Friday , August 12 2022
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Three Things I Think I Think – Some Things Never Die

Summary:
Here are some things I think I am thinking about: 1) The Money Multiplier Lives! Longtime readers are probably very tired of watching me try (unsuccessfully) to kill the money multiplier. I’ve written countless articles about it, a book with an entire section on it and I’ve also started posting short videos for people with no attention span (I know, that’s all of us now). So I was really sad to see it crop up again today in an article in the Financial Times by Sheila Bair who wrote: Gahhh. This is classic money multiplier thinking and it starts with the myth that banks aren’t lending their reserves because the Fed is paying them not to. No, no, no. To reiterate: Banks do not and cannot lend out their reserves to non-banks. Banks leverage their capital. Reserves are an asset for banks.

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Here are some things I think I am thinking about:

1) The Money Multiplier Lives!

Longtime readers are probably very tired of watching me try (unsuccessfully) to kill the money multiplier. I’ve written countless articles about it, a book with an entire section on it and I’ve also started posting short videos for people with no attention span (I know, that’s all of us now). So I was really sad to see it crop up again today in an article in the Financial Times by Sheila Bair who wrote:

Three Things I Think I Think – Some Things Never Die

Gahhh. This is classic money multiplier thinking and it starts with the myth that banks aren’t lending their reserves because the Fed is paying them not to. No, no, no. To reiterate:

  1. Banks do not and cannot lend out their reserves to non-banks.
  2. Banks leverage their capital. Reserves are an asset for banks. Giving a bank more reserves does not mean they have more capital. And while the interest they earn on that asset can influence their capital it does not ultimately determine whether a well capitalized bank is willing or able to make loans. After all, banks were earning about 0% on reserves from 2008 until 2015 and lending was weak the whole time. Do we really think banks weren’t making loans because they were now earning a risk free 0% on their reserves? No, that’s silly. The reason banks weren’t making loans during this period is because consumer balance sheets were broken and demand for loans was weak.
  3. It’s always better to start with capital and demand for loans as the driving sources of whether banks will make new loans. While overnight rates and interest on reserves can certainly influence bank lending it’s important to get causation right here. Reserve balances and interest are a secondary influencing factor in loan creation, but shouldn’t be viewed as the dominant causal factor in whether banks can or will make loans.

2) Indexing is (still) Killing the World!

Certain people hate indexing companies. It tends to be high fee asset managers (for obvious reasons) and…Socialists. That second group is a strange one mainly because indexing has been horrible for high cost Wall Street and has democratized investing in important ways. But the Socialist view basically comes from the idea that indexing companies are going to take over all the voting rights and ruin the world because, you know, corporations are evil or something like that. I’ve spilled a lot of ink on why I think this risk is vastly overblown, but Barry Ritholtz went into some detail on the topic and took Bernie Sanders to task. It’s a good piece so go have a read.

My view, in short:


Three Things I Think I Think – Some Things Never Die
  1. Indexing does far more good than harm because it’s reduced costs and given retail investors a simple way to access financial markets.
  2. While indexing firms have become unusually powerful in corporate boardrooms they tend to abstain from voting influentially. That is, they tend to side with the executives on most matters which is exactly what we should expect a passive indexing firm to do!
  3. At a more technical level, “indexing” is just a low cost form of active management. There is no such thing as truly “passive” indexing in the first place. There are only varying degrees of active management. So a lot of this discussion is based on misleading terminology. But what indexing has done is important – it’s transformed active management from a performance chasing high fee endeavor to a return taking low fee endeavor.

3) The Purchasing Power Principal Paradox

One of the great paradoxes in finance and economics is what I call the purchasing power principal paradox. That is, we all want nominal stability AND real stability. We want to know that $100 today will be $100 tomorrow both in real terms AND in nominal terms. It’s part of what makes investing so difficult because we need to hold nominal cash as well as instruments that will protect that cash from eroding in real terms because cash, by definition, will always lose to inflation in the long-run. But once you start taking long-term real risks you sacrifice some of your short-term nominal stability. This is why stock market investing is rife with behavioral biases – we don’t really know the time horizon of the stock market so while it’s generally a great real return protector in the long-run it’s a horrible short-term nominal stabilizer.

This is related to many investing and economic myths that won’t die. For instance, people love to talk about how the US Dollar has lost 95% of its value over time, but ignore the fact that real output has boomed over the same period. Or, my continual Twitter debate with Larry Swedroe who insists that real returns are all that matter while I am arguing that investors care about both real and nominal returns. It’s not an either/or discussion in my view. You want nominal short-term stability in your portfolio and your currency, but you also need real long-term stability. With a properly diversified portfolio these things are perfectly consistent with one another and you don’t have to sacrifice one for the other.

Anyhow, I guess I have a lot of myth busting left to do. Have a great weekend everyone.

Cullen Roche
Former mail delivery boy turned multi-asset investment manager, author, Ironman & chicken farmer. Probably should have stayed with mail delivery....

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