BY JAKE YOCOM-PIATT ON JULY 1, 2020
Many of us in the cryptocurrency space have been waiting for the next major market contraction for several years, and it has finally arrived, in spectacular fashion. COVID-19 and government response to it are disrupting markets in a way that few could have expected, putting a massive strain on markets already leveraged to the point of malfunction. The US central bank, the Federal Reserve System (“FRS”), is running the same plays it did during the 2008 crisis to address the market contraction: a combination of reducing its target interest rate and using effectively-unlimited credit to backstop various markets directly. Since Bitcoin was released shortly after the 2008 crisis, many people have come to understand the substantial shortcomings in the fiat banking system through the lens of Bitcoin, Decred, and cryptocurrencies more generally. In short, the fiat banking system is a blatantly rigged system and cryptocurrencies are less-rigged systems, which creates an incentive to adopt cryptocurrencies over fiat currencies. There is a lot to unpack in the prior sentence, and we will be specifically addressing the statement “the fiat banking system is a blatantly rigged system” in what follows. This article is the first in a series, with the next one being about Bitcoin.
The Fiat Banking System
In order to understand how the fiat banking system is rigged, we must first understand what it is and how it operates. This overview is intentionally reductive and focuses on the important concepts, not the details. Modern finance is rich with abstraction, which is used to obfuscate core concepts and flaws in the system, so we will not dwell on it. Don’t take the decoy.
Since FRS is the world’s most important central bank for now it will be used as the example under discussion. Many central banks in other nation states follow a substantially similar model to FRS, so the reasoning that follows maps pretty cleanly onto most modern central banks.
Structure and Purpose
In response to the Panic of 1907, the Federal Reserve Act was passed in late 1913 and it created the Federal Reserve System of 12 regional Federal Reserve Banks, which are jointly responsible for managing the country’s money supply, making loans and providing oversight to banks, and serving as a lender of last resort. FRS’s purpose is commonly stated as having 3 key objectives: maximizing employment, stabilizing prices, and moderating long-term interest rates. These stated objectives are pretty reasonable because they are intended to minimize social unrest, which US citizens collectively benefit from.
Commercial banks obtain credit from FRS via a fractional reserve system, where a commercial bank deposits funds into its reserve account with FRS and is given a corresponding amount of credit. The reserve requirement for FRS is 10% of the credit issued must be deposited with FRS, so a commercial bank would deposit 1 million USD and receive 10 million USD in credit. Commercial banks then issue credit to their customers in the form of loans, where the interest rate offered is higher than the rate paid to FRS, and they derive income from the spread between the market interest rate and the interest rates they charge customers for credit.
In order to maximize employment, stabilize prices, and moderate long-term interest rates, FRS will adjust its target interest rate, adjust reserve requirements, and intervene directly in various markets during times of crisis. On a multi-year timescale, FRS will typically adjust its target interest rate up when the economy is doing well and adjust its target interest rate down when the economy is doing poorly.
By lowering the interest rate, FRS reduces the cost of credit to commercial banks, creating incentive for banks to issue credit to their customers. Similarly, when increasing the interest rate, FRS increases the cost of credit to commercial banks, creating incentive for banks to tighten their credit issuance to their customers. Under stable market conditions, this manipulation of the target interest rate is a very effective tool for managing the US economy.
In a crisis, FRS will directly intervene in various markets, directly buying, selling or otherwise taking custody of fiat financial instruments. These interventions are typically intended to be short to medium term actions, where FRS eventually liquidates its positions over time.
The Social Contract
While we have already reviewed the broad strokes of how FRS is structured and operated, it can be easy to overlook the implicit social contract dictated by FRS via the Federal Reserve Act:
“If US citizens want maximized employment, stabilized prices, and moderated long-term interest rates, they must grant FRS the ability to manipulate interest rates, the money supply, and various important markets.”
This gives FRS an enormous amount of power over US citizens, where the citizens have no direct power over FRS, beyond having indirectly approved it via elected representatives back in 1913. At best, US citizens could press for legislative changes to the Federal Reserve Act, which has a very low chance of succeeding due to the alignment of incentives of various powerful interest groups.
COVID-19 (“CV19”), a particularly nasty variety of coronavirus, has initiated a substantial contraction in many nation state economies. CV19 has several relatively unique qualities that have led to both serious public health and economic problems:
- it has a long (roughly 2-24 days) asymptomatic phase
- absent quarantines of various sorts, the average number of new infections transmitted by a single infection is 2 or more
- 5-20% of those who are symptomatic and test positive require ICU level breathing assistance
- a fatality rate of roughly 2-5% amongst symptomatic patients, when ICU care is available
- it can be spread by contact and aerially via coughing and sneezing
Due to the nature of CV19, many US states and counties have opted to cancel or ban most events, force restaurants to do delivery or drive-through only, and close most offices, which are all forms of systemic quarantining. Even under these conditions, CV19 continues to spread, albeit more slowly.
The result of both the government countermeasures cited above and the resulting widespread fear is that US and its individual state economies have contracted substantially. If you consider that 40% of Americans don’t have 400 USD available for an emergency expense, it is reasonable to assume that some sizable percentage of US businesses are similarly marginal, e.g. 40%. Many businesses cannot weather a total or near-total loss of revenue, even for a short period of time, and this has a variety of second order effects:
- staff are fired, laid off or furloughed
- supply chains are forced to reorganize
- banks are incentivized to tighten credit issuance
- business and personal loans go into delinquency or default
- bank revenue declines
- bank stocks drop in value
- bank customers become concerned about the safety of their deposits and withdraw their funds
- banks are insolvent and stuck with a bunch of repossessed assets
- links in the supply chain collapse outright
Some of these second order effects have already occurred, and some may or may not ultimately occur before this market contraction ends.
The predictable response to this crisis from the US government (“USG”) and FRS has been to issue credit on a massive scale, which is commonly referred to as “helicopter money”. The intent here is to soften the blow for banks financially and to stabilize important credit markets that underpin a highly financialized economy. Here is a list of countermeasures currently being deployed or in the planning phase:
- FRS backstops short term repos
- FRS drops target interest rate to 0-0.25%
- FRS backstops short-term corporate debt, allowing stock to be used as collateral
- FRS backstops mortgage-backed securities
- FRS backstops US treasuries
- FRS backstops foreign exchange swaps with major central banks
- FRS backstops corporate bonds
- FRS funds USG aid programs
When FRS dropped the target interest rate to zero, it had the immediate effect of increasing the profits commercial banks receive from issuing credit to their customers via loans. Increasing bank income from loans is a way to offset inevitable losses from businesses and individuals defaulting on their loans.
In addition to the substantial intervention of FRS in various markets, the USG is deploying its own financial stimulus package. Similar to the FRS stimulus, the USG stimulus has several facets:
- USG pays individuals directly
- USG pays and issues loans to businesses
- USG backstops unemployment insurance policies
- USG funds state and local governments
USG intervention is intended to preserve confidence in existing governance systems, reduce social unrest and help businesses weather the economic contraction.
In the following, we will focus primarily on FRS. It is worth noting that USG stimulus has substantial similarities with FRS stimulus, so much of the reasoning will apply to USG as well as FRS.
A Blatantly Rigged System
After reading the overview of how FRS and fiat banking work in the US, both in stable and unstable market conditions, it may seem that everything about the structure and operation is pretty reasonable and nominally fair. As is typically the case, you must pay careful attention to see how the system is rigged.
The primary means through which the fiat banking system is rigged are:
- a central planning committee
- subjective amount of credit issued
- subjective distribution of credit
Each of these methods of rigging deserve further discussion.
Central Planning Committee
The vast majority of human organizations currently have some form of central planning as their governance model, and FRS is no different in this regard. FRS is managed by the Board of Governors (“BoG”), which is a body of 7 members, where the Vice Chair and Chair of BoG are appointed by a current or previous US President. The remaining 5 members are also appointed by a current or previous US President.
Despite FRS BoG being based solely on US Presidential appointments, the Federal Open Market Committee (“FOMC”) is comprised of the 7 members of the BoG along with 5 of the regional Federal Reserve Bank Presidents. The 5 regional Federal Reserve Bank Presidents are each selected by their respective Board of Directors. Each regional Federal Reserve Bank’s Board of Directors is composed of 3 groups: representing the banking industry, elected by member banks (Class A), representing various industries, elected by member banks (Class B), representing various industries, appointed by BoG (Class C).
FOMC is the body that decides on target interest rate changes and other open market operations, which have been referenced above, so this group wields an enormous amount of power. To summarize the above, it is composed of a group appointed by US Presidents (BoG) and a group appointed by regional Federal Reserve Bank Class B and C directors, which represent member banks and various powerful industries. As a result of the composition of FOMC and the selection process for Bank Presidents, it is entirely unsurprising to see it routinely take actions which disproportionately benefit banks and major corporations.
From the perspective of incentives, FRS is setup to primarily benefit the groups that are involved in appointing board governors and electing regional bank presidents, which comprise the FOMC. The groups involved are (1) US Presidents, past and present, which act as a proxy for USG, (2) the US banking industry, and (3) major US corporations.
Subjective Amount of Credit Issuance
Determining when too much or too little credit has been issued is a subjective process. The FRS mandate of maximized employment, stabilized prices, and moderate long-term interest rates suggests that more credit issuance leads to higher employment, increasing prices, and decreasing long-term interest rates, and less credit issuance leads to decreased employment, decreasing prices, and increasing long-term interest rates. A consequence of this manually-adjusted target rate is that USD holders cannot predict the future adjustments of the target rate and cannot manage their expectations correspondingly. This makes USD an asset that is always having its value inflated on a schedule that is non-deterministic.
Beyond the steady state behavior where FOMC adjusts the target rate, gradually eating away the value of USD and assets denominated in USD, during periods of crisis it has become typical for FOMC to issue massive amounts of credit to various financial institutions and large corporations. This makes the credit issuance process even more unpredictable than the steady state case, more acutely mismanaging expectations for those who hold USD and USD-denominated assets.
Both the steady state and crisis issuance processes mismanage USD asset holder expectations, but the fractional reserve system is where a more serious problem occurs. Since it is possible to take credit issued by commercial bank A and deposit it at commercial bank B, which occurs naturally as credit from bank A is paid to a counterparty at bank B, this allows commercial banks to run with an effective leverage that far exceeds the 10x amount that comes from the 10% on deposit with FRS. This multiplicative nature of credit issuance via fractional reserve banking means that the only practical limit on the credit issuance process is that banks need a certain amount of funds on-hand to avoid near term insolvency. Larger US banks must undergo a stress test simulation, and this is done to, hopefully, avoid exactly the failure mode cited above.
Whether it occurs via steady state changes to the target interest rate, crisis-driven credit issuance, or fractional reserve credit multiplication, the amount of credit being issued and corresponding leverage is entirely subjective and effectively unbounded, subject to the constraint that the system appears solvent.
Subjective Distribution of Credit
Determining who does or does not receive credit is a subjective process. Anyone who has had a difficult time getting a loan has seen this firsthand, despite seemingly reasonable justifications from commercial banks. It is often the case that people who have the greatest direct need for credit cannot get it, but those who do not need it can easily get it. An individual or corporate entity with low income often struggles to obtain credit, while those with higher income can obtain credit with ease.
Banks judge creditworthiness on their perception of a borrower’s ability to repay the loan. This has the property of magnifying the flow of credit to people who are already wealthy, while starving those without substantial assets of credit. Issuing credit to creditworthy borrowers makes sense from a risk and return perspective for a bank, but it acts to magnify social inequality and creates a “catch-22” for low income borrowers.
The process of assessing creditworthiness for the purposes of obtaining USD loans is necessarily subjective and is the primary means of credit issuance via FRS. A creditor’s perceived ability to repay a loan is the primary basis upon which creditworthiness is judged, and this serves to magnify income inequality and create barriers to obtaining credit for lower income individuals.
FRS is a blatantly rigged system that uses central planning, subjective amounts of credit issuance, and a subjective distribution process for credit to benefit major US banks, major US corporations, and USG. Central banks in other nation states have a substantially similar structure and similar problems, which reflects the extent to which fiat banking is a blatantly rigged process setup to benefit a handful of selected key actors. Since so much of human society depends on the underlying financial systems, the rigging of these systems acts to substantially constrain the evolution of society as a whole. In order to evolve as a society, it is necessary to question the legitimacy of fiat banking and investigate whether it is possible to deliver a better, fairer financial system. Bitcoin is the first major step towards such a fairer system and the next article will discuss this in detail.