In this article, I will explain everything you need to know about the Fed Put versus the Government Put, and how money printing actually works!
I will reveal shocking insights that are definitely going to blow your mind.
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How Does The Fed Put and Quantitative Easing work?
The first thing we need to do is define two terms: Base money and broad money.
To do that I'll use the Investopedia definition.
A monetary base is the total amount of a currency that is either in general circulation in the hands of the public or in the commercial bank deposits held in the central bank's reserves. This measure of the money supply typically only includes the most liquid currencies; it is also known as the “money base.”
In other words, bank reserves held at the Fed, and broad money…
“Is a category for measuring the amount of money circulating in an economy. It is defined as the most inclusive method of calculating a given country's money supply, the totality of assets that households and businesses can use to make payments or to hold as short-term investments, such as currency, funds in bank accounts, and anything of value resembling money.”
– Investopedia
Take a look at this chart I drew where I compare Fed Put Vs Gov Put.
On the left side we have base money, and on the right side, broad money. They're separated by the black line in between.
I want to point out before we go any further that the left side of the board, where we're dealing with base money, creates boom-bust cycles, and it's all about the financial economy.
While on the right side, broad money is more about inflation, deflation, and the real economy.
When I'm referring to a Fed put or a government put, I'm just talking about a backstop for the stock market and asset prices.
So, the explanation starts on the left side of the board with the little red house which represents the Federal Reserve, and the green house, which will be their primary dealer bank who I called Goldman Parachutes.
I think you can guess who that is.
So, the Fed says: ”Goldman Parachutes, we need to buy some of your assets because we have to print up some funny money. We have to increase the base money supply.”
Before the transaction, the balance sheet of Goldman Parachutes has bank reserves and treasuries, and the Fed has bank reserves which are really just deposit accounts for the primary dealer banks and the banks under the Fed's umbrella.
They might also have some treasuries, mortgage-backed securities, or something like that.
But, after the transaction, what happens is Goldman Parachutes sells the treasuries to the Fed. Those go to the Fed's balance sheet, specifically onto the asset side.
To pay Goldman, the Fed prints up base money bank reserves and adds it to their account. So when the transaction has concluded, the Fed increases the size of its balance sheet.
They now have more assets and more liabilities. Yet, the balance sheet of Goldman hasn't changed at all, they have the same amount of assets.
The only difference is instead of having the treasuries, now they have additional bank reserves.
In the same example, let's say the Fed's balance sheet went from 5 trillion to 7 trillion. It's increased in size, they've printed money, but it's only stayed in this financial economy. It really hasn't gone out into the real economy.
Here is a chart of the Fed's balance sheet.
Notice that, especially since COVID-19, their balance sheet has been going parabolic. This means the amount of bank reserves or base money has also gone parabolic as, you can also see in the following chart.
So… It's time for a quick quiz!
If the situation I just described is all that happens, meaning the asset swap between the primary dealer bank, and the Fed prints $7 trillion, $10 trillion, $100 trillion dollars of base money…
How much does this affect the broad money supply, or how much does this affect inflation or deflation?
Hopefully, you answered zero. It doesn't affect it at all. The key is there has to be a transfer mechanism to turn the bank reserves into additional lending. Therefore, additional money in the real economy.
The way I like to look at it is quantitative easing only adds balance sheet capacity to the commercial banking system.
In other words, it gives them the opportunity to create more loans and more money supply that can circulate in the real economy, and if it does with velocity, then we potentially see inflation.
This is predicated upon two things.
- Those banks have to be willing to lend into the real economy. They have to be willing to create more loans.
- The borrowers have to be willing to borrow.
If you're the average Joe out there and you're being hit with all the lockdowns from COVID-19, there's a lot of uncertainty.
Plus, you've got a $100,000 dollar Ford truck payment that you're making, you've got a mortgage, you're sending all your kids to school, you really are just living paycheck-to-paycheck although you might be making $75,000 a year…
Does your personal balance sheet have any more capacity to take on any more debt?
No.
Therefore, the additional bank reserves get stuck at the Fed and that additional balance sheet capacity.
Let's not forget the government needs inflation, they're the largest debtor in human history. They have to have inflation or they're going to flat out default.
Those are pretty much their only two options.
But how can they achieve this if the transfer mechanism is broken?
This is why Powell always comes out and says that we need more fiscal spending.
He's saying we need a Government Put not only for the market to boost asset prices, but also to create this inflation so the government debt doesn't implode in the future, bringing down the entire house of cards.
I always say the economy is built on three things, asset prices, debt, and confidence. When we look at the Fed Put or the Government Put, we need to look at it through that lens.
When you understand they have to keep asset bubbles inflated and create inflation, everything that Powell says the Fed does start to make sense.
This assumes they're benevolent and they know what they're doing. Of course, that is a huge assumption.
The Government Put Explained
The government put is when the Fed monetizes a debt.
Here is a chart of the Federal Reserve turnings around the world.
I know you hear that term all the time, but I'm going to explain how it works using my whiteboard drawing.
On the left side of the board, you can see 2 houses, the government and the fed (in red). In this case, the government issues treasuries, and the Fed buys them directly.
It's through a shell game with the primary dealer banks like Goldman Parachutes (G/P).
But, the bottom line is those treasuries end up on the Fed's balance sheet within minutes or sometimes days of the auction.
The treasuries go from the government to the Fed, the Fed puts them onto their balance sheet, and to pay for those treasuries, they print up funny money or additional bank reserves.
What's interesting is the commercial banks and the primary dealers have accounts with the Fed where they keep their bank reserves but so does the treasury. Its called the T-G-A, the Treasury General Account.
It's a checking account to hold the bank reserves, the exact same as the commercial banks.
Since the treasuries have gone to the Fed, the Fed is paid for those by increasing the number of bank reserves in the TGA.
The Fed's balance sheet has expanded just like in my first example.
We can say it's gone from $5 trillion to $7 trillion, but now, instead of the bank reserves just being with the commercial banking system, just to reiterate, they're with the government, with the treasury and the TGA.
Now, we get to the point where things are a lot different from the example number one, where everything was contained in the financial economy and the base money supply.
In this new situation, the government will spend the money into the real economy, let's say through infrastructure spending, maybe stimulus.
The right side of the image is the real economy, where the broad money lives, and where we have to deal with inflation and deflation.
This part starts with Joe, the little guy I drew, just like you and me having a normal bank account. Let's say he banks with the little green house called B of B. Of course, that stands for Bank of Bailouts.
Joe banks with Bank of Bailouts and his account starts with 100 dollars. B of B's balance sheet has bank reserves on the asset side that are held over the Fed base and the liabilities are the deposits that Joe has with the bank.
When the government gives Joe additional stimulus money, the bank liabilities increase, that's the way Jeff Snyder always says it.
But to pay for the additional liabilities, the TGA sends the bank reserves to B of B.
If the TGA just created more deposits, they'd be creating additional liabilities for B of B, but they wouldn't be giving them any additional assets, so they would make them insolvent. We don't want to do that.
After the transaction's done, it goes back to the Fed's balance sheet on the left side of the board, the asset side will still look the exact same.
They have some mortgage-backed securities and the treasuries they originally purchased from the government through monetizing the debt.
They have the exact same amount of bank reserves. The only difference is now the TGA doesn't have any money in their account.
This is only in this example, the TGA got a lot of money in their account right now, or 1.7 trillion. Just for the sake of this example, we'll say the TGA spends all of their money into the economy.
The bank reserves that are liabilities with the Fed are the exact same dollar amount, but they've just changed hands.
They've gone from the government to the commercial banking system and that's reflected by the asset side of B of B's balance sheet.
What's happened is the base money has increased through the government transaction to the Fed and the broad money has also increased by the government spending those bank reserves, or creating additional deposit liabilities in the real economy. That's the big difference.
When the Fed does quantitative easing it's just with the base money supply, it's in the financial economy.
But, once the government put comes into play, when they start doing fiscal deficit spending, that means the Fed is most likely monetizing it.
They're spending it into the economy so it's creating additional base money but it's also creating additional broad money. This is what most people consider money printing.
It gets really confusing because we use the term money printing to not only talk about an increase in base money, but also an increase in broad money.
Most people when they hear the term money printing think about it creating inflation.
To make things easier to understand, we should really only use the term money printing when we're talking about the broad money supply.
The Fed technically doesn't print money, they only print bank reserves.
But, there are additional deposits in the system, and what's been happening lately is those deposits are going straight into Robinhood accounts.
Look at the little man I drew on the board, I call him Davy Day Traders, he has a box of pizza and a computer. Of course, the only thing on the computer screen is the word buy, for obvious reasons.
They put this new stimulus money right in their Robinhood account and they spend it into the financial economy. At the same time, on the left side, there are people like Jaime Damon, the little person with the hat.
He has a briefcase full of new money in excess balance sheet capacity but sees that there could be inflation expectations in the marketplace, so he goes straight into the stock market.
So we have Davy Day Trader taking the deposits, going into the stock market, and Jaime taking the excess balance sheet capacity going into the stock market as well.
This Government Put recently has caused the base money to increase, the broad money to increase and the stock market to go up as well, but it hasn't really created the type of inflation the government needs.
Going back to example number one, there was a problem. They had a transfer mechanism that they couldn't get around.
Now, they've solved the problem of the transfer mechanism but still have the problem of velocity in getting people to actually spend the money to get it circulating in the economy.
This is done to create the inflation the government needs to pay its debt back with devalued currency units. But there's a problem. They still have to rely on Davy and Jaime to keep the asset bubbles inflated.
What if we get to a point where Davy isn't stupid enough to continue to play ball and Jaime isn't greedy enough to play the game?
I realized that's not going to happen, Jaime's always going to be greedy enough.
But you get my point, they still have to rely on things that are outside of their control.
Asset Bubbles And Inflation Time Bombs You Need To Be Aware Of
I've been thinking about this time bomb for the last couple of weeks. They're not predictions by any means, but I'm just trying to figure out the probabilities.
Here is a chart for a better understanding.
First up is the inflation time bomb on the right side of the board. I would like to think back to a podcast with my good buddy, Erik Townsend on Macro Voices in his most recent interview with Dr. Lacy Hunt.
Dr. Hunt outlined how in his opinion he thinks we're in a deflationary cycle. But what would change his opinion dramatically is if the Fed started to spend money.
In other words, if the Fed monetizes the government debt directly, like we talked about in example number two, and because of the governments and the Fed “relationship”, the deposits in the real economy increase.
Dr. Hunt referred to this as the Fed spending money, it goes from just base money to affecting the broad money supply.
This is the catalyst that he pointed out, I'm not putting words in his mouth, where he would go from a deflationary stance, not to inflation, but directly into hyperinflation.
To understand this more, take a look at this piece of the Macro voice podcast where he explains it with his own words.
Dr. Lacy Hunt: That does raise the risk, and you're correct to say so, that we change the Federal Reserve Act and we let the Federal Reserve print money, that's a real risk.
It's a risk that I am extremely cognizant of. Let me tell you this. We're going to make everyone extremely miserable in very short order. There are numerous cases of this.
This was tried by Chiang Kai-Shek in the 1930s, Germany in the 1920s. This was tried by Yugoslavia and Hungary at the end of World War II, there was a famous Bolivian case in the 20th century.
Basically, it was the path that was taken by the Bourbons of France, the Romans, and the Mesopotamians; they built up huge debts, which they could not service.
Take the Bourbon case which is perhaps the most well-documented.
They took on a great deal of debt to finance the French and Indian Wars, which was really a world war, in Europe, it was called the Seven Years' War.
Then they financed the American Revolution, and it cost the French more for us to win the American Revolution than it cost us. Then, they went into high living and so forth.
Was the solution of the Bourbons? Well, to issue a worthless metallic coin, and eventually the inflation became extreme.
Going to money printing is an avenue and it may be seized upon but the result is social rupture and collapse of the financials.
People will not want to hold financial assets. The whole world will be turned upside down here.
(End of interview)
Take a look at the left side of the board, on it I'm referring specifically to the stock market bubble. The example comes directly from Michael Green.
I've been listening to a lot of his podcasts recently. If you haven't heard Mike Green on Real Vision, or Grant Williams and Bill Fleckenstein podcast The End Game, you have to do so. I can't recommend it enough.
The following example is a massive oversimplification of what Mike talks about. But I think I'll do an article on it later because it's absolutely fascinating.
This example explains the difference between passive investing and active investing and how all of the money goes into passive investment vehicles like Vanguard, which we'll call the Mega Fund.
Imagine there is a 50/50 split between the guy with glasses, or the active managers, and the passive funds.
The way the active manager makes his or her decisions is through qualitative or quantitative analysis. They use the balance sheet, the P&L, future cash flows, PE ratios, and macro analysis.
Not so for Mega Fund. The only thing they use to make their decisions on whether or not they're going to buy or sell is if they have people that have invested in the fund saying, “Hey, I want my money back.”
Or if they have other people that say, “Hey, here's some more money.”
If the people want their money back, Mega Fund has to sell. If the people give them more money, Mega Fund has to buy. This is literally their entire decision-making process.
We've seen recently the trend towards more and more people going into Mega Fund because their fees are so cheap and people like Warren Buffett say it's the best thing to do.
Pretty much every single financial guru on YouTube tells you to do the exact same thing: “Going to an index fund it's the best way to invest for the average Joe and Jane.”
What happens if we go from 60% to 70%?
Just as a thought experiment…
What if we went to 100% of the investable assets for the stock market in the Mega Fund?
It becomes the Thanos Mega Fund, it just controls everything.
There are no more active managers that are doing quantitative or qualitative analysis.
The investors go to the Thanos Mega Fund and say, “Hey, we want our money back, we're retiring, we're baby boomers we've got bills to pay.”
The only thing Thanos Mega Fund can do is sell.
The problem is who do they sell their stock to?
Before they'd sell it to the active manager at a certain price because he or she would do valuation analysis and say, “Okay, at 20 dollars I don't like it but at five, I'll go ahead and hit the bid.”
In the Thanos case, regardless of how low the price goes, there is no bid because all of the assets are in the Thanos Mega Fund.
Who would have to come in and hit the bid?
Of course, the only player left in the game, the Fed. As you know right now they're buying corporate and junk debt, mortgage-backed securities.
They're buying treasuries like they're going out of style, all of these assets are going on to the Fed's balance sheet.
And…What happens in the future when the Fed becomes the only potential buyer of stocks when the people that are in the Thanos Mega Fund want to sell?
The Fed ends up owning all the assets.
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