Here’s part 2 of last week’s Q&A. Sorry for the delay in answering….
Q: How does trade and foreign capital flows affect the domestic money supply? For example, if a foreign investor decides to buy a US government bond, what is the effect on M2 and how does the interaction with the Fed and Banks work?
A: I always find it helpful to think of dollars as never leaving the USA. So, in the case of the USA running a trade deficit with China the Chinese exporter will initially increase its quantity of USD, but not RMB. The exporter will then exchange the proceeds at a Chinese bank for RMB and subsequently the PBoC will purchase the USD from the Chinese commercial bank. This FX purchase by the PBoC will lead to an increase in RMB settlement balances and the PboC will neutralize this by sales of T-bills presumably. So if the import is $100, then the US domestic private sector’s assets minus liabilities go down by $100. The non-bank Chinese sector’s assets increase by the quantity of the FX conversion in RMB. The Chinese commercial banks’ assets and liabilities increase by the quantity of the conversion RMB (assets T-bills) liabilities: deposits created in exchanging USD with the exporter. The PBoC’s assets increase by $100 and liabilities by RMB630 assuming its own bills are sold to banks. I hope that all made sense. Lots of moving parts….
Q: “Of course, QE isn’t really ending. The Fed is still reinvesting principal proceeds”
Can you elaborate on what you mean by this?
A: Anyone who owns bonds will receive principal when they mature. The Fed will be reinvesting any principal proceeds so it’s best to think of the Fed as currently maintaining the size of its balance sheet as opposed to actually letting the balance sheet naturally shrink. Remember, when the Tsy pays the Fed at maturity it is repaying the Fed with reserves so the Fed’s own balance sheet is shrinking in much the same way that a bank’s balance sheet shrinks when you repay a loan. But the Fed is not actually allowing its balance sheet to shrink. It is reinvesting the principal back into new bonds. It’s a long way of basically buying more bonds to maintain the current size of the balance sheet without it being potentially contractionary. At some point the Fed will stop reinvesting principal at which point the balance sheet will naturally shrink.
Q: What do you make of the Positive Money movement? Seems Martin Wolf’s a fan, and possibly Izzy Kaminska (https://ftalphaville.ft.com/2014/10/31/2025592/why-banking-got-out-of-control-in-the-digital-age/). Sharp observers. Would this be a good thing? Seems to me that growth in corporate investment would be hitched to state money-growth mandates. Do I have that right? Would that arrangement be preferable to private credit-money? Thanks!
A: The Positive Money people really understand endogenous money. They’ve done some nice work there. I don’t know if I agree with their conclusions though. A private credit based money system makes a good deal of sense because you’re forcing the money issuance process to be regulated and overseen in a risk averse manner. Banks have to manage their liability risk before all else. Presumably, a state run entity doing all the money creation will be far less prudent in its risk management process. So I am not so sure it would be wise to allow the state to control the money supply in this manner….
Q: What are some of the books you’ve been reading lately? I read your book, and it is by and far the best economics / finance / investing book I’ve read…
A: Thanks! I haven’t had time to read a good book lately. And it might come as a surprise to know that I actually don’t read a lot of finance/econ books any longer. I spend most of my reading time online and on research notes. If I had more time I’d probably try to get around to Peter Thiel’s new book Zero to One….
Q; Are you ever going to get back to the paid mailing list? It was an invaluable resource for so many of us, esp. now that you’ve stopped making market calls on pragcap.com.
A: I seriously doubt it. Writing those research notes was very time consuming and difficult. I just couldn’t leverage my time well enough to continue doing it. Sorry.
Q: iPhone 6 plus envy? After being a long time Android user, I’m switching over. What are your thoughts?
A: Not for me. I have an HTC M8 and I absolutely love it. In fact, the iPhone 6 looks like a complete replica of it. It’s the first Android phone that I’ve considered to be on the same level or higher than the iPhone. And since I use Google everything now there’s no way I could go back to Apple. I did switch from an old Android tablet to the iPad though. The Android tablets still aren’t on the same level with Apple….
Mr. Roche is the Founder and Chief Investment Officer of Discipline Funds.Discipline Funds is a low fee financial advisory firm with a focus on helping people be more disciplined with their finances.
He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance, Understanding the Modern Monetary System and Understanding Modern Portfolio Construction.