Thread:

Understanding how the Federal Reserve is NOT monetizing debt - or anything, really.

A (somewhat one-sided) thread summarizing (one side) of two days of debate. 1/

2/ In previous threads, we’ve talked a bit about how the money creating motion of our financial system is largely debt-based. It’s been suggested (by me) that when there’s more debt, the money supply increases.

But not always…

3/ To get to the bottom of this, we have to first understand 2 ways debt can be created. The two distinct forms of debt are 1) self-originated debt, and 2) counterparty-originated debt.

We are more familiar with 2 so let’s start there.

4/ Counterparty-originated debt is like when you go to the bank and get a loan. The bank is the counterparty, and you are the borrower. They’re sort of… “arbitraging money over time” to you, and that’s how they make a profit.

It’s their whole business model.

5/ This is what makes the bond market so important - it’s the locus of their arbitrage. They lend you debt at, say 3% while (in theory) paying something like 1% to borrow and profit by eating the spread (2% in this example).

6/ In order to create counterparty-style debt, banks typically need to have “reserves” they hold on their books, and can only lend a multiple of reserves. This is how we control debt levels.

(yes, I know there are no reserve requirements right now - sit down I’ll get to you)

7/ The original intent of reserve requirements is to preserve bank solvency. See Sahil’s thread below for an incredibly well-detailed explanation of how reserves function. https://twitter.com/SahilBloom/status/1298660564688728069?s=20

8/ If you read the thread above, you'll understand that reserves are often an important (and state-mandated!) part of making counterparty-debt-babies.

The other kind of debt is self-originated debt.

9/ Self-origination means I holler out into the world “hey I’m selling 100k of debt -- what kinda rates you want to give me on that?”

If someone answers, we negotiate the cost of that capital and make sweet, sweet debt together -- this, friends, is how "bond babies” are made.

10/ In counterparty-style lending (not self-originated debt), reserves can act as a governing force on how much debt is allowed to be created.

The only governor on bond-variant debt is the self-originating party’s ability to (legally) sell it to the markets.

11/ After origination, both kinds of debt babies venture out into the world and get traded around, and their prices start to vary based on the perceived solvency of the debt holder (and other stuff).

These bonds live, work, and play in markets of debt, which are deep and liquid

12/ Post-origination, both kinds of debt become tradable assets, so t’s most useful to think of post-origination debt as a ‘proper’ asset, just like a house or a building.

Debt does have its own unique properties: (risk, yield, spread, other stuff…)

But it’s just an asset.

13/ Now let’s get to the good stuff: what is this “monetization” everyone has been talking about?

It’s when someone invents money out of nothing and buys assets with it.

Pure and simple, that’s what it is.

14/ Really any asset can be the apple of monetization’s eye -- so long as the thing would *otherwise* be paid for with not-invented money. Cars, houses, planes, land, whatever.

Oh, and also: bonds, of course.

15/ So if we saw someone inventing money out of nothing and paying for real assets (like bonds) with it, we’d know that was monetization.

But isn’t that what QE does?

16/ No! It’s totally not!

What QE does is pay for assets (of varied kinds) with *reserves.* Those same reserves we talked about above. So the Fed receives assets and offers in return “one of the ingredients for money.”

17/ Because it’s not paying with the assets (usually bonds but could be whatever) with money and it’s only paying with *one* of money’s many ingredients (others being stuff like “lending demand” and “borrower solvency”)

It truly, truly is not monetization.

Not at all.

18/ Now, astute observer, you might be wondering: why in the hell would a bank take X worth of a single money ingredient in exchange for an asset when they could flat out sell it for X worth of actual money, avoiding the trouble of getting the other ingredients to making money?

19/ Well that’s just their lot in life. The end.

…

Okay I’m kidding. But I’m also not: it fully is their lot in life.

If the regulating body (the Fed) says that’s how it is, then they can sort of either take it or stop being a bank.

20/ But that’s a cop out answer, and the financial system would not have survived for centuries if some totalitarian asshole agency was running around bullying the banks.

So what’s the bank’s incentive in the QE exchange?

21/ Well, over a longer time horizon QE is not bad.

Banks don’t need to win tomorrow, they need to win over a decade. Expanded reserves help them do this.

Remember: the Fed totally controls this one money ingredient.

Reserves are literally the “philosopher’s stone” of money.

22/ And later, as the economy recovers, it's highly likely that reserve requirements will come back (they always do) and the credit cycle will restart.

It might be a few years, but it will.

23/ And when it does, and credit conditions suggest a prudent return to reserve requirements (gently, at first, of course), banks will emerge with more reserves and greater lending capacity.

And more profit potential.

24/ Bankers’ ability to think about money over very long time horizons is key to their success. It’s why the big, brawny institutional banks (like JP Morgan) are named after long dead people with funny mustaches.

Because banks endure.

(it would appear I'm too wordy, the continuation of this thread can be found below). https://twitter.com/coloradotravis/status/1298704972251426816?s=20