Part VII of the Bitgenstein Serialization

photo by Fikri Rasyid, via Unsplash

What if we foolishly do not think that economic health rests on growing the capital stock, but rather on the instantaneous magnitude of consumption? If we grow weary of the hard work of farming and think the path to happiness lies instead in feasting on our seeds? How will our analysis differ?

First, we will see financialization as unequivocally good and be totally indifferent to the risks and the fragility it creates. When prices naturally increase as present value is crystallized and exchanged, we will have little choice but to conceive of this inevitability as an intrinsically good thing, since increased consumption is a good thing, and increased prices can’t help but follow.

In particular, we will encourage entrepreneurs to assume any increase in purchasing is fundamentally sustainable, regardless of what their judgment and their knowledge tells them, because this will motivate capital investment in increasing the production of whatever is being purchased. If more such investment can be financialized, all the better, because that starts the loop all over again. Financialization is good. Pumping out more stuff is good. Number go up is good.

Because we don’t care about the risks of these experiments failing — only that they are attempted — we will be in a curious position when they do fail. What we will see will be asset write-downs that mean purchasing power evaporates and consumption slows. This slowing down will force sellers to lower prices, at least for the period over which capital can be re-allocated to reflect this change. Hence, we will have little choice but to conceive of decreasing prices as an intrinsically bad thing, since decreased consumption is a bad thing, and decreased prices can’t help but follow.

The solution, naturally, will be financialization. We replace the uncertain value that has since proven to be certainly valueless with more crystallized value traded for future uncertainty and go back to step one. Financialization is good. Pumping out more stuff is good. Number go up is good. All the while the natural depletion of the capital stock is not offset, and the price increases that follow from real costs increasing is mistaken as a sign of health.

Depressing as this would be, this is actually a much rosier picture than reality because there is still an alignment between those taking and bearing the risks. What we are effectively assuming is that willing contributors of capital waste it on ill-advised experiments over and over and over again until they have none left. This is still unideal because the ability to increase output for the same input of time and energy is universally positive. But it is only indirectly bad for those that do not contribute to such financialization and simply save instead. The output they can purchase may have fallen, but at least they will retain entitlement to a given share of it.

This also shows why it is unlikely: it relies on capital providers and entrepreneurs being neverendingly stupid. They must make poor judgments about the sustainability of their investments over and over and over again, and take more and more risk with less and less realistic likelihood of the risks paying off. They suffer by far the most from their own folly. To understand why reality is far worse than this, we must return to the question of the supply of money.

What If Money Were Debt? No, Seriously …

photo by Ruth Enyedi, via Unsplash

We must be clear on how money is created in real life. My sense is many have the impression that fiat money is created by central banks. This is partly true, but is not an exhaustive explanation, and is actually misleading in isolation. It is true that “quantitative easing” involves creating new central bank reserves for member banks, but this is not the only way, nor the most common way. The majority of “new money” is created by banks making loans. Contrary to popular belief, modern banks do not “intermediate between depositors and lenders”. As is nicely explained in this Quarterly Bulletin from the Bank of England, when a bank makes a loan, it wills into existence a deposit that is the debtor’s asset and its own liability. In fact, it is more accurate to say that loans create deposits than it is to say that deposits create loans.

This might seem bizarre, but the explanation requires being clear on what fiat money even really is: it is a fungible pan-bank liability. Other than the tiny minority of modern money that exists as cash, there is simply no such thing as a dollar, a pound, or a euro, that is not a right to claim that amount of cash from a bank — which of course nobody does because it is far, far safer to keep cash in a bank, and far, far easier to make almost all payments by instructing your bank to just change the title on that amount of its liabilities. If the payee has liabilities with bank B, then bank A must transfer that value of its central bank reserve assets to bank B, so bank B can create a matching liability. Banks tend to have accounts with one another so they don’t have to resort to this so often, but it is central bank reserves that are the ultimate mechanism for value settlement.

There are two peculiarities with all this. First, there will almost certainly be far more debt than there is any real appetite for because it is not possible to save outside of financialization. The only way to save is to accumulate the residual of credit that has already been issued completely outside your consent or approval. You might think that holding others’ debt can still be worthwhile if it is paid back. But the situation here is far more perverse: your asset with the bank is the bank’s liability, matched by a loan somewhere else. That loan is that person’s liability. That person may accumulate their own assets in the form of bank liabilities, which means the bank has been transferred reserves assets to balance these liabilities. This person may then pay off the loan, at which point the bank cancels the two. But you get nothing. All that happens then is that the bank uses the new reserve cushion to justify making more loans. Your credit might exist because the bank made a loan, but it is not in that loan; it is in the never-ending recycling of one loan into another into another …

The second peculiarity is that those signing off on the risks are not those bearing the risks. In fact, the reader will be forgiven for having completely lost track of the real risk here because it is so well obscured. If enough loans go bad that the bank’s equity cushion is wiped out then the central bank will be forced to create reserves to ensure the bank’s liabilities can still be met (i.e., money can still function). But the original liability will now never be netted off, meaning there are permanently more such liabilities, which means there is permanently more money, which means everybody’s money is worth less. This will be true in both senses of “inflation”: it is true by definition in terms of share of the total, but it will be true for prices as well, as the local slowing in consumption that would have paired the initial quickening due to financialization just never happens. Don’t let any nasty Bitcoiners tell you that the dollar isn’t backed by anything, when we know full well it is backed by self-referentially mispriced toxic loans and stabilized by a military and commodity cartelization pact with Saudi Arabia:

Hopefully I will not be tarred and feathered as a fiat apologist nocoiner shill for making the following observation, but I contend that this setup does not absolutely necessarily lead to catastrophe. If a central bank is run such that the moral hazard of its relationship to member banks and bankers is taken seriously; if banks are kept as small and as systemically unimportant as possible; if the pain of systemic deleveraging and the ecstasy of systemic leveraging are insulated from political interference; if retention of adequate reserves is mandated and is eaten into by bad credit; all with an eye towards faithful risk pricing and a healthy capital stock … then things might be okay. It should also be noted that money is a technology that has no platonic form, and that relative to most real-life alternatives, fiat has the dramatic advantage of vast payment reach and inexpensive settlement that count in its favor at all the times it isn’t imploding.

However, if the prevailing sentiment of those responsible for such a setup foolishly believe that economic health rests not on growing the capital stock, but rather on instantaneous magnitude of consumption, then slow motion disaster will be next to inevitable. Let us explore the mechanics of such a catastrophe.

Gradually, then Suddenly

photo by Martin Adams, via Unsplash

To start with, the oversupply of debt forces the price of debt down to clear the market. The ranking of experimental viability that the market might have carried out to allocate scarce capital becomes irrelevant and all prospective experiments are carried out. This juncture is key. These experiments are, by their nature, uncertain. The price of the capital they would faithfully attract can hardly be better described than a crowd-sourced best guess as to their risk relative to the opportunity set. It is possible that these guesses are conservatively false and that all will succeed. But it is likely that more bad experiments will fail than would have otherwise, hence more debt will tend to mean more bad debt.

And not only this, but the experiments’ financial capital is all bidding against each other for real production capital — which cannot be artificially increased as can the debt to finance the experiments — hence the costs of running the experiments go up just as the cost of financing them goes down. The effect is akin to redistributing the mean risk created by the marginal risky experiment to the entire ensemble. We get more individually bad debt and more averagely bad debt.

It is highly likely many more of the experiments will fail than otherwise would have. This ought to lead to persistent lower later consumption to reflect the capital that has been destroyed, but in our brave new world, such politically incorrect outcomes are not to be tolerated. Consumption cannot slow! Consumption is wealth and wellbeing! The central bank will first buy the bad debts with newly created reserves, meaning banks are not forced to write down their own assets, as doing so would threaten the quality of their liabilities and the entire systemic functioning of money, causing consumption to collapse even further. Then, the central bank will lower the rate paid on its reserves, meaning banks must create more (probably bad) loans to maintain their profitability. It may combine both efforts and buy toxic credit assets on the open market, freeing up the balance sheets of capital market participants beyond just banks to take on these new loans.

By this series of machinations, we emerge with more financialization, borne not of the opportunity to create capital, but the necessity to stabilize money, and the desire to increase consumption. We get more dilutive equity and yet no redemptive deleveraging, as financialization cannot decelerate and any deflation, however transient and coincidental, is deemed bad and triggers further panicked intervention. We get short-term price increases in response to the crystallized value of financialization that become permanent inflation as no matched future value ever materializes. We get official proclamations that this inflation is good and ought to be targeted. And from the starting point of an oversupply of debt we get … an oversupply of debt.

Believe it or not, it gets even worse. It is possible, however unlikely, that the originally expanded set of experiments all work despite their risks being systemically mispriced. But if the nearly inevitable long-term inflationary features of such a system are widely enough appreciated, this will distort the incentives of those trying to create and preserve value. A risky entrepreneurial endeavor making a return below this inflation rate will no longer be creating wealth for its owners but losing it — not as fast as holding fungible pan-bank liabilities (money), admittedly, but then money is thought to have no risk. The point of the risk of entrepreneurship is to get a real return.

Hence all return-seeking capital assets are unnaturally incentivized to lever up to stay ahead of inflation. This will likely be how the market clearing of the debt oversupply is matched — unnatural supply met by unnatural demand. Of course, all that is really happening here is that by swapping equity for debt, the experiments themselves are forced to become riskier than they ought to be. They become more fragile, which creates more bad debt, which will eventually require permanentizing inflation. It also makes a corrective rate rise prohibitively systemically risky because more and more debt can only be sustained at progressively lower rates. If rates rise, debt fails, and if debt fails, money fails.

The slim possibility of all experiments miraculously working evaporates as experiments are forced to be bad and get worse. From the starting point of the widespread belief of systemically necessary inflation we get … the widespread belief of systemically necessary inflation.

continue to Part VIII:

or go back to Part VI:

n.b. This is a serialization of my previous trilogy on Bitcoin, economics, and capital markets: Wittgenstein’s Money, The Capital Strip Mine, and, Bitcoin is Venice.

follow me on Twitter @allenf32

maybe a squirrel. maybe not. views my own, not my employer’s.

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