

47:18

have assets. They can access credit

47:20

generally cheaper and in a more friendly way.

47:23

By doing that they just become richer they

47:26

own more assets the newly created money end

47:28

up in houses they push up the housing

47:30

market and the guy at the bottom of the ladder

47:32

is left out and he's left behind. So

47:35

that's the downside of this system the

47:38

alternative

47:39

is a

47:41

non elastic or much less

47:43

elastic form of

47:46

a monetary system that basically

47:49

has

47:50

let's call it firm money

47:53

as a firm anchor

47:55

effectively to

47:58

the unit of exchange that we use. values.

48:01

And you know, it could be gold,

48:03

it could be Bitcoin to this extent,

48:06

because these assets are effectively extremely

48:08

limited in growing their supply.

48:10

It's very predictable. You can't make

48:13

new gold out of gold. You can't make

48:15

new Bitcoin out of Bitcoin. Well, you can,

48:17

but really, the underlying assets

48:19

is an anchor that is limited

48:22

in supply. And

48:24

so when you do that, what

48:26

happens when you do that?

48:29

You have the value,

48:31

you can rely on the value

48:34

of that firm money because you

48:36

can't water it down. You can't create more

48:38

of it, basically, not that easily.

48:41

That's good. That's

48:42

a good feature to have.

48:44

But during an economic downturn, that

48:46

might be a problem because you cannot

48:49

expand credit. You don't have an

48:51

easy way, basically, to make sure that you give

48:53

more resources to the private sector when they

48:56

need it the most.

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51:38

Yeah, see, that's where I always come to the point where

51:41

as if it's too easy

51:43

to access the tool to expand the

51:45

credit, and if you combine that with the political

51:48

cycle, then there's always a

51:51

skewed incentive

51:53

to make promises to the electorate.

51:56

I've just seen that, I've just been to Argentina

51:58

and they have...

51:59

very severe economic problems

52:02

right now. They have 43%,

52:04

I think, living in poverty, and

52:06

the

52:07

controlling party will continue

52:09

to make promises to that large election

52:13

block, that large block of voters. And so

52:15

they're incentivised to constantly

52:17

use the money printer rather than

52:20

using it for a time when a country needs it. And

52:22

so I don't know what the answers are, but I always

52:25

wonder, how do you... Because

52:28

I understand the desire for an elastic

52:30

money supply. I understand why people want that.

52:32

As a Bitcoiner, I want Bitcoin because I'm

52:35

fed up of this overly used

52:38

elastic money supply.

52:40

But how do you even create rules where it's used

52:42

when it's most needed? Or should

52:44

we just not have an elastic money supply

52:47

and we deal with and

52:49

handle and accept there will be boom

52:52

and bust cycles? Well, look, is

52:54

the problem that we're trying to eliminate

52:57

the bust? Yeah, that's most

52:59

of the problem, you're right. So we are

53:02

trying to engineer a system where recessions

53:05

aren't allowed.

53:07

They aren't allowed anymore. The US

53:09

hasn't been in a recession for 15 years.

53:13

So 2020, of course, was, you can call it a recession.

53:18

It was more of an exogenous shock. 2020, it

53:22

lasted for a few months until the US

53:24

government said, well, here is five trillion

53:26

dollars. Let's see if you now have a recession anymore.

53:29

Obviously, we didn't have one anymore because it's

53:31

way too much money being created all at once.

53:34

The last true recession

53:36

was in 2008. That's 15

53:39

freaking years ago. And I'm not

53:42

cheering for one. It's not like recessions

53:44

aren't good. Nobody likes them.

53:46

But

53:48

if

53:50

you think about a healthy

53:52

economic system, then generally

53:54

speaking, they have been historically

53:57

part of the cycles.

53:59

And now instead, we're trying to eliminate them. And

54:03

look, the one

54:05

of the- Hold on, sorry. You say that,

54:07

but it feels like at the moment they're trying to engineer

54:09

a recession in the UK and

54:11

the US. And there's a solid argument

54:14

that we are in recession, but they are

54:16

trying to engineer it

54:17

right now. So look, what

54:19

they're trying to do is what central banks and politicians

54:22

care the most about, which is get back

54:24

control.

54:25

Credibility, status quo, get

54:28

back into a box that is controllable and

54:30

predictable is the number one, two,

54:32

three, four, and five priority for

54:34

any elected politicians or central

54:37

banker. When I was in my previous job,

54:39

one of my upsides was that I could speak

54:41

to these prime ministers and central

54:44

bankers. Look, we

54:46

talked about- I talked with the G10

54:48

prime minister back then. And

54:50

we're talking about what its country

54:52

might need to improve the long-term

54:55

potential for growth. So we're talking

54:57

about the judiciary reforms.

55:00

We're talking about structural reforms,

55:02

education, and investments and stuff

55:04

like that. And it would be like, yeah,

55:07

for sure. I mean, I can see the merits in all of that,

55:09

but I have an election in two and a half years. So

55:13

if I spend my political capital on

55:15

all that stuff, the results will

55:17

be evident in five to 10 years from

55:19

now. And I'm going to lose the electoral

55:21

cycle. And the guy who benefits from this

55:24

is the opposition. I'm not going to do that. And

55:27

I'm like, geez, man, I mean, you're supposed to be

55:29

a statesman. I mean, if you don't think

55:31

about this, who will think about

55:33

this? And he's like, yeah, I know. But you know, if

55:36

I get reelected, I have a stronger political

55:38

base and then maybe at the next round I can

55:41

think about this. So you're right. Political

55:43

incentive schemes are extremely important. Yeah, it's

55:47

just such bullshit. Unfortunately,

55:50

the political incentive schemes are bad.

55:53

This is the way we have constructed our system.

55:56

They play a big role in it. And that's why

55:58

now you say people will. want to engineer

56:00

recession. Well, what

56:03

they want is for inflation to come back

56:05

because if inflation is somewhere

56:08

where they can feel it's controllable, they

56:10

go back into a mechanism where they

56:13

feel comfortable and they feel in control

56:16

for a policymaker. Not feeling

56:18

in control is the worst feeling ever. That's

56:21

also why we have a 2% inflation target

56:23

because 2% is enough far away

56:25

from

56:27

the scary deflation. If you deflate

56:31

a debt-based system, that's

56:33

a serious problem. You are making

56:35

the debt, the credit,

56:37

the leverage,

56:39

the future promise dollars worth

56:41

more. You are making your problem bigger,

56:44

in other words, with deflation. So

56:46

you don't want that. In a credit system, you don't

56:48

want deflation. Some

56:50

people want that. Well, sure. Some

56:53

people want that, but people that live in

56:55

a fiat money system and are

56:57

part of it and architect of it, they don't

56:59

want deflation because basically

57:03

the debt and the credit that we

57:05

have built and engineered the system with

57:08

will become a huge problem in a deflationary

57:10

episode. It becomes worth more.

57:13

And instead, they don't want 5% inflation, 6% or 7% uncontrollable

57:16

inflation. They

57:20

want 2% inflation. Well, maybe 2.5%, 1.5%, 3%, 1%. Those are the acceptable

57:22

outcomes,

57:27

but 0% or 4% or 5%?

57:30

Again, they are not acceptable because they

57:33

go outside the comfort zone. They go outside

57:36

the area where political incentive schemes

57:38

kick in. So what they want now is to bring

57:40

inflation back down. Why?

57:43

To gain control. Is it going to cost something

57:45

to the economy? Sure. Do

57:47

they lose their job because of it? No. So

57:50

again, it's important to understand the political incentive

57:52

schemes.

57:53

Yeah. Okay. Can we talk about credit

57:56

ratings? Sure. Because

57:58

yeah.

58:00

Bit of a surprise to me because

58:02

I didn't see it happen in, but there

58:04

was a downgrading of the US

58:07

credit rating. Yeah. So

58:09

just for people to understand, what

58:12

are these credit ratings? Who

58:14

gives them? What do they mean? How important

58:16

are they?

58:18

So how important

58:20

are they? The answer is

58:22

pretty much zero in

58:24

the very, let's

58:27

say, deep sense. This is another

58:31

self-created structure

58:33

where we give three rating

58:35

agencies the power to say that a certain

58:37

credit is worth X. Let's remember

58:40

that Fitch, S&P and Moody's gave AAA

58:42

rating to subprime mortgages two

58:45

months before the crisis unfolded. So please,

58:47

I mean, also Italy was rated AA plus

58:50

and Greece was rated AAA. So,

58:52

I mean,

58:52

again, from the

58:54

deep sense of things, they really don't matter. But they

58:57

still are an important part

59:00

of this

59:01

weird architecture that we have

59:03

created around our financial system. So why

59:05

do they matter in the first place? The

59:08

United States now has two

59:11

AA plus ratings and only one AAA

59:13

rating. So what happens is

59:15

that the second best rating of the United

59:18

States is now AA plus, not AAA

59:20

anymore. Good. Why second

59:22

best rating matters? In

59:25

the price of bonds, an interesting

59:28

part of it is the supply and the demand

59:30

for these bonds. Right. And while people like to focus

59:32

a lot on the supply, it's easy to measure

59:35

how much bonds are being issued by the government,

59:37

how much deficits are we doing? It's a very easy

59:39

variable to measure. What about the demand?

59:41

Who's buying this stuff in the first place? Are

59:43

they buying more? Are they buying less? Amongst

59:46

the biggest buyers of Treasuries

59:49

out there

59:50

are banks, pension funds

59:53

and foreign exchange reserve

59:55

managers.

59:56

Now, banks, we covered them before, right? I

59:58

mean, these are the guys that they. the reserves, they are

1:00:01

forced by regulation to buy bonds, to

1:00:03

hold liquid assets. And

1:00:06

now bear with me because the regulator told

1:00:08

banks,

1:00:09

no capital requirements. Do

1:00:11

you want to buy Treasuries? 0% capital

1:00:14

required. But what do you mean? Price got? No,

1:00:16

no, no, it's fine. It's safe collateral, AAA,

1:00:19

nothing can happen. 0% risk

1:00:21

weight, go for it. 0% capital.

1:00:25

Between a AAA rating or a second

1:00:27

best AA plus rating, there

1:00:29

is no difference. Banks still

1:00:31

get the 0% capital

1:00:33

requirement there. So for banks,

1:00:36

Peter, this downgrade doesn't really change

1:00:38

the equation. It's marginally irrelevant.

1:00:42

Big buyers, pension funds. So

1:00:45

why would a pension fund buy Treasuries? Well, they have

1:00:48

long duration liabilities. They promise

1:00:51

pension premiums 30 years from now to the pensioners.

1:00:54

So as they have long duration liabilities,

1:00:56

they need long duration assets as

1:00:58

well. And they need these assets first

1:01:01

to hedge the interest rate risk of

1:01:03

long duration liabilities with long duration

1:01:05

assets. They also use it

1:01:08

as a part of a portfolio. The portfolio has

1:01:10

equities and corporate bonds because they need

1:01:12

to generate a return as well. And Treasuries

1:01:14

are seen as a safe

1:01:15

hedge against the moment where

1:01:17

equities drop. So they

1:01:20

structurally need these Treasuries

1:01:22

also for them. Regulators have decided

1:01:25

again that Treasuries are super safe. And

1:01:27

whether it's rated AAA or AA plus that

1:01:30

doesn't change for a pension

1:01:32

fund. Same goes with all the collateral

1:01:34

management where they take the Treasury, they lend

1:01:36

it, they get cash. It doesn't really change.

1:01:40

Again, regulation is the key word here

1:01:43

because it's the regulator that decides

1:01:45

what is the capital, what is the financial

1:01:48

incentive schemes behind these operations. And

1:01:50

they've basically decided that Treasuries are

1:01:52

a 0% capital requirement

1:01:55

asset for banks and pension funds.

1:01:58

Last and super important.

1:01:59

often is the FX reserve

1:02:02

manager. Who the hell is this guy? This guy's

1:02:04

China. This guy's Brazil. This guy's

1:02:07

Saudi Arabia. We've built

1:02:09

a system where about 70% of the transaction of

1:02:12

goods and services that happen in the world

1:02:15

are denominated in dollars. 70%,

1:02:18

that's a lot. So

1:02:20

that means that if Brazil is selling soybeans,

1:02:24

they're getting dollars in exchange for soybeans.

1:02:28

And so they get these dollars. The dollar enter the

1:02:30

Brazilian banking system. And

1:02:33

they ultimately need to be invested in some

1:02:35

assets, right? I mean, these dollars need

1:02:37

to be kept safe and invested. And

1:02:40

what's the asset?

1:02:41

Well,

1:02:42

you're looking for something that is very liquid, has

1:02:44

a good repo market.

1:02:46

You can trust it. It's well regulated. They're

1:02:49

denominated in dollars. So you buy treasuries

1:02:51

as well.

1:02:52

Also for them, they tend to

1:02:55

put bonds rated between AAA

1:02:57

and AA minus in the same

1:02:59

safe bucket. So from AAA to AA

1:03:02

plus, it really doesn't change. All

1:03:04

this story to say that for the main actors

1:03:07

out there in the market, the one that are either

1:03:10

driven by the system, take the FX

1:03:12

reserve managers, they get the dollars, they

1:03:14

have to invest the dollars, or by regulation,

1:03:17

banks and pension fund, this downgrade

1:03:19

really doesn't change much.

1:03:22

Right. Is there

1:03:24

a wider issue in that they've

1:03:26

almost been put on notice? And

1:03:28

also this has happened in a time where there

1:03:31

is now global competition to be the

1:03:34

reserve asset. Yes, Bitcoin is small,

1:03:36

but there are people moving to Bitcoin. But

1:03:38

there is this fast growing BRICS group

1:03:41

of nations, which is expanding and

1:03:43

is questioning or considering

1:03:46

its own reserve asset. Is

1:03:48

there a risk that the US gets downgraded

1:03:51

further?

1:03:52

So, well,

1:03:56

it's hard to look at the political incentive

1:03:58

scheme of a rating agency.

1:03:59

You can always make a story and say that the US

1:04:02

isn't worth a double A plus

1:04:04

anymore and it's worth double A minus

1:04:06

and get people really scared about the story.

1:04:09

So again, it's a lot about incentive schemes.

1:04:11

And for me, I don't have an edge to understand

1:04:13

these incentive schemes. But what I can comment

1:04:16

on

1:04:16

is the BRICS story.

1:04:19

So remember what we discussed. What we discussed

1:04:21

is a system where who sells goods

1:04:23

and services to other countries

1:04:26

gets mostly dollars in exchange

1:04:28

today. But

1:04:31

what if we

1:04:33

start selling them and getting one

1:04:35

or Brazilian Real or something else

1:04:37

in exchange, not dollars?

1:04:40

What happens then?

1:04:43

So one of the key of our

1:04:45

system is that you need to have a safe

1:04:48

place where you can invest

1:04:51

the one and the Brazilian Real that

1:04:53

you get from selling your goods and services.

1:04:55

Because once you sell them and you get your Brazilian Real

1:04:57

and you're one, what are you going to do with it? You

1:05:00

need a safe place where to invest

1:05:02

the surplus because

1:05:05

then your country might need to sell down these

1:05:07

reserves in case of an economic downturn

1:05:09

or if you need to do so. But

1:05:11

you need a liquid asset for that. You need something that you

1:05:13

can sell and you can monetize very quickly

1:05:16

and you can trust.

1:05:17

And

1:05:20

the Chinese bond market doesn't particularly

1:05:23

strike me as a very open, transparent

1:05:26

and trustable market. Does it to you, Peter?

1:05:29

And I like Brazil in

1:05:31

the sense of in this particular

1:05:34

cycle, I am even invested in Brazil

1:05:36

as part of my investments. But

1:05:38

would I think that Brazil can

1:05:41

be the example for a liquid transparent,

1:05:45

non-corrupted rule of law

1:05:47

dominated country? I can't make the case

1:05:49

for that either.

1:05:50

So the story is that

1:05:52

unfortunately, as per today,

1:05:55

it's

1:05:56

very hard for BRICS to gain traction

1:05:58

because of inherent incentives.

1:05:59

instability,

1:06:01

an inherent lack of transparency and

1:06:03

rule of law that is one of the requirements

1:06:05

that global investors will have when they

1:06:07

say, well, I'm very happy to sell you my

1:06:09

goods and I'm very happy to get one back.

1:06:12

What the hell am I going to do with my one though,

1:06:14

if you have capital controls in China?

1:06:17

So the moment I need, I mean, seriously,

1:06:19

think about the practicalities of

1:06:21

this. At the moment, it really wouldn't

1:06:24

work unless we see a different behavior

1:06:27

from this group in general. The

1:06:29

problem is when you get away from

1:06:31

dollar income in a

1:06:34

dollar based system, you might

1:06:37

have some leverage issues. There

1:06:40

are $12 trillion

1:06:42

of dollar denominated debt

1:06:45

that exists today. It has been

1:06:47

issued by countries outside

1:06:51

the US jurisdiction. So that means

1:06:54

Brazilian corporates, Indian,

1:06:56

Chinese, they

1:06:58

have issued dollar debt.

1:07:00

So how do you repay your dollar debt? How do you

1:07:02

service? How do you pay your coupons? They are denominated

1:07:05

in dollars. Well, you need dollars to pay dollars. That

1:07:07

seems very clear to me, right? So where do you

1:07:09

get these dollars from? Well, you sell

1:07:11

soybeans in dollars. You sell goods

1:07:14

and chips and whatever you need to sell in dollars. The

1:07:16

moment you don't sell them in dollars anymore, you

1:07:18

understand that you might have a bit of an

1:07:20

issue in servicing your $12 trillion

1:07:23

of dollar denominated liabilities.

1:07:25

You can choose to default on them, sure,

1:07:28

but this is going to further

1:07:31

harm your credibility

1:07:33

as a BRICS reserve currency if you choose to

1:07:35

default on existing debt. So

1:07:38

there are a lot of complications and people like

1:07:40

an easy narrative. They like to say the US is

1:07:42

doomed and the BRICS are going to replace it.

1:07:45

I'm here just to explain a

1:07:47

few facts that might complicate the matter,

1:07:49

let's say. That's fair.

1:07:51

What about the level of interest

1:07:54

payments on the debt? Fitch pointed out

1:07:56

that

1:07:58

interest payments are nearing $1 trillion a year. We

1:08:00

know tax receipts for the US government is about 6.5 trillion.

1:08:04

It's growing. It's continuing to grow.

1:08:07

Is there not the risk that they head

1:08:09

into some form of debt spiral? That's

1:08:13

another

1:08:14

good point because it brings me

1:08:16

to think about two things. Interest

1:08:21

payments from the United States on

1:08:23

their debt are interest income

1:08:26

for somebody else. Think of it.

1:08:28

Think of it.

1:08:29

Who owns these treasuries that are paying 5% risk-free

1:08:31

rate today? I own them. That's

1:08:33

super good. You can just get paid 5% on T-bills

1:08:36

now. You

1:08:38

basically have no risk. I mean, you have no interest rate risk. They

1:08:40

mature in three months to a year. You get 5%.

1:08:43

So the 1 trillion, which is a payment

1:08:45

for the United States government, is income for somebody

1:08:47

else. Justin wants something

1:08:50

to consider.

1:08:52

Nevertheless, the

1:08:54

moment that your interest payment represents

1:08:57

a larger and larger portion

1:08:59

of your tax revenues, of your spending

1:09:02

also, you might run into

1:09:04

some decision-making to do. And there

1:09:06

are really two ways to do this. Well,

1:09:09

the first is to say, I'm

1:09:13

going to stop issuing

1:09:15

all this debt. So I'm going to clamp

1:09:17

down. I'm going to raise my taxes. I'm

1:09:20

going to

1:09:21

basically slow down the economy, right? Destroy

1:09:23

money, raise taxes, and repair

1:09:25

my budgets. And

1:09:28

that's the standard way of thinking about

1:09:30

it. That's what

1:09:31

fiscal orthodox people would think

1:09:33

about. That's what Germany would do straight away

1:09:36

immediately. The second way is,

1:09:39

well, I might run more deficits

1:09:42

so that I print new money

1:09:45

with which I can try and repay

1:09:47

my interest

1:09:48

on that. That's

1:09:50

a very dangerous path to go through

1:09:52

because what happens is you're basically snowballing

1:09:56

your debt by doing so. And

1:09:58

there is a point at which markets might do it. out

1:10:00

your ability to bring this thing under control.

1:10:03

This is a typical emerging market problem,

1:10:05

right? When people start to wander, like in

1:10:07

Argentina, whether they're ever going to be able to

1:10:10

get a grip on this snowballing

1:10:12

inflation or budgetary problem.

1:10:15

And yeah,

1:10:17

look, it's a very valid concern,

1:10:19

Peter. I don't think it's biting yet,

1:10:21

but I think it's something to watch. There has been

1:10:23

a recent paper that actually have opened right here.

1:10:26

It's called, and everybody should read it from

1:10:28

the Federal Reserve Bank

1:10:32

of St. Louis. So

1:10:34

it's literally the Federal Reserve branch that is

1:10:37

publishing this paper. It's called fiscal

1:10:39

dominance and the return

1:10:42

of zero interest bank reserve requirements.

1:10:44

So it covers fiscal dominance. It looks exactly

1:10:47

at this snowballing effect. So just to

1:10:49

say, Peter, even policymakers are starting

1:10:51

to think about this and

1:10:53

I don't, there is no easy fix. Really.

1:10:56

You either slow the economy down, you either try

1:10:58

to repair your budgets or you try

1:11:00

to say, well, look, guys,

1:11:03

if I am paying interest on that, you

1:11:05

are making money. You are receiving this interest.

1:11:08

So you should be happy about it in the first place. It's

1:11:10

a very difficult thing to communicate, but

1:11:12

it is correct. And you could also say,

1:11:14

why would we tax you and reduce

1:11:17

this wealth creation effect? We

1:11:19

are just going to try and run this

1:11:21

smoother so that we do more deficits.

1:11:24

We inject new money into the system. You

1:11:27

guys become richer. Remember money printing

1:11:29

fiscal deficits, but will the

1:11:31

populace get this? How do you communicate

1:11:34

this in a smooth manner while

1:11:36

everybody starts to wonder about, are

1:11:39

you going to be able to repay your debt? So it's really

1:11:41

a communication issue in the first place.

1:11:43

We are not there yet, but it's a very valid concern

1:11:46

to put through.

1:11:47

It does feel like we

1:11:50

are walking an economic tightrope

1:11:52

at the moment with someone

1:11:54

trying to push us off one side and winds

1:11:57

coming the other side of rain coming down

1:11:59

on us.

1:11:59

The rope is

1:12:02

wobbling about a bit. I

1:12:05

don't like this position. I

1:12:08

constantly worry about where

1:12:11

am I going to get fucked? Who's going to

1:12:13

fuck me here? Well,

1:12:16

look, there is a thing

1:12:19

in markets, two

1:12:22

mottos that I really like.

1:12:24

One that basically says that

1:12:27

markets need reasons to

1:12:29

go down. They don't need

1:12:32

reasons to go up. It's a thing that

1:12:34

made me think a lot. It's like,

1:12:36

well, in a system

1:12:38

where we have still

1:12:40

some productivity levels, we are able to

1:12:42

generate some levels of structural growth

1:12:44

much less than 30 years ago, but somehow we are.

1:12:48

You know, the world grows and it's a credit-based

1:12:50

system. So if it doesn't grow fast enough, we'll throw

1:12:52

credit at it and make it grow. That's what we

1:12:55

did for the last 30 years. Great.

1:12:58

And it's a very dangerous system

1:13:00

to run because the

1:13:02

growth up is linear, right? It's

1:13:05

a nice growth trajectory. And

1:13:07

as long as you can keep everything under

1:13:10

check, it works nicely. But

1:13:13

because we're also repressing the normal

1:13:15

release valves, we are not allowing for a recession

1:13:17

normally speaking. We hate recessions. We're

1:13:20

basically going to the second part of the motto

1:13:22

that I like the most from Hyman Minsky that says

1:13:25

artificial instability, sorry,

1:13:27

artificial stability leads

1:13:29

to further instability down the road.

1:13:32

So the system is created through artificial

1:13:35

stability. We try to keep everything in check.

1:13:37

We have a fully elastic credit system. We

1:13:40

do a wealth disparity. We

1:13:42

now run into some fiscal dominance

1:13:44

problems, maybe even.

1:13:47

And in the meantime,

1:13:48

as long as everything is kept in check, asset

1:13:51

markets go up, asset prices go

1:13:53

up, and everybody seems to be relatively

1:13:55

happy about it. But you go up via the

1:13:57

stairs and you go down via the elevator.

1:14:00

such a system because it's so

1:14:02

leveraged and so financially complicated,

1:14:04

really, and the financial architecture is so

1:14:07

embedded and leveraged now that obviously

1:14:09

the breaking points can be extremely vicious.

1:14:11

So I understand where you say,

1:14:14

where am I going to get fucked? Because the

1:14:16

jump risks in such a system

1:14:18

are something to always consider.

1:14:21

We should have done this a long time ago. This is

1:14:23

brilliant.

1:14:25

I understand some things I didn't fully

1:14:27

understand before. So I'm very grateful to

1:14:29

you for that. Please

1:14:31

tell people where to go to follow the work you do.

1:14:34

If you Google the

1:14:36

macro compass, themacrocompass.com,

1:14:39

it's the website of my company. It's

1:14:42

a macro investment strategy firm,

1:14:45

which basically means I

1:14:47

not only blabber about macro

1:14:50

and I seriously, I try to be as educational

1:14:52

as I can and explain all the things in

1:14:54

details and follow the economy and follow markets.

1:14:57

Most importantly, try to make it practical.

1:15:00

So I'm an investor in the first place and I try

1:15:02

to make it in a way that it can become actionable

1:15:04

as well. And if you want to follow my

1:15:06

work, it's on the macro compass.com.

1:15:09

Amazing. Listen, thank you for this.

1:15:11

We're probably going to,

1:15:13

I could see us getting you back regularly to discuss

1:15:15

these issues because you explained it so well

1:15:18

with so much clarity. So thank you, Danny. Anything

1:15:20

from you?

1:15:21

No, I think that was good.

1:15:23

All right, man. Well, listen, have a great weekend

1:15:26

and yeah, we'll speak to you soon. Hopefully at

1:15:28

some point we can do this in person, but yeah, speak to you

1:15:30

soon, my man. Thanks guys. Talk soon.

1:15:36

All right. What

1:15:38

do you think of that? How cool is MacroElf? Okay.

1:15:40

So if you listen to my show with Lint Alden

1:15:42

and Jeff Snyder, when we're in Miami, you

1:15:45

will know that I had no idea what the fuck they were talking

1:15:47

about. They got into a big debate about money printing

1:15:50

and it flew right over my head, but

1:15:52

I know I'm not the only one. So to get into

1:15:54

money creation with MacroElf was very cool. He explained

1:15:56

it in a way that I hadn't fully

1:15:58

thought about. I hadn't fully understand. for. So I really

1:16:00

appreciate him coming onto the show and doing that. Okay,

1:16:03

listen, I am on holiday. I'm taking a few days off.

1:16:05

So I'm going to head off now. Big shout out to my team.

1:16:08

Nice one, Danny. Thanks, Ben, for taking this edit

1:16:10

last minute. Also, Aussies, come

1:16:12

to our Aussie show September 9th, Masonic Center.

1:16:14

Go to whatbitcoindid.com and click on WBD

1:16:16

live. Okay, love you all and

1:16:18

I'll see you all later in the week.

1:16:30

Transcribed by https://otter.ai