75 years in the making.

Around 75 years ago after WW2, the gold standard was replaced by the Bretton Woods system and the USD became the global reserve currency - pegged to the price of, and convertible into gold.

At that time, the US held the most gold and was responsible for managing the supply of USD to maintain the gold peg, and other currencies were convertible into USD. Practically perfect.

By the 1960s, and around the time Walt Disney released Mary Poppins, U.S. share of global output and gold had dropped, inflation had risen and eventually in 1971 Nixon broke the gold peg. The world pivoted to a new (and still current) system of inconvertible paper money, or fiat. Essentially, an IOU backed by government edict.

Today, we have the economic costs of an unresolved trade war that has decreased GDP, QE Infinity which has increased debt and de-monetised money, the baby boomer exit that will take liquidity out of equities and bonds, and the multi-location COVID-19 response package.

We are now seeing QE Infinity, grants, bail outs, forgivable loans, equity for debt swaps, and together this has de-monetised money as we know it.

Last week we witnessed the UK Treasury monetise its deficit by extending its overdraft with the Bank of England (BoE) through the creation of new base money. Bypassing the bond market might be an early sign of an impending liquidity trap, and only a half skip away, if that, from what was originally described by Milton Friedman as inflationary helicopter money.

But, for today’s purposes let’s call it chimney money.

I believe that this move to chimney money in the UK and elsewhere as well as grants, forgivable loans and global QE Infinity has again brought us to the monetary crossroads, after 75 years. If the trillions of new accommodation ($9 trillion in the U.S. alone) and the U.S. Fed’s commitment to buy up assets across the spectrum creates an inflationary slingshot post-COVID-19, we might need to imagine up a way better system.

And, that’s what prompted me to write this article.

So, let’s go fly a kite as we explore banks, chimney money and the various different ways large economies are trying to fight the economic effects of COVID-19.

We will also explore the potential long-term impacts of this on the economy, and then wrap up with some probably controversial views on a more reliable system of money.

Economic response to COVID-19, so far.

Governments are basically playing the role of insurance company and banker, with the help of their treasuries and reserve banking systems. They are replacing lost income, and some will be buying unwanted financial liabilities. Essentially, lock-down insurance.

The waterfall of COVID-19 economic response tools so far includes:

• Fiscal spending - allocation of taxes and other Government revenue to projects albeit so far quite difficult with physical distancing and lock-downs

• Fiscal repair/bail-out packages - guaranteed lending, wage subsidisation/reverse taxation, grants and forgivable loans (see Chimney money) and other assorted equity for debt bail-outs

• Quantitative Easing or QE – central bank open market purchases of bonds and government securities to managing down interest rates/increase the money supply to spur on lending and investment (QT, or tightening, is the opposite)

• Debt monetisation - new money created by a central bank and provided to a treasury to fund a deficit via direct digital credit into households and businesses, and which is serviced and repaid by the treasury, and most likely inflationary (helicopter money, if it’s not repaid)

• Chimney money – roughly the same as debt monetisation in terms of new digital credits direct to households and business, but non-repayable and without a coupon, i.e., a liability without a corresponding asset, and most likely inflationary (helicopter money)

• Debt forgiveness jubilee – rip up the debt as though it never existed

• Pandemic or corona bond (mooted) – A European level bond cross-guaranteed by all the members but which so far cannot be supported by Germany and the Netherlands despite admission of a debt crisis

• Some other form of fiscal/monetary hybrid guarantee or tool yet to be developed

There’s so much of it, my abacus can’t keep up.

The UK Treasury is monetising the government deficit by taking new money created by the BoE to fund its commitments to households - but it might turn into chimney money based on more COVID-19 bail-out money not allowing its repayment. Either that, or it will need to be refinanced with a gilt issue, adding more debt.

The U.S. continues along the jetstream of QE Infinity with an additional $2.3 trillion announced last week and still to be approved, including money-financed tax cuts which bypass the banking system. Add to that $350 billion in forgivable loans, $100 billion in asset backed and $600 billion in mainstream loans and a commitment from the U.S. Fed to buy just about any asset if there is no other buyer. Airlines will now receive $25 billion, with 70% in the form of a grant and 30% by way of loan with Treasury receiving stock options over 10% of the amount over $100 million. The grant/loan ratio is telling.

QE, loans, monetisation, chimney money, grants and equity! A veritable corporate takeover by the U.S. taxpayer who will never see it.

In the EU, the ECB continues with QE Infinity. There is no consensus on a European level pandemic bond and to make matters a little spicier, ex-ECB chief Mario Draghi recently suggested that pandemic related commercial indebtedness (i.e., ‘keeping the lights off’ loans) should be forgiven, something that would have the same effect as chimney money. And, most major economies are issuing forgivable loans. There’s a liability, but no corresponding asset.

China is yet to show its hand, and this may continue unless it experiences a second wave of COVID-19, or liquidity starts to dry up.

Central bank balance sheets are not the problem, because they are facilitation mechanisms for governments and the banking system/bond markets, and not a store of real value.

However, massive increases in accommodation placed into the external banking system translate into massive banking system liabilities due to fractional reserve banking which is discussed below.

The real economy problem here is that these liabilities can easily become attached to assets which either won’t perform well in a recession, or which don’t exist at all, i.e., in the case of zero coupon chimney money.

And, too much Disney money in an economy where the central bank has agreed to buy those liabilities (which may not have a corresponding asset on the other side) has the capacity to create a crisis of confidence and destruction of trust and credibility.

On the other hand, large single figure decreases in GDP in a country that is already in the 100%+ debt to GDP club is dangerous, and is likely to require a bail-out. So there are still issues with having too much government debt without sufficient GDP.

COVID-19 has brought all of these risks to the surface.

Before we look at specific economies, here’s a quick refresher on where we’ve got to with the fractional reserve banking system, and QE Infinity, for added context.

Fractional reserve banking and required reserve ratios.

When money or digital credits are internally created by a central bank, it’s fake. The only reason it has any legitimacy is that lenders, borrowers, investors, traders and other countries remain confident the central bank is strong and will be around tomorrow to stand behind its IOU.

In other words, public trust and international confidence are key, but aside from that, central bank balance sheets can continue to grow by an almost unlimited number of penguin dollars.

Central banks use open market operations (need more liquidity in the economy – buy Government paper, need less money in the economy, sell) to influence the interest rate at which banks will lend to each other, and in turn the rates between banks and their customers are established. Heating up or cooling down the economy is pretty straightforward and the central acts like a thermostat.

However, the moment ‘money’ enters the external banking system i.e., bank to customer, it’s used to leverage up debt, with banks only required to keep a low amount of reserves (between 5% and 30% depending on the country).

That means banks can leverage up wholesale funds by factors of 3x to 20x depending on the reserve ratio. And each time it goes from one bank to another, these leverage multiples on the same $1 lent increases as the receiving bank keeps a small slither of it and on-lends the rest, or parks it with the central bank depending on the risk/return profile at the time. You will no doubt remember this, and its drawbacks from the GFC.

As a side bar, a key drawback of this system is that when things get too risky for the banks, they park money that they should be lending, in a central bank account. This traps the money in a revolving door and starves the real economy. Very strong borrowers can access it and in the past decade a lot of this cheap money was accessed to fund buy-backs, which kept a floor under the equities market.

After a while and in an attempt to get banks to stimulate growth and inflation, the central bank decreases the rate it will pay the bank and/or imposes a levy/charge in an attempt to make parking money with the reserve less attractive, and lending more attractive. In the EU, Mario Draghi did this and created negative interest rates.

In contrast to central bank expansionary tools and behaviour, commercial banks need to be careful about the nature, scale and price of assets they take on and the reserve ratio is one of a number of ways of imposing prudence on banks.

Nonetheless, as a result of various responses to COVID-19, reserve ratios are being relaxed, meaning more debt will be created to allow companies to navigate around the economic sinkhole created by the virus. But, GDP will contract, meaning the debt will not be productive. Banks will take on riskier assets and the U.S. Fed in particular has said it will buy them! Last decade was the great buyback binge, perhaps this one will be the great put.

To emphasis the point, this put option or insurance is not economic stimulus, and it will largely be unproductive in an economic sense because GDP will not increase. It will decrease and the IMF has already provided its view on quantum and no doubt that will need to be updated again.

GDP contraction of 3%+, higher unemployment and a significant lag in getting the economy back to where it was before COVID-19 is likely to lead to an inability to service some of this debt - and more thought will need to be applied to a viable solution to ensure the banks don’t bring down the economy, yet again.

Zero Interest rates + QE Infinity adds to tuppence.

It’s also worth considering that most global central bank dry powder (short of large scale debt monetisation, forgivable loans and direct chimney money) has been fired off as a result of zero and negative interest rates having pretty much been reached.

Here you go.

I won’t rehash the course of QE Infinity as it’s a massive topic on its own. But if you follow the NextLevelCorporate blog you will be well aware of where we stand, although you can grab a quick refresher here.

Since the GFC, the world has been pretty unsuccessful in normalising interest rates and balance sheets. The only central bank which tried (under Janet Yellen) is now offering (under Jerome Powell, or wait, is that Donald Trump?) the largest ever put or insurance policy that asset holders have ever seen.

But, we have so far been defining ‘normal’ under old economic terms, and perhaps we have moved so far beyond the Keynesian theory at the heart of fiat that we now need to embrace a new normal and find a new way to conduct money and credit.

That said, the U.S. Fed’s plan to buy up assets across almost all conceivable asset class is what’s at the foundation of the recent recovery rally in equities. On the buy-side, current equities market behaviour would suggest that investors/traders are ignoring the 2020 effects and looking straight through to 2021.

The more debt monetisation/forgivable loans and chimney money utilised to keep everything going, the higher the probability a central bank and its sovereign will lose credibility. If this was to occur in relation to the U.S. Fed, it could in its final iteration lead to a move to another global reserve, or even a new system of ‘exchange’.

We still have an unresolved trade war, and given the lock-down in certain parts of the world, Government sponsored fiscal repair projects will be more challenging with a large part of the workforce physically distanced. We also have the baby boomers exiting, plus a timed ban on buybacks for companies that avail themselves of the emergency loans in the U.S.

There won’t be a lot of support under equities after that lot.

It all seems to point to a stampede out of investments, with central banks having to take on distressed and non-performing assets, perhaps for tuppence a bag.

With that in mind, here’s how some economies relevant to Australia have been financing their COVID-19 responses, rightly or wrongly.

The U.S. Fed is flying its biggest kite of all time.

In the U.S., QE Infinity has been the Fed’s favourite weapon. One of the key by-products has been unlimited amounts of helium unleashed in the equities market, predominantly by fuelling the great buyback splurge of the last decade.

The massive package announced a couple of weeks ago to combat COVID-19 is estimated to produce a $6.2 trillion plus insurance package for affected people, businesses, organisations, municipalities, etc.

Only some of this will be created on the Fed’s balance sheet because the real leverage comes from the banking system as a result of fractional banking.

That is, the ~$500 billion of guaranteed funding from the Government is expected to create an additional $4.5 trillion of bank lending based on a 10% required reserve ratio.

On top of that, the liquidity ratio of 3% for banks with assets of over $250 billion has decreased by 2 percent in aggregate and Wells Fargo’s limitations were recently released to enable further lending.

Currently, the Fed’s balance sheet is at its highest ever point, floating way above the chimneys at an altitude of about $6.1 trillion.

But it’s the multiplier effect in the fractional reserve banking system that will create the next $4.5 trillion.

This and other amounts will be added to global debt which will probably increase to $260 trillion plus. Conversely, GDP before factoring in COVID-19 hovered around the $78 trillion level, so this should decrease. As a result, global debt to GDP will most likely exceed 340-350% as a rough guess.

With less cash flow (and USD) around to service the debt and repay maturing debt, comes more swap lines plus an overall higher risk of financial distress.

And if that wasn’t enough, on Friday, FOMC unanimously voted to provide an additional $2.3 trillion in support, predominantly through the banking system. This includes expansion of previous business and consumer facilities to $850 billion with 10% supported by Treasury. Add to that $500 billion in direct lending to states and municipalities, with 7% of those covered by Treasury. Full details can be found here.

Still subject to approval as at the time of writing, this will bring the COVID-19 aid package in the U.S. (including the estimated leverage) to around $9 trillion so far, and as previously mentioned this will likely increase.

It’s no wonder it’s needed - take a look at the third week in a row of never before seen initial jobless claims numbers. Also in March, retail sales in the U.S decreased by 8.7%, the highest ever drop.

To put the 16.8 million initial claims into perspective, that’s about 10% of the workforce gone in 3 weeks, and to put the human scale into context, it’s equivalent to 70% of the entire Australian population.

Money will be used to ensure businesses and people will still be standing after the lock-down (however long that might be) – but it’s not really stimulus, it’s more like income protection insurance and a lot of it is being directly monetised by the treasury.

Given annual U.S. GDP prior to the pandemic was running at ~$21 trillion (just under a quarter of total pre-COVID-19 global GDP) - the Fed and Treasury together have committed to lending and/or paying out around 40% of annual U.S. GDP, so far.

This is unprecedented, but will it even be enough? Recent IMF predictions of global GDP growth reveal a near-on 200% reversal from a 3.3% expansion to a 3% contraction, and suggest it won’t be.

Whilst the Fed has little choice in these actions given it failed to run-off the balance sheet and increase interest rates, and despite the short term insurance effect being awesome in its size and scope, the long term effect of financing lost GDP is highly dubious.

This is because the money will find its way to all sorts of weird and wonderful instruments, including less than investment grade corporate debt.

If the trade war is not properly resolved and defused and if the pandemic lock-down and recovery phase continues for longer than expected, we could see the unraveling of the risky end (call it around 10%) of the ~$12 trillion corporate debt market in the U.S., as one example.

Something like this would be larger than the mortgage unwind we witnessed during sub-prime. Let’s hope we don’t go there.

What’s coming down the chimney in the UK?

In the UK, interest rates have been cut to 0.10% and last week the £645 billion QE program was enhanced with emergency debt monetisation/chimney money.

“HM Treasury and the Bank of England (the Bank) have agreed to extend temporarily the use of the government’s long-established Ways and Means (W&M) facility. As a temporary measure, this will provide a short-term source of additional liquidity to the government if needed to smooth its cashflows and support the orderly functioning of markets, through the period of disruption from Covid-19.

The government will continue to use the markets as its primary source of financing, and its response to Covid-19 will be fully funded by additional borrowing through normal debt management operations. Any use of the W&M facility will be temporary and short-term. As well as temporarily smoothing government cash flows, the W&M facility supports market function by minimising the immediate impact of raising additional funding in gilt and sterling money markets. The W&M facility is the government’s pre-existing overdraft at the Bank. Any drawings will be repaid as soon as possible before the end of the year.

HM Treasury, the Debt Management Office and the Bank will continue to cooperate closely to support the orderly functioning of the gilt and sterling money markets.”

So, the UK Treasury has effectively hijacked the BoE and looks to be accessing new base money to fund itself, instead of going to the gilts (bond) market.

One attraction of monetary financing is that money dropped directly down chimneys, so to speak, gets to households immediately without having to issue gilts. Fast money.

However, it can also be a sign that the Treasury thinks it’s COVID-19 response requirement is going to mean it can’t honour the IOU implicit in a gilt, and that it’s heading for a liquidity trap.

So far this is monetisation financing, because it appears the BoE will receive servicing payments plus a repayment of the incremental increase in the overdraft.

However, if the BoE doesn’t eventually receive payment/repayment, it will retrospectively become chimney money. That is, the BoE’s liabilities will have increased, but the asset will be written off as though it never existed, just like the Bert’s dancing penguins.

Don’t forget, the BoE said it would not engage in debt monetisation, and now it has.

What then happens if the UK government needs further funds as a result of a longer and nastier COVID-19 outbreak and the gilts market is illiquid?

Perhaps chimney money becomes the new normal.

In the lead up to all of this, populist moves in the form of Brexit and Trump’s tariff/trade/tech/currency war have fundamentally weakened the global economy, making it far more susceptible to the COVID-19 shock.

The EU is wobbling like a poorly baked Panna Cotta.

In the EU, QE Infinity continues because there’s no other solution. In March, the ECB added €870 billion to fight COVID-19 under the Pandemic Emergency Purchase Program.

Many member states like Spain, France and Germany have launched their own fiscal packages. A pandemic bond or ‘corona bond’ to be issued at the European level with cross guarantees from members has been discussed, although it is yet to find consensus support.

More interestingly, ex-ECB boss Mario Draghi wrote a COVID-19 opinion piece at the end of March, in which he stated:

“The challenge we face is how to act with sufficient strength and speed to prevent the recession from morphing into a prolonged depression, made deeper by a plethora of defaults leaving irreversible damage. It is already clear that the answer must involve a significant increase in public debt. The loss of income incurred by the private sector — and any debt raised to fill the gap — must eventually be absorbed, wholly or in part, on to government balance sheets. Much higher public debt levels will become a permanent feature of our economies and will be accompanied by private debt cancellation.”

His view is that some companies will be able to absorb the crisis for a short period of time and raise debt to keep staff at work. But he also feels that accumulated losses risk impairing the ability of companies to invest afterwards. If the virus outbreak and associated lock-downs were to last, his view is that the reality is some businesses will only be able to stay in business if the emergency debt is eventually cancelled.

Let me think about that for a second – yep, forgivable debt, same effect as chimney money.

Current ECB boss Christine Lagarde was shocked at his suggestion to simply tear up the debt.

Here’s the response from Lagarde on French talk back as reported by Reuters:

“That seems totally unthinkable to me. It’s not the right time to ask the cancellation question, right now we are concentrated on keeping the economy going. Later we will look at how to pay down the debt and how we manage public finances in the most efficient way.”

I get it, it’s not as though the Government owns the businesses, however perhaps that is part of the solution – cancel the debt for equity. This is what happened in the U.S. with Freddie Mac and Fanny Mae after sub-prime. When they recovered, they paid dividends to Treasury.

China has also implemented equity for debt swaps as a condition of some of its bank bail-outs.

But it’s unlikely member states could come together over this, unless they adopt a form of pandemic or corona bond that is able to treat all countries fairly. Is there such a thing? Wait, didn’t Maastricht try to accomplish this through the convergence criteria? How did that pan out? In any event Germany won’t stand for it.

Instead, last Saturday, eurozone finance ministers reached an in-principal agreement to add further aid via an economic relief package worth €540 billion.

It will include access to cheap credit from the eurozone bailout fund, the European Stability Mechanism, more guarantees for the European Investment Bank to step up lending to companies (note the multiplier effect here), and a scheme to subsidise wages so that firms can cut working hours, not jobs.

However, Lagarde may have to think again about kicking the can before this is all over. If a consensus or different solution cannot be found, member states with capacity will have to move to debt monetisation and bail-out others, because too many members will be fighting for airtime in an ECB helicopter which is from home in agreeing to a debt jubilee/forgiveness. 

China and Australia, old dance partners.

So far, China has not had to open its accommodative floodgates for COVID-19.

Over the past few years as its growth rate has been slowing, it has been steadily accommodative in terms of bail outs and pumping money into the banking system via reducing reserve ratios and direct liquidity injections via the PBOC.

Aside from the risk of a second wave of COVID-19 (I sincerely hope not) the real question for China is how long it will take to repair the activity shocks as per below.

If internal confidence-led consumption does not rise due to fear of a second wave and/or whether the cities/jobs are safe, China will need to rely on exports to other countries, all of which are way behind it, in terms of recovery.

Otherwise, the Party will need to come to the party, big time, and presumably reset/weaken the yuan as the PBOC opens the accommodative floodgates.

Ordinarily a weaker yuan to the USD would be a good thing for China. However, this would run counter to having a stronger yuan with which to make the stipulated purchases required under the Phase One tariff ceasefire agreement.

On the other hand, there is no arbitration clause in it, and Phase One can be ripped up. Also, under Article 7.6(2) there is a requirement for the parties to consult in the case of a force majeure style event which causes a delay.

Might explain a few things.

Seemingly, forever tied to China as it’s number one export customer, Australia’s economic response so far has been QE and a steadily increasing fiscal repair package. But, to a large extent the real spoonful of sugar for Australia is Chinese demand for rebar steel and agriculture - even if demand for hot rolled steel, coal and energy for manufacturing wanes for awhile.

On the bright side, the IMF believes China and India will print GDP expansions this year of 1.2% and 1.9% respectively.

The RBA has said it may increase QE but won’t use negative interest rates, nor does it want to go to zero. The rescue package continues to grow down under, so we’ll be watching to see how far the RBA is forced to go.

Grab your brolly and let’s imagine up a better way.

With an infection tally now over 2,000,000 people, COVID-19 is a massive and tragic health event.

In an attempt to deal with its fallout treasuries and central banks are bending our economic infrastructure to its limits, and cracks are again forming.

I believe COVID-19’s arrival during the unresolved U.S./Sino trade war debacle has brought us to the crossroads of global money and credit. If the trillions in new accommodation ($9 trillion in the U.S. alone) and the U.S. Fed’s commitment to buy up assets across the spectrum creates an inflationary slingshot post-COVID-19, we might need to imagine up a way better system.

Fundamental change to our system of money is not unprecedented, and usually follows a war or similar crisis. The last major change was 75 years ago after WW2 when the gold standard was replaced by the Bretton Woods system. In 1971 it partially changed again after the gold peg was abandoned, and inconvertible fiat stood alone.

Today, we have the economic costs of an unresolved trade war that has decreased GDP, QE Infinity which has created a debt bubble and de-monetised money, the baby boomer exit which will take liquidity out of equities and bonds, and the multi-location COVID-19 response package we’ve explored today.

So far, printing and forgiving money seems to be the incremental response.

But, where is the spoonful of medicine to make all that monetary sugar go down?

So far there hasn’t been one, and continual sugar intake is causing global diabetes.

The medicine is not to rip up, nor roll short term debt into longer term debt. That’s not sustainable because of the huge default premium demanded by lenders (think about sovereign defaults like Greece after the GFC) and because it creates more debt and kicks the forgiveness can further down the road.

I don’t believe we can go back to commodity money.

I also don’t think the answer is SDRs, because each of the five basket currencies can be overprinted.

For me, the enabling technology for a new system of money, exchange and credit is probably still in experimental code on a laptop owned by people a lot smarter than me. The money construct is probably going to have elements of real value assets tethered to a permissionless blockchain, so it won’t be a brand new concept. The exchange and credit structure might be made up of online social meeting and consumer marketplaces which already connect billions of people, peer to peer - and in way bigger numbers than any one central banking system.

Is it not time to move away from Disney money?

Best wishes, stay safe and chim chim cheri!

Mike.

NextLevelCorporate is a leading financial & strategic corporate advisory firm with a multi-decade track record that speaks for itself. Helping clients in all industries to prepare for, respond to and deliver transformative corporate finance strategies and transactions in and out of Australia, is our passion.

All images attributed to Disney/Fox.