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Three Things I Think I Think – Thursday Edition

Back to the usual nerdiness:

1) The word is getting out on how banks work!  

Here is a great article from the Financial Times on Tuesday discussing why everything we know about banking is wrong and why it matters. The author goes into great detail explaining endogenous money and even cites Pragcap’s Basic Banking page.  He writes:

The fact that banks create money “out of thin air” has three profound implications for how we think about credit and monetary policy and financial regulation.

The first is that it invalidates common views about the effect of central bank reserves – the banks’ own deposits that they are required to hold with their central bank in proportion to their deposits.

The second is that the right model of how banks work gives rise to a more correct – and much scarier – appreciation of how banking affects the macroeconomy.

The third is that “shadow banking system” is a bit of a misnomer. That’s the label commonly given to a swath of the financial sector outside of formal banks. The idea is that many non-bank institutions (such as money market funds) perform the same function as banks – and therefore should be regulated in a similar way lest destabilising behaviour simply migrates from the formal banking sector by the time the regulation has fully caught up with it.

Great stuff!

2)  Coping with the unknowable future. 

I loved this section from the latest Howard Marks letter:

It’s one thing to know what’s going to happen and something very different to have a feeling for the range of possible outcomes and the likelihood of each one happening. Saying we can’t do the former doesn’t mean we can’t do the latter.

The information we’re able to estimate – the list of events that might happen and how likely each one is – can be used to construct a probability distribution. Key point number one in this memo is that the future should be viewed not as a fixed outcome that’s destined to happen and capable of being predicted, but as a range of possibilities and, hopefully on the basis of insight into their respective likelihoods, as a probability distribution.

There’s little I believe in more than Albert Einstein’s observation: “Not everything that counts can be counted, and not everything that can be counted counts.” I’d rather have an order-of-magnitude approximation of risk from an expert than a precise figure from a highly educated statistician who knows less about the underlying investments.

I’m probably more explicit than Marks is about the necessity of making forecasts.  But we’re probably saying the same thing in different ways. That is, I think it’s necessary to have a general forecast about the macro environment. But you allocate assets around that general forecast so that you’re not perfectly aligned with it. The reason for this is precisely what Marks cites. You’re trying to be vaguely right rather than risk being precisely wrong. Thinking in terms of probable outcomes helps us create an asset allocation plan that can succeed even if you’re not precisely right. And that’s a big part of portfolio management – preparing for the reality that you can’t know everything all the time. Smart portfolio management isn’t just about being mostly right, but preparing your portfolio so that you aren’t catastrophically wrong.

The whole Marks letter is excellent as always.  Have a read here.

3) Interest rates aren’t artificially low. 

Antonio Fatas touches on an important point about interest rates that I’ve discussed before – interest rates aren’t “artificially low”.  This commentary is usually mentioned by people who imply that the Federal Reserve controls the entire economy through its interest rate policies.  Here’s the reality:

  • The Fed is the monopoly supplier of reserves to the banking system.  Therefore, it can always set the Fed Funds Rate.  In fact, in order to supply reserves (which are issued primarily for payment settlement) the Fed must ALWAYS force the Fed Funds Rate HIGHER from 0% where it would naturally go if the Fed did not establish a floor of some sort.  I like to think of the entire Fed System as an intervention in what would otherwise be a private clearing system.  Therefore, if you want to think of the Fed as an “artificial” construct then fine.  But we should understand that “artificial” construct as it is and not how we want it to be.
  • While the Fed Funds Rate is important it is simply one rate out of many.  Remember, banks and other credit issuers use the Fed Funds Rate as a benchmark, but that does not mean it controls interest rates across the entire economy and across all financial assets.  It is merely one component of the spread that determines how profitable various credit instruments may or may not be.
  • Most importantly, we have to understand how interest rates are set.  Interest rates are largely a function of economic strength and the rate of inflation that accompanies economic growth. When the economy is strong and inflation is rising the banking system will experience pricing power which will generally allow lenders to raise rates on borrowers. In order to influence the rate of lending the Central Bank can alter the spread at which banks earn a profit (by changing the Fed Funds Rate). But the important point is that the Fed is responding to and forecasting the economy, not controlling the economy.  So, not only does the Fed force the Fed Funds rate off of a 0% floor (as mentioned above), but the Fed is only controlling one rate that has an outside influence on the broader banking system and the economy. The Fed couldn’t make the entire world of interest rates artificial even if it wanted to. It simply doesn’t control all rates in any direct manner that allows this.

So, it’s better to say that the economy, the markets and the banking system drive interest rates.  The Fed controls one rate, but that does not mean that all interest rates are therefore “artificial”.*

* NB – Think of it this way. If the rate of inflation surged while the Fed was on a 0% interest rate this would force the Fed to play catch up. So, they’d raise rates and likely do so long after many other markets had already started to move higher. That is, the markets would force the Fed off of a 0% rate. Of course, they could leave overnight rates at 0%, but that would be highly unlikely because they’d be concerned that low rates are spurring the inflation. This is a simple example that shows how the Fed reacts to the economy and the interest rate environment rather than artificially steers it.