Bitcoin and the Fed Issue #1 - USD Whitepaper

April 26, 2021

There is no calamity greater than lavish desires. There is no greater guilt than discontentment. And there is no greater disaster than greed. – Lao-tzu

Overview

The following information is meant to serve as a broad informational piece touching on current macro global economic conditions, and how the central bank for the US influences control of the macro economy. Please keep in mind when reading that it is in no way intended to be a comprehensive insight into every single facet of the subjects covered and contains several opinions of the author. I hope that content below serves to help you better understand operations of the Fed, the current economic climate, and why Bitcoin is more relevant today than at any time in the past decade.

The Fed

The Federal Reserve was created in 1913 with the goal of central control of the monetary system to mitigate financial crises and achieve stability of the US Financial system. Here we will cover its primary tools for affecting the economy. The first and primary tool the Fed possesses is the discount rate. The discount rate is the interest rate at which The Fed lends to member banks. This is primarily meant to be a backup source of liquidity, with the intention that the Fed is a lender of last resort, or an emergency backstop to keep banks from failing in times of liquidity crisis. Decreasing this rate makes it cheaper for banks to borrow, and subsequently increases the amount available credit and lending. Inversely, raising the discount rate has the effect of making borrowing more expensive for banks, and reduces credit and lending activity. Once again, this is intended to be a backup source of liquidity, not a primary means of liquidity. Member banks will prefer to borrow from or lend to each other for any shortages or excess capital from their reserve balance through the overnight lending market, which brings us to their next tool, The Federal Funds Rate. The Federal Funds Rate is intended to be a guidepost for member banks to set their rates by for borrowing amongst each other. Banks are required to keep a certain percentage of their deposits on hand to cover depositors’ withdrawals and other obligations. If a bank finds that it will have an excess of capital in relation to it’s determined needs at the end of the day, it will seek to lend this excess through the overnight lending window to other banks at an interest rate. Conversely, if a bank finds itself with a shortage of reserves, it will seek to borrow funds to shore up its reserves to the appropriate level. These loans are only for overnight terms to adjusts reserves based on needs and are not long term. Keep in mind that the fed funds rate is just simply a target, and the actual rate will vary depending on supply and demand for overnight lending, and is also pursed by the Fed through in open market purchasing or selling of treasuries, effectively increasing or decreasing the money supply, to move towards the intended rate.

What is inflation? Deflation? Why is it important?

Now that you should have a general understanding of the Fed’s primary tools for controlling the economy, let’s build on that foundation, and explain how it achieves its central goal of maintaining stable inflation through them. First it is important to understand what exactly inflation is. At its core, inflation is simply a function of supply and demand for money. This is due to several contributing factors, however here we will keep the explanation simple. This can be defined as the decrease in the purchasing power of a given currency, relative to increasing prices of goods and services in an economy. On the opposite end, you have deflation, which can be defined as the increase in purchasing power of a given currency, relative to the decreasing price of goods and services. So why does the Fed care so much about controlling inflation? As we noted in the prior section, their primary purpose is to maintain economic stability. When inflation runs too hot, the US dollars purchasing power shrinks, and when it is too low, its purchasing power is increased. By increasing or decreasing the money supply through influencing interest rates, the Fed can effectively stimulate or slow down the economy. The Fed has long maintained a target inflation rate of 2% per annum. So why is inflation such a hot topic of debate currently? You are likely reading or hearing about inflation on almost a daily basis currently. If inflation is allowed to run too hot or rise excessively, you risk entering hyperinflation, a state where prices of goods and services rise so quickly that you risk economic meltdown, as individuals struggle to afford items due to the rapidly accelerating depreciation of their currency. This also has the effect of causing the general population to flee to other forms of currency, i.e. foreign currencies, or other stores of value like gold, silver, etc.

How Did We Get Here?

Current macro-economic conditions have been largely impacted by over two decades of unprecedented expansive monetary policy. This began with the 2001 recession, and eight-month economic downturn set off by the Y2k scare and culminating with the September 11, 2001 attacks on the World Trade Center. To maintain economic stability, the US Federal Reserve worked to lower rates to the lowest levels seen in the post Bretton Woods Era (the era following the abandonment of the gold standard). These historically low rates, combined with federal policy created to encourage home ownership, set off a boom in real estate and financial markets alike, causing a steep rise in total mortgage debt. Firms created new types of lending products, with lax credit standard for borrowers who could not previously qualify (known as “subprime”), with the expectations being that rates would remain historically low, and that home prices would continue to rise indefinitely. Prime examples of just how creative lenders to get to originate more loans during this period were products such as “Stated Income Stated Asset” loans (SISAs), and “No Income No Asset” loans (NINAs). Greed was rampant, and everyone was making money slinging risky loans. It was not uncommon during this period for loan officers (LOs) to coach their clients to call back and falsely state the necessary income needed to qualify. Appraisers were even paid off to make sure homes met the necessary value for the loan to close. LOs also received higher compensation for placing customers into higher rates, often leading to predatory lending. Another key contributing factor to the incoming collapse was the prolific use of the Adjustable Rate Mortgage during this period, known in short as ARMs. ARMs have an initial period of fixed interest, lower than traditional products. Once this initial period ends (typically three, five, or seven years), the rate then starts adjusting based on the index it is linked to (typically LIBOR during this time). The initially low rate was used as selling point by loan officers, who hawked these products to borrowers with the premise that because rates would stay low and home prices would keep increasing, the borrowers could simply just refinance once the fixed period of the loan ended. The result of this sudden boom in lending led to high demand for housing, which consequently caused the prices of goods and services to rise. From 2004 through 2006, the Fed slowly began slowly increasing interest rates to offset rising inflation. Good intentions can often lead to unintended consequences, and the increase in rates had a negative effect when these recently originated ARMs, with borrowers finding their previously low rates rising dramatically when they began to reset to the adjustable period of the loan, causing interest rate shock, and subsequentially mass default. To make matters worse, lenders had discovered that by packaging many of these risky subprime loans with higher rates into tranches within new securities with A paper loans (loans made up of borrowers with ideal credit and profile), they were able to maintain a better rating on the security, making it attractive to investors looking for investment vehicles with better returns. Financial institutions and banks became heavily over leveraged with these investments, ignorant to the ticking time bomb that was these incredibly risky loans packaged into their investments. The collapse began with investment banking giant Bear Stearns and culminated with the shuttering of Lehman Brothers. The ensuing fallout devested the US and spilled over globally, and the economy plunged into a deep retrace, now known as the “Great Recession”. The Fed sprang into action to try to keep the collateral damage to a minimum. The Fed Funds rate was slashed to a record low target of 0%-.25%, with the discount rate only slightly higher. They spun up what is now known as QE, or quantitative easing, which is to say, the central bank started injecting liquidity into the economy by purchasing of government bonds and other assets, including MBS (Mortgage Backed Securities). Fannie Mae and Freddie Mac, both the primary GSEs, or Government Sponsored Entities, were bailed out by the US government, and placed into conservatorship to ensure they remained solvent. Banks were provided with a staggering 7.7 trillion dollars of liquidity in the form of loans, and 787 billion in deficit spending, to try to stimulate the economy. New financial regulations were created to reform the broken system, known as the Dodd-Frank act. After going through a period of sharp but brief deflation, the former actions returned inflation to the forefront as the money supply was rapidly increased once again. The economy officially exited the recessionary period, and we entered the last decade, which has been the longest period of economic expansion in history. But at what cost was it to make this possible? In 2013 Ben Bernake (The Fed Chairman at the time) announced that they would begin reducing the rate of asset purchases at a future date, and effectively begin to reduce the money supply. The mere news of this caused bonds yields to rise sharply, and investors to panic, with the DOW experiencing only a temporary decline in mid-2013. This event came to be known as the “Taper Tantrum”. In 2015 the Fed finally embarked on their intended goal to taper asset purchases. Between December of 2016 through December of 2018, the Fed had gradually raised the Fed Funds Rate eight times. In 2019, the market began to stall and grow slowed. In March of 2019, the yield curve became inverted for the first time since the Great Recession. The yield curve is a way to measure bond investors’ appetite for risk. When the yield curve becomes inverted, this means that short-term yields exceed longer term yields, and the term spread becomes negative. Effectively, this signals that the market is betting on interest rate declining. The inversion of the yield curve has an impressive record for predicting incoming recessions. It has inverted before each recession in the past 50 years, with the recession typically happening one year after the inversion on average. President Trump, who had been frequently associated with the robust performance of the stock market during his tenure, started to panic. He began to pressure the Fed to reverse course and start another round of rate cuts, seeking to keep the economic expansion rolling. This was at odds with his prior statements, particularly during his election run, criticizing the Fed for keeping rates too low, and letting them rise to a level that would naturally attract private investment, allowing the Fed to unwind its balance sheet. Facing increased political pressure, the Fed complied, rates were once again slashed, and markets returned their ascent to new highs. Moving into 2020, as you the reader are aware, the world saw the emergence of the covid-19 pathogen. As the virus began to quickly spread nation by nation, the markets began to panic. It became clear that life as we know it would be essentially put on pause. The market panic began to create fallout. With the economy closing and the government barring lenders from foreclosing on borrowers due to missed payments because of job loss, mortgage lenders found themselves in a particularly difficult situation. They began to tighten credit standards, attempting to limit the amount of risk they would taking on with newly originated loans. Liquidity was drying up so fast, many found themselves with a potentially large amount of loans on their warehouse lines and nowhere to deliver them. The MBA, Wall Street, and President Trump began to call for help from the Fed. The Fed complied, slashing the Fed Funds Rate and discount rate to at or near 0%, completely undoing any previous rate hikes. They also announced several special purpose vehicles, designed to inject liquidity to support the flailing markets. The level of QE was more substantial than even a decade ago. Markets, high on the news of the incoming flood of liquidity, reversed course instantly. Mortgage Banks were suddenly caught in another precarious position. Because they hedge their interest rate risk on their pipeline, they began to find that their recent hedge positions on these pipelines began to blow up, forcing massive margin calls industry wide. It was chaos, however the pain in across Wall Street and Main Street slowly eased as stocks marched back towards previous highs.

What Happens Next?

So, what happens now that record expansive monetary policy is once again threatening to throw the dollar into hyperinflation? It is a conundrum of a colossal magnitude. By taking such extreme measures so quickly, the Fed has essentially propped up all markets on an avalanche of liquidity and stimulus, and they will find them to be extremely rate sensitive. The smallest adjustment to policy could send shock waves through the markets once again, and potentially collapse. Logically, they will have to act slowly, with extremely tempered message to participants. It could be argued that it may be impossible to reverse course at all without causing devastation to the economy. The truth is the action was not well thought out and was completely knee jerk in response to political pressures. That is not to say it was unnecessary at all, but the support should have been more gradual. The hard truth is that markets are cyclical in nature. The bear markets are just as necessary as the bull. In a sense, they mimic life. Just as we need winter for the ecosystem to die and regrow stronger, markets must go through recessions to rebuild and bounce back. The past three recession have been short term because they have not been allowed to play out organically, as they should be. Now this leads us into the topic you readers are surely most interested in. What does this mean for Bitcoin? As the world’s only asset with a fixed supply, it seems perfect. It was born out of the Great Recession to guard against Central Banks’ reckless disregard. But will it just continue to shoot through to the heavens due to rising inflation pressures, with the dollar subsequently crashing? Not so fast. Despite what has been said publicly by the Fed so far in terms of letting inflation run hot, make no mistake, they are concerned. They cannot, and will not, just stand by as the dollar crashes. You must remember the US Dollar is the world’s reserve currency. It cannot maintain that position if the value continues to implode. They will eventually be forced to act to preserve the strength of the dollar. The US’s place as the largest economy relies on it. Governments also prefer sovereign currencies. They are easier to control. What is to keep a government from enacting regulation to limit Bitcoin’s prolific spread, or banning and confiscating it? Many of you may be rolling your eyes in contempt, but you must consider the possibility. This has happened in the past, and can happen again (see Executive Order 61020). Furthermore, Bitcoin still trades like a risk asset. I hear arguments about how it is an optimal store of value. Is it though? An optimal store of value does not have wild swings in valuation, which truthfully currently makes it quite suboptimal. The counter argument I often hear to this prior statement is that it always outperforms over time. That, however, does not make it an optimal store of value. Something that must go through a 50-70% draw down before seeing a return to original value cannot be considered a optimal store of value. That is not to say that it will not get there. With adoption, ideally it will stabilize in time, and the violent swings we are accustomed to will be a thing of the past. The likely scenario is that we are on the verge of one of the greatest bubble collapses of all time. In theory, this could even be brought on by a collapse in bitcoin itself. That may sound ludicrous but consider the sheer amount of institutions that recently gained exposure on their balance sheet, many significantly so. All a bubble needs to pop is a catalyst. History does not always repeat, but if often rhymes. Just as the economy’s boom of risky mortgage assets was the downfall of institutions leading to the Great Recession, what if this decade’s catalyst becomes the very thing intended to save it?

by Pentoshi

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