Just think of money as a database for resource allocation across time and space.
Elon Musk
I recently found myself in the deep, winding rabbit hole of a podcast with one of the godfathers of Modern Monetary Theory (MMT), and it's got my circuits spinning. Ideologically, I am probably as far away from MMT as it is humanly possible. Yet, it was one of the most interesting podcast episodes I had listened to in a while (link at the bottom of this newsletter). Is it possible that I've been wrong about the financial system? Have I been clinging onto outdated monetary dogma?
Now, for those of you whose eyes glaze over at the mention of MMT, fear not. I'm going to break it down, both in professor mode and ELI5 style. “ELI5” means Explain like I'm 5 (years old) for those of you who are too cool to use Reddit.
Modern Monetary Theory suggests that countries with their own sovereign currency—think Uncle Sam and his greenbacks—can print as much money as they need to fund government spending. Traditional worries about deficits and debt, according to MMT, are old hat. I know it sounds idiotic, but bear with me.
If the economy starts to overheat (which means too much money chasing too few goods, hence causing inflation), the government just needs to pull back on spending or increase taxes. Essentially, MMT sees fiscal policy, not monetary policy, as the primary mechanism for managing the economy.
ELI 5 Version
Think about playing a big Monopoly game with all your friends. There's a special rule in this game - the banker (the government) can magically double everyone's money. Woah! That's fun, isn't it? Everyone feels like they're twice as rich!
But here's the thing - the Monopoly board (our economy) stays the same size. There aren't suddenly more properties to buy. Now everyone has more money, but there's still the same amount of stuff to buy.
So, your friend Timmy, who always wanted Park Place but never could save up enough, can now afford it. So can Susie and Jack. They all want Park Place, and they all have lots of money to spend. So the price of Park Place starts going up and up and up. This is what we call inflation.
But don't worry! Our game has a rule to handle this - it's called the Modern Monetary Theory or MMT. According to this rule, when prices start to rise too much (inflation), the banker can do two things to cool things down:
The banker can start asking for more money when players land on 'Go' (raising taxes).
Or, the banker can stop giving out as much money when players pass 'Go' (reducing government spending).
Authors: Me and my good friend, ChatGPT
When it comes to printing money, you did not have to push governments too much to fire up the money printers during Covid-19. They printed, and they printed, and they printed, and oh, surprise, surprise! We had inflation! All this talk about where inflation comes from is just a distraction. In the US alone, the quantity of US Dollars increased by more than 40%, so of course, it triggered inflation.
The year 2023 has been a harsh teacher. Yes, the theory of unlimited money printing sounded like the ultimate cheat code for a video game, and politicians loved it, but in reality, it's more like playing Russian roulette with a fully loaded gun.
Why? Because politicians are about as likely to hike taxes or cut spending during inflationary periods as my dog is to pass up on a thrown tennis ball. When people are already feeling the pinch of inflation, asking them to tighten their belts even more is not exactly a winning campaign strategy. The premise that politicians would act responsibly and prudently when the inflation monster starts roaring was unlikely to survive the test of reality.
So why am I confused? Because according to the MMT tenets, what the Fed is doing by jacking up interest rates to 5% is inflationary, while the Fed is doing it to tame inflation.
In Argentina, the central bank’s interest rate is 97%, and the inflation rate is 114%. In Japan, the central bank’s interest rate is -0.1%, and the inflation rate is 3.2%. So clearly, it doesn’t seem that high interest rates are an effective cure for inflation.
So, what is going on? By increasing its main benchmark interest rate from 0% at the beginning of 2022 up to 5% now, the Fed is allocating new units of currency to people and institutions that already have a lot of it.
During Covid-19, stimulus checks were sent to most Americans. Higher interest rates are another form of stimulus, but this time it’s only for people with money. If you have money, with just a few clicks, you can deposit your US Dollars and earn an annual yield of 5%. R-i-s-k F-r-e-e. Courtesy of the US Government.
Here is where it gets crazier. You don’t even have to lend to the US Government to enjoy the juicy 5% yield. You can have your money deposited straight with the Money Printer itself: at the US Federal Reserve! You see, the Fed realized it kind of overdid it by increasing the number of US Dollars by more than 40% in two years in 2020 and 2021 (see M2 money supply here), so it had to figure out a way to take money out of the system so that it would not be spent, which would fuel even more inflation. Enter the Reverse Repo Facility. This is a facility where financial institutions can deposit money directly at the Fed and earn interest on a daily basis. The Fed currently pays an annual interest rate of 5.05% on close to $2 trillion that has been deposited.
The money deposited at the Fed serves no purpose. It is not lent out to corporations, individuals, or even the government. It just sits there. The only purpose of this facility is to keep liquidity out of the financial system. The cost: about $400 million PER DAY, $2 billion PER WEEK, $8 billion PER MONTH, and a cool $100 billion PER YEAR.
Where does the money come from to pay for this? Here is where it comes from:
That’s right. The Fed just creates new dollars every day to pay interest on the deposits left at the Reverse Repo Facility. Even better than lending to the US Government, you get paid by the money printer itself! This is why a good chunk of the $5.7 trillion in money market funds (a type of mutual fund that invests in highly liquid, short-term instruments) is now deposited directly at the Fed.
I was also about to forget that banks have about $3.3 trillion of reserves parked at the Fed. Banks receive a 5.15% interest rate, also paid by the money printer itself. Why bother lending to anyone?! 5.15% x $3.3 trillion = about $170 billion of new dollars created to compensate banks for the hard work of leaving money at the Fed. It’s hard being a bank.
If you had cash before Covid, you did not receive any interest on it. Now, you get 5%. This is a stimulus in disguise, paid by everyone for the benefit of those with cash. Why? Because this additional interest is paid in two ways:
The US Government pays a higher interest rate on its debt (the annual interest expenditure almost doubled from $549 billion in early 2020 to $929 billion in Q1 2023)
The Fed creates new units of currency to keep money out of the financial system (about $270 billion a year at the current interest rate level, as described above)
Why is it a problem? First, when the Fed prints money, it debases the currency. It dilutes the value of the dollars you own. Second, the higher interest the US Government pays is financed by borrowing more money, not from additional revenues. In 2023, the US Government is projected to have a budget deficit of $1.5 trillion, and it’s not going to get any better in the future.
The cost of the stimulus check sent to Americans during Covid was $817 billion. The increased interest payments made by the US Government, coupled with the new dollars that the Federal Reserve is creating to compensate for deposits at the Fed, collectively provide a stimulus of equivalent magnitude.
High interest rates are a way of reallocating resources from debtors to creditors and savers. New units of dollars are created for those who already have dollars. If you need to borrow, you’re out of luck.
If high interest rates are inflationary, then what is the endgame of the Fed? It’s to slow down the economy, most likely by increasing the unemployment rate, which should have the mechanical effect of slowing down demand, which should translate into lower prices.
So, do I agree with the principles of MMT? Absolutely not! You can’t print your way out of problems. Just ask Venezuela or Lebanon! But I have to recognize that MMT proponents have a very good understanding of the fiat monetary system and how the financial system's plumbing works. I had never considered that high interest rates could be a form of stimulus.
If you have dollars and are not earning at least 5% on them, you are getting diluted. In the crypto world, they would call this “staking” your tokens. If you don’t stake your dollars, you are leaving money on the table, and you are getting diluted by those who do stake their dollars.
If you found the previous part of the newsletter too complicated, don’t worry! You can always do like the Central Bank of Sweden and blame inflation on random events like a Beyonce concert. This is not a joke. This is very much real.
I couldn’t finish this week’s newsletter without a few mind-blowing examples of what you can do with AI. This week, just look at the videos of what you can do with the new AI-powered Photoshop. No need to be an expert designer anymore. You can just prompt what changes you want to be done, and Photoshop takes care of it.
Best Podcast Episodes From Recent Weeks
Below is a selection of episodes I've enjoyed listening to recently