8 Months of Stimulus Just Unraveled | Economics Explained - YouTube

Adjusted for inflation the U.S. has  now spent more money fighting the  

economic fallout of the coronavirus than  it spent fighting both world wars ... combined.

Unsurprisingly, this has caused  some distortions in the economy that  

may come back to bite us in the future.

In fact, there is something very concerning taking  place in the global economy at this moment.

Now, I know that might be a phrase  that you are sick of hearing,  

especially in these last 18 months.  But, this may genuinely be one of the  

defining issues of the next two decades  and nobody is really talking about it.

And what is this issue?

In essence, The Federal Reserve  Bank of the United States,  

as well as a selection of other central  banks from around the world are being  

forced to take back all of the cash they have  been busy printing to fund stimulus efforts.

The Fed’s Reverse Repos recently spiked to 1  

trillion dollars, which effectively undid  over 8 months of quantitative easing efforts.

Now, if you are not sure what  this all means fear not,  

we are going to explain it all in this  video because it is genuinely important  

that everybody has at least a general  understanding of what’s going on here.

If you do understand it, and think that  taking cash out of circulation is a good  

thing right now (especially in light  of fears about hyperinflation), well,  

maybe, you might be right. But if that was  the case, this would – at best – a temporary  

solution, or at worse, something that will mask  the problem only to make it much worse later on.

But to be able to draw your  own conclusions on this matter  

you are going to need to understand a few things.

So.

What are these Fed Reverse Repos  that have economists so concerned?

Why are people saying that this could  ease the risk of hyperinflation?

And finally, why might this  phenomenon make everything,  

including inflation, worse in the long term?

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Ok, so Repos or "repurchase agreements",  are simply a financial instrument  

that is a secured very short-term loan,  sometimes as short term as a day or two.

For example, if a company pays all of  its employees on the 15th of the month,  

but they just purchased a huge new  piece of equipment on the 13th,  

they may be in a position where they don’t have  enough cash-on-hand to pay their employees.

Now, instead of delaying people's paychecks  or going through the lengthy process of  

applying for a business loan, the company  simply calls up their bank and agrees to  

sell this shiny new piece of  equipment to the bank itself.

Say this piece of equipment  was worth $1,000,000

the bank would likely only buy it under  such an agreement for $500,000

but, written into the terms of this  contract would be the requirement for  

the bank to sell this machine back to them  for say $501,000 at the end of the month.

Normally, during this time the  company will also be allowed  

to keep on using the big fancy machine as well.

This is a great deal all around. The company got  access to the cash flow it needed to pay its staff  

for a very low effective interest rate, and  the bank had an extremely secure position,  

because even if the company didn’t  end up buying back the machine (which  

they would be very silly not to do)  well then the bank could just sell  

this machine easily making its money back  because, remember, [the bank] technically owns it.

This sale, with the Agreement to Repurchase, at a  later date is how these financial instruments get  

their name. Financiers are a creative bunch,  just not when it comes to naming things.

Now, regular banks and central banks effectively  do something very similar every single day.

If a regular bank is running low on cash, they  can enter into a repurchase agreement with the  

Federal Reserve. This normally involves  them selling very low-risk assets like  

treasury bills in exchange for cash at a very  low-interest rate. This is also known as "the cash rate."

This is there to ensure that banks can  lend out more and more money without the  

risk of running out of cash if lots of people  decide to withdraw their funds on a given day.

Not having money on hand to honor withdrawals  is bad news, as it would cause a run on the banks.  

So, deposit-taking institutions and The Fed  take this responsibility very seriously.

Ok, this is great but repos aren’t even what  we are interested in here. The problem at the  

moment is actually with Reverse Repo’s, which, again, as the name would suggest is exactly the opposite.

In the same way that you can deposit money  into your bank account for safekeeping,  

your bank can keep money with The Fed for  safekeeping through these reverse repos.

In this kind of deal, the bank will  purchase assets from the fed for cash,  

with the agreement that the  fed will buy back the bills  

the next day for a slightly higher price. And I do mean very slightly higher.

If J.P. Morgan let's say, bought a billion dollars  worth of assets from The Fed they would only be  

able to sell them back for a $5,000 premium, which  to you or I might sound pretty good for one day,  

but for a billion dollars it’s pretty terrible.

Now the fact that both Fed Repo (where  the private banks sell their assets and  

get given cash) and reverse repo (where  The Fed sells assets and gets given cash)  

happen on one-day terms is why you have  likely heard the term, "overnight cash rate."

This is what The Federal Reserve Bank actually  changes when it changes interest rates –

that is, the premium that it receives, or "gives", on these repurchase agreements.

Alright, so now that you understand what  actually goes on under-the-hood at The Fed,  

it’s time to learn why this spike in cash  going back to The Fed is causing concern.

The coronavirus pandemic caused a lot of economic uncertainty. Businesses were closed,  

people were out of work, companies couldn’t operate. I mean you know the drill. You were there.

In response to this economic downturn, the Federal  Reserve lowered its overnight cash rates from a

2.50% effective annual rate down to a  0.05% annual rate. This is the same thing they did  

after the crash of 2008, and pretty much every  other economic downturn for the past 5 decades.

The hope here was that this would  encourage banks to lend more money  

because they could load-up on cash at cheap  rates and pass this along to consumers.

It also simultaneously acted as a deterrent  for banks to park piles of cash with the fed  

because, as we saw earlier, they wouldn't get much money for doing so. In fact, given our  

example from earlier, if J.P. Morgan was to deposit  those same 1 billion dollars overnight in mid-2019  

they would have received close to $70,000  in repo premiums which is “not bad”.

Anyway, the ultimate hope of this carrot and  stick approach is that more money gets out  

into the economy for people to spend – thus, counteracting  the effects of the recession in the first place.  

This is, in essence, countercyclical monetary policy.

The problem is, right now, it's not really working.

You see, a lot of money has been created recently  to fund the various stimulus efforts that went  

into fighting the coronavirus. Everything from  the Paycheck Protection Program (PPP) to those $1,400  

checks was paid for with nice  fresh new piles of new money.

But despite the imagery, almost none of that money  was kept as cash, but rather, is kept digitally in  

people's bank accounts. Now, normally, banks would  take this money and loan it out or invest it,  

that’s how they make profits, but they are kind  of limited in how they can do that right now.

They don’t really want to write  residential home loans that will  

last for 30 years at record low interest rates,  

business loans are a bit hit and miss right  now. And even credit card usage is falling  

fast – thanks in part to competition from zero  interest "buy now, pay later" companies, and also  

from a new wave of educated consumers who doesn’t  feel like paying 20% interest on their spending.

What's more, is that a lot of banks are  afraid to invest in the stock market  

while it is so hot. Remember, it’s  not actually their money to speculate  

with, so they do try to remain relatively  conservative with their investments.

So, banks are holding piles of cash on behalf of  a nation of businesses and individuals that have  

been the recipients of the largest stimulus effort  in history.

But okay, maybe this isn't awesome for the quarterly profits of financial institutions, but it still doesn’t sound that bad ... right?

Well, it might. For two reasons.

For starters, it shows that the overall  confidence level of participants in  

the economy is very low. Everybody from  working-class individuals to the largest  

banks in the country are hoarding as much  cash as they possibly can, just in case.

Just in case they lose their job. Just in case  their business is forced to close again.

Or, just in case there are better investment opportunities that present themselves in the future.

Now, this increased savings rate is not  so much a problem in and of itself,  

Rather, it’s just a warning sign that people might  not be 100% confident in the future right now.

What could be a problem is that  this much money sloshing around  

fundamentally limits some of  the control over the economy.  

This all has to do with something that  economists refer to as The Velocity of Money.

When we made our video on hyperinflation  last month, a lot of people said that the  

risk of sustained inflation wasn’t huge because  the velocity of money was at all-time lows.

Now in fairness, this is half-correct.

So, are the doom and gloom economists wrong?

Well, the velocity of money is a  measure of how fast money changes hands –

normally measured on a quarterly basis.

If, for example, you spend a dollar at a local  convenience store and then that dollar gets given  

to an employee of that store, who in turn spends it buying an iced tee from a vending machine,

then the velocity of money  would be 2, for this quarter.

This means that we can actually work out GDP using this measure.  

GDP simply equals the money supply,  multiplied by the velocity of money.

And, if we wanted to get really technical, we  can work out "Real GDP" (that is GDP adjusted for  

inflation), by putting the whole right-hand side  of this equation over the inflation rate plus 1.

I’m sorry to have to bring "maths" into this but  

don’t worry it’s actually pretty  simple and you will see why soon.

Now, here is the thing ... The velocity of money  

normally hovers around 1.5 to 2  transactions a quarter in the U.S.A., it has  

been trending down in recent years, but after the  fallout of the coronavirus, it fell off a cliff.

Now, this was caused by two things. For starters, we have all seen the money printer memes.

More cash in circulation meant that the  transactions as a portion of this increased  

pool of cash was naturally lower. Increase the denominator, the result gets smaller.

But what's more, is that as we saw earlier, people  are spending less money, either out of fear,  

or lack of opportunity, or lack of  ability to get outside and spend up.  

People are just sitting on their piles of cash.

Now, of course, this won’t last forever.  The money supply won’t decrease,  

but people will eventually go out and spend  it, so let’s map out what happens with that.

Let’s take our equation here again. If the  velocity of money is to bounce back to a  

somewhat normal level, let's say increasing  from 1 average transaction a quarter to 1.5  

average transactions a quarter, that would mean  either real GDP would have to increase by 50%,  

the money supply would need to contract by 33%, or, indeed, inflation would need to increase by 50%.  

Now ask yourself: What do you think is most likely to happen?

Now, if you don’t like maths think of it like this.

Imagine the economy is a balloon, the air inside that balloon is the money supply, and the balloon bursting represents a hyperinflation armageddon.

You can pump a lot of air into this  balloon – and eventually it will burst.

But if the air molecules aren’t moving around very fast in there, you'd find that you would have to put a lot more air in there than you might expect.

On the other hand, if you increase the velocity  of the air particles in this balloon, you will  

find that the air expands – eventually bursting the balloon ... even if no more air was actually added.

Or, worst-case scenario, let's say you pump your balloon full of air while it’s really cold,  

and then wait until it heats up. Yeah it’s gonna pop. Don’t believe me?

Well, it’s like a million degrees in America at  the moment go and try it out for yourself,  

while I enjoy winter down here in Sydney.

Economists are worried that we are pumping the  economy full of "cold money" at the moment, but  

as soon as things heat up again and those  particles of money start moving around  

we might have a problem we  are ill-equipped to handle.

Am I being overly pessimistic here? Well probably. Nobody can predict the future,  

least of all people on the internet or economists,  or worst of all economists on the internet.

Look, hopefully, it will be some combination  of all three of these factors, and hopefully,  

it will happen very slowly.

50% inflation in two  years is devastating, 50% inflation over 20 years is perfectly fine.

But in the meantime, we  need to come to terms with the fact that we  

are sitting on top of a lot of dry powder at  the moment. And the thing about dry powder,  

is that if you’re not careful it, it has  the tendency to blow up in your face.

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As always, thanks for watching mate. Bye.