23.01.05 - Pragmatic Capitalism

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2		Pragmatic Capitalism: What Every Investor Needs to Know About Money and Finance
3		By Cullen Roche
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5		Amazon: Link
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7		#	Highlights
8		1	If you pick up a finance or economics book these days, you will rarely find a thorough explanation of what money is. In fact most modern economists do not even agree on a set definition of money, and many do not include money in their models of the economy.
9		2	As highly socialized and intelligent animals, we humans have created various tools that improve our ability to trade and interact. A barter system is relatively primitive and insufficient because it forces you to be able to obtain something that someone else will want in exchange for the things you might need. Creating a universal medium of exchange is the bind that ties all goods and services together by making all goods and services exchangeable. At its core money is simply a social construct that allows for the exchange of goods and services.
10		3	Why do we stress and worry about money? It might help a bit to think of money as a theater ticket.1 If the economy (and our access to goods and services) is the theater, then we can think of money as the ticket that gains us entry to the show. In a modern monetary system a specifically designated form of money is little more than something that gains you entry to be able to transact within that economy. And we work because of and stress about our ability to obtain money because our access to the goods and services that we need ultimately relies on obtaining this tool.
11		4	But what is the primary purpose of money? As I mentioned briefly earlier, the primary purpose of money is to provide us with a convenient medium of exchange for access to goods and services. That is, instead of toting around bars of gold to buy groceries at Walmart or relying on a barter system, we have created convenient ways to record our payments in order to obtain goods and services that we might desire. This gives us access to the ability to feed our families, send our children to school, maintain our health, enjoy ourselves, and so on.
12		5	Almost anything can serve as money. You could take toilet paper to the local pawnshop and trade it for something of equal value, assuming the pawn shop will find it valuable. More commonly we tend to see people view precious metals like gold as money. This is not incorrect. Anything can serve as a medium of exchange. It’s just that gold is a rather inconvenient form of money. It’s heavy, hard to value in real time, and not widely accepted as a medium of exchange. So it’s a fairly inconvenient means of purchasing goods and services.
13		6	Most of the money in a modern monetary system is what’s called fiat money. Fiat money is money that has no intrinsic value but is used as a medium of exchange because a specific government deems it so. In Latin fiat means “let it be.” Today’s monetary systems are designed as social systems that institutionalize and organize money under specific laws within specific societies. Governments regulate these monetary systems and identify the entities that may issue specific types of money. The US government regulates the US monetary system, which is designed around the private banking system. You can think of the private banking system as the playing field upon which the US payments system works. The government is the referee (regulator), and we are the players trying to obtain balls (money) to score goals (consume and produce). But if you want to play on the field designated and regulated by the US government, then you must use the ball that it deems to be acceptable, and that means engaging the playing field that is the US banking system.
14		7	Today’s monetary system exists primarily on spreadsheets as numbers in computers recorded by banks as bank deposits. Bank deposits are created when banks make loans; then these deposits are used as the primary means of transacting business at the point of sale. Modern money is both someone’s asset and someone else’s liability, existing primarily in computer systems as records of this basic accounting. For instance, when a bank creates a loan, the loan generates four specific accounting entries. The loan is an asset for the bank; when the recipient of the loan deposits the money, the deposit creates a liability for the bank. For the borrower the loan is a liability and the deposit is an asset.
15		8	understanding that most modern money is based on the electronic deposit system controlled by the banking system, and that this money is created as credit through the loan creation process, is crucial. This sophisticated banking system allows us to conveniently and efficiently exchange goods and services by establishing a money supply that is elastic. This means the money supply can expand and contract according to the needs of its users.
16		9	In today’s electronic money system most money exists as a record of account on spreadsheets as a result of the accounting relationship that created the money through the loan creation process.
17		10	It’s easier to look like a great swimmer if you know the direction of the current.
18		11	With the value creation of stock picking and security analysis waning for the average market participant, an understanding of the macroeconomy’s environment matters more than it ever has. It is increasingly important with regard to how we will analyze economies, markets, finance, and money. If you’re going to understand the rapidly changing global economy, you need to understand the macroeconomic environment—that’s something I cannot stress strongly enough. The problem is, as we transition to a new macroeconomic world, most of us are still living in a microeconomic world. It’s estimated that 71 percent of the movements in the financial markets are the result of macroeconomic trends, yet 69 percent of all market participants still focus their approaches on a company-specific microeconomic view.2 That macroeconomic trends drive the markets has only become more pronounced in recent years. This became obvious when the central banks and governments of the world were forced to coordinate policy in 2008–2009 because they realized how interconnected all their actions were.
19		12	US stock market indexes once were made up of truly American companies. That is, the vast majority of revenues came from the domestic economy. But as technology has opened doors to new markets, we’ve seen local companies become national companies and then become multinational companies. Since 1990 S&P 500 companies have grown from generating 22 percent of their revenue from abroad to 30 percent. Although data don’t exist for the early decades of the 1900s, one can presume that this revenue figure is up substantially since then and likely only to increase. In fact, if we consider that the US produces just 22 percent of all global output, a vast world of revenues remains to be generated from foreign markets that have yet to be tapped. And if the S&P 500 were taken to its logical extreme, where it becomes a truly international index, we should expect that international revenue number to go well north of 50 percent, 60 percent, and even as high as 70 percent. The S&P 500 is no longer a US index. It is becoming a global index, and understanding its constituents requires a global big-picture understanding as never before.
20		13	All the monetary transactions in the world are what economists call a flow of funds. And, like blood flowing through the human body, this flow of funds keeps the system moving forward. If the economic machine has no flow, it suffers the equivalent of a heart attack. So the most basic component of the economic machine is this series of flows through the system that help generate revenues for businesses, incomes for households, and tax revenues for governments. And here we can begin to see why understanding money matters. Money is the blood flow in our economic machine. It is the thing that is used to transact and keep the flow going. Remember, the macroeconomic machine is just the sum of all these microeconomic transactions. GDP is just the monetary value of all the finished goods and services produced within a country in a specific time period. This is one way to measure the success of a particular economy. I’ll cover the details of this calculation in a later section, but for now it’s important to understand that the monetary machine is largely driven by the flow of funds that produces this output.
21		14	Most of us think of investment in the stock market sense. Most of us think we invest in stocks and bonds. But we are not actually investors in the purest sense of the word when we buy stocks and bonds. Most of us are simply savers who allocate our assets to certain financial instruments. To understand this point it is necessary to understand exactly why these financial instruments exist. When a new corporation is formed, it might raise money in a number of different ways. The most traditional form is a simple bank loan or the issuance of corporate debt. But it could also raise money by selling equity, or ownership, in the company. When someone provides funding for a corporation in this manner, it will issue them the equivalent of a stock certificate, which gives the investor a legal claim on a certain ownership portion of the business. In making this investment the investor has provided the corporation with current capital that will help it create future production. The investor has made a real investment in the company. Remember: Investment is spending not consumed for future production. The investor in this example has spent but not consumed in order to fund the future production of the firm. Now, what if that initial investor no longer wants to own that stock certificate and sells it to a neighbor, Sue, who thinks the company is a good value? In this case Sue will exchange cash for the stock certificate, which results in a change in ownership of the stock certificate. When Sue buys shares in this manner, she is allocating savings. The buyer is not an investor in the same sense that the initial investor was because the underlying company has no real involvement in the transaction. This purchase of stock does not actually fund future production of the company. It simply changes the legal ownership of the outstanding stock from one person to another. An exchange or reallocation of savings has occurred, but no funding of future production has occurred.
22		15	When confronting the world of money and how you will participate in the economy, nothing is more important than understanding when you are an investor, when you are a saver, or when you are both. Remember: Real investors seed future production by providing capital for future production. Savers merely allocate their unconsumed income to financial assets. When you think about your overall portfolio, you should try to think of your asset allocation in terms of this breakdown. If you are a true investor in the sense that you seed capital for the purpose of future production, you’re playing a different role than someone who is simply exchanging shares on a secondary market and allocating savings. It’s a nuanced point but an important one that will guide your understanding of how you obtain money, how you use it, and how you protect it. Figuring out whether you’re an investor, saver, or both is how you’ll make many of your most important financial decisions.
23	X	16	Most of us go through life thinking of investing as something you do in the stock market or in other companies. We don’t always think of it as something personal. But the reality is that the best financial investment most of us will ever make is in our own future production. The key to understanding our value in a monetary system is understanding how each of us is uniquely valuable to other people. In this interconnected monetary world we all have something that other people can find value in. And one thing you have to figure out is what that means to you. Of course it means different things to different people. We all have different talents and different specialties. The best investment you’ll ever make is in trying to understand and maximize the value you can contribute to other people. A capitalist system is often portrayed as an individualistic and selfish construct. But I think the best capitalist systems are those built on the simple understanding that we serve ourselves best by serving others. This means that most of us will make our true investments in things like our educations, skills, training, and so on so we can provide something even more valuable to others. This is where we will spend our own capital in the hope of generating future production.
24		17	Our investment portfolio has one primary goal: To help maximize future production. For the vast majority of us our savings portfolio needs to achieve only two goals: To protect us from the loss of purchasing power. To protect us from permanent loss of funds. The mistake many of us make is assuming that our savings portfolio is our investment portfolio, and we improperly allocate our savings in a manner that exposes our portfolios to huge amounts of risk. That creates instability in our lives and our overall portfolios. This in turns disrupts our ability to plan for the future and creates unnecessary stress. This doesn’t mean your savings portfolio is a no-risk portfolio. It doesn’t even mean that your savings portfolio can’t include components that might be investments (for instance, a hedge fund making private equity investments). It just means that to understand the proper construction process for a portfolio, it helps to have a sound understanding of what savings and investment are. Then you can apply these concepts properly to your personal portfolio’s needs and goals.
25	X	18	Let me begin by saying that I have nothing but the utmost respect for Warren Buffett. When I was a young market practitioner, I printed every single one of his annual letters and read every word. It was, and remains the single greatest market education I have ever received. I highly recommend it for anyone who hasn’t done so. But in digging deeper I realized that Warren Buffett is so much more than the folksy picker of value stocks portrayed by the media. What he has built is far more complex than that. In reality Buffett formed one of the original hedge funds in 1956 (Buffett Partnership Ltd.), and he charged fees similar to those he now condemns in modern hedge funds. Most important, though, is that Buffett was more an entrepreneur than a stock picker. Like most of the other people on the Forbes 400 list of wealthiest people, Buffett created wealth by creating his own company. He did not accumulate his wealth in anything that closely resembles what most of us do by opening brokerage accounts and allocating our savings into various assets. Make no mistake: Buffett is an entrepreneur, hedge fund manager, and highly sophisticated businessman.
26		19	The original Buffett Partnership fund is especially interesting because of Buffett’s recent berating of hedge fund performance and fees. Ironically Buffett Partnership charged a fee of 25 percent of profits exceeding 6 percent in the fund. This is a big part of how Buffett grew his wealth so quickly. He was running a hedge fund no different than today’s funds. And it wasn’t just some value fund. Buffett often used leverage and at times had his entire fund invested in just a few stocks. One famous position was his purchase of Dempster Mill in which Buffett actually pulled one of the first-known activist hedge fund moves by installing his own management. Buffett, the activist hedge fund manager? That’s right. He was one of the first. His purchase of Berkshire Hathaway was quite similar.
27		20	Many people outsource their savings portfolio to professional money managers who supposedly perform better because, well, they’re professionals. But the money management business is just like any other competitive business. Not everyone can be great at it, and often times the people you think are professionals are not really professionals at what they advertise. I spent a brief stint working at insurance firms and the best-known brokerage firm on Wall Street before I started my own firm. Many of you would probably be shocked if I told you that most of these professionals are much closer to car salesmen than financial experts. In fact that’s largely what the business of money management is these days. Too often these managers or advisers are selling you something they simply cannot deliver or are not experts in delivering. And the odds are they’re charging you far in excess of what it would cost you to make these same investments on your own or through a less expensive alternative.
28		21	has generated a 2.1 percent greater annual return. I should note that reviewing quantifiable risk is an extremely imprecise way to understand a fund’s actual risks. For instance, Figures 4.4 and 4.5 are analyzed using a simple definition of risk where risk equals standard deviation. But does this really quantify risk accurately? Of course not. If you had a fund that generated annual returns of 5 percent, 25 percent, and 30 percent, and another fund that generated returns of 5 percent, –5 percent, and 5 percent, you might conclude that the first option is worse than the second option simply because standard deviation says so. But this ignores the actual risk that most real portfolios face— the risk of permanent loss. In fact the second portfolio exposes you to greater downside loss. This is just one of the flaws in relying on a measure like standard deviation for risk. There are risk-adjusted measures that correct for this (like the Sortino Ratio or the SDR Sharpe Ratio), but even these metrics can be flawed because they ultimately are on a fool’s errand of overanalyzing past returns—and we must never forget the age-old rule that past performance is not indicative of future returns. But the point about quantifiable risk doesn’t necessarily alter your conclusions about hedge fund performance because the real risks in hedge funds are often unquantifiable.
29		22	A savings portfolio is what economists call a stock that flows from your income. In other words your income is the flow of funds, some portion of which you then allocate to a stock of assets such as equities, fixed income, and the like. Your primary source of income (your day job) is how most of us are likely to get rich. For most of us our portfolio is simply a repository that protects our financial wealth from the risk of permanent loss and loss of purchasing power. Thinking your portfolio is where you “get rich” is backward thinking. It’s true that you might get rich by buying stocks, but the overwhelming majority of us are much more likely to get rich by focusing on our primary source of income.
30		23	The problem with the stocks-for-the-long-run approach is that none of us can really adhere to such a simplistic view of the world. The reason is something I call the intertemporal conundrum. The intertemporal conundrum is the problem of time in a portfolio. A portfolio does not have a start date and end date, even though such approaches are usually sold using past performance data that stretch across many life spans. The problem is that our financial lives have lots of start dates and end dates. Most of us accumulate assets during the forty years between our mid-twenties and our mid-sixties. During this period we are constantly encountering times when we must use substantial chunks of our savings for what we might call important life events. You might get married in your twenties. You buy a home in your early thirties. You have children around the same time. You buy the new car in your mid-thirties. You start planning for the kids’ college payments in your forties. You plan for retirement in your fifties. You break a hip in your sixties. You see where I am going with this. Life doesn’t start in your twenties and end at sixty-five. Life happens all the time. And constructing a portfolio is all about understanding and preparing for this. You have to balance a portfolio and allocate your savings in such a manner that you can create some certainty that it will be there for life’s big events.
31		24	A good question to ask yourself when considering commodities in your portfolio is whether you want to own a barrel of oil or whether you want to own shares in a company that knows how to take that barrel of oil and turn it into something much more valuable. In other words are you someone who bets on innovation and progress or are you someone who bets purely on the supply and demand function of the raw materials we have on the planet? Perhaps you are the latter, but bear in mind that you’re making an explicit bet against the innovators in this case. If you think the price of commodities in general will rise, you’re making an explicit bet that human beings will not find ways to use commodities more efficiently or, better yet, that we won’t find ways to circumvent the need for commodities in many things we use.
32		25	But none of this analysis means that buying a house is a bad idea. We have to live somewhere, and this analysis does not compare the specifics of renting versus the specifics of buying a house outright, buying a house with a mortgage or using the property as an income source (which could be viewed as investment and an alternative income source). The analysis is simply intended to put the total costs and real, real returns in the proper perspective for those of us who buy a house with a mortgage and live in that home (as most people do). I view buying a home as a less expensive way to live than the option of renting (you could make both arguments depending on where you live). Plus, numerous intangibles involved in owning a home make it a wise purchase. But we shouldn’t always think about housing as if it’s an amazing investment. Whether we rent or buy, we are experiencing an expense. The real costs of that expense will depend on your specific situation. But in both real returns and real, real returns (including taxes and fees), the returns are unlikely to be anything to boast about. And certainly not what I would refer to as a good financial investment. Of course, you might time the market just right, and some speculators will always be able to time their use of financial assets better than others, but over an entire market cycle you have to consider the poor real, real returns of housing and the strong likelihood that you won’t get rich by investing in a home.
33		26	Modern portfolio theory assumes that we can calculate risk and create efficient portfolios by understanding this quantifiable variable. The efficient market hypothesis assumes that market participants are rational and incorporate all existing information in pricing assets, thereby making it virtually impossible to outperform the market. MPT and EMH suffer from what I believe are several flaws in the foundation of such thinking: 1. Beta, or risk, is not the same thing as volatility (which is how academics quantify risk). 2. Because modern portfolio theory assumes that risk equals volatility, the theory assumes that asset price returns are normally distributed. 3. Correlations are not static. Therefore returns can vary according to different macroeconomic environments. 4. Markets work with highly imperfect information obtained by highly imperfect participants, rendering their conclusions imperfect and at times completely wrong. The efficient market hypothesis and modern portfolio theory assume that risk is something that can be quantified and measured. Risk is generally calculated as equivalent to volatility, or standard deviation. This makes it easy to calculate and works great in a textbook. But volatility is not equivalent to risk. Risk is much more than volatility. In fact volatility might even make a portfolio less risky. For most practical purposes financial risk is defined as the potential that we will not meet our financial goals. This is not the same thing as volatility, and perhaps investors should not rely entirely on such a narrow definition to steer the portfolio process.
34		27	Entrepreneurs essentially engage in a form of arbitrage in which they identify a market flaw and produce something superior to what exists or supply what doesn’t exist. The secondary market is simply an extension of the primary market. And it is a much more public market—more information is readily available, and there is greater competition to arbitrage any price discrepancies that might occur. But that doesn’t mean the secondary markets are perfectly efficient. It just means they’re more efficient than the primary markets. Interestingly, much of the information that is available to any entrepreneur is available to anyone making a decision in a secondary market, so you should conclude that successful entrepreneurship should be impossible if you adhere to the strong form of the efficient market hypothesis. Again, that’s obviously false. Entrepreneurship is not easy. And most companies don’t succeed. But that doesn’t mean it is impossible, and it certainly doesn’t mean that the market is perfectly efficient.
35		28	Most people approach the markets with the mentality that they want to maximize returns and the way to do that is simply by taking more risk. Given enough time, we’re taught, this risk is worth the reward. This can be a highly dangerous and misleading view of the world. After all, if risk was simply volatility, or standard deviation, then high risk assets like stocks could always be relied on to generate high returns over the long term. But these high returns do not always materialize across equities. In fact, if you look at primary markets, where the majority of businesses actually exist, you’ll find that 30 percent of all small businesses fail in their first year, 50 percent fail within the first five years, and 70 percent fail within the first ten years.4 Risk certainly does not always equal reward here.
36	X	29	Hyman Minsky’s financial instability hypothesis states that a capitalist system will gravitate from stability to instability and that in fact its very stability can contribute to the instability.6 In financial markets the riskiest periods are often those periods when it looks as though everything is stable. Why? Because this is when human beings become complacent and irrational. And this is when humans take their efficient market models and embed unrealistic future projections based on rearview mirror data and extrapolate out into the future. And then, when the model has found a perfectly low risk way to produce profit, humans leverage the model up and count the dollars flowing in.
37		30	The vast majority of assets are managed by people who perceive risk as something very different than the way their clients likely perceive it. And this is because of the failed attempt to define risk as a specific number. This enormous problem in investment management desperately requires an alternative approach.
38		31	What we’re beginning to see is that financial risk is much more than volatility, standard deviation, or beta. Financial risk is a much more complex and abstract concept than the math behind many models makes it appear. Instead of thinking of financial risk as a number, I want you to think of financial risk as the potential that you will not meet your financial goals. Financial risk, in the most practical and realistic sense, is the likelihood that we won’t have the money we need when we need it. This is the risk the average person confronts when allocating savings to a secondary market. And it should be the central risk you try to protect against when designing a savings portfolio.
39		32	The problem with buying financial assets is that they expose us to the risks of the entities that issue them. This means there is substantial risk of permanent loss. Warren Buffett famously described his two rules of portfolio management as follows: Rule No.1: Never lose money. Rule No.2: Never forget rule No.1
40		33	When we buy claims against firms, we are essentially buying a claim on a portion of their cash flow. Equities, for instance, provide the owner with a claim on profits. Corporate debt provides the owner with access to a fixed percentage of interest plus principal at maturity. These instruments are just claims on the firm’s cash flows. But where do these cash flows come from? Remember, the monetary system is just the sum of all the transactions that occur within it. So we know that profits come from a specific flow of funds. According to the Jerome Levy Forecasting Center we can derive profits from a simple equation: Profits = Investment–Household Savings–Government Savings–Foreign Savings + Dividends In short, profits come from business spending, household spending, government spending, and foreign spending.10 This equation is expressed visually as a percentage of gross domestic product since 1960 in Figure 5.7.
41		34	When I refer to the concept of true diversification it’s crucial to think of the full spectrum of available assets and how they fit into an asset allocation plan. Equities should be an integral piece of any asset allocation plan because they are the asset which connects us directly to productivity and output thereby providing us with protection against purchasing power loss. But we must also consider how other assets can be used in conjunction with the equity component to help us achieve our goals. In particular, fixed income plays a key role in helping balance the risk of permanent loss. To emphasize this point, I want to highlight the nature of a bear market in fixed income. While many of the current fears in fixed income portfolios are valid, a bear market in bonds is nothing like a bear market in stocks. For instance, since 1928 the ten-year Treasury note has been negative in just 14 calendar years. And those negative years have averaged just –4.2 percent. On the other hand, US stocks have been negative in 24 calendar years since 1928 with an average decline of –13.6 percent. The worst calendar year decline in stocks was –43 percent, while the worst calendar year decline in Treasury notes was –11 percent. The data is even less bearish for the aggregate bond market where the worst calendar year return was just –2.9 percent. Let’s talk about true diversification in more detail.
42		35	Professor Marc Lavoie of the University of Ottawa likes to say, “Everything comes from somewhere and goes somewhere.”11 What he means by that is that all the instruments we use in the financial world are issued by specific entities and held by someone who purchased them. So, in order to understand the user of an asset, you must also understand the issuer of that asset. When we study the capital structure of any economic participant, we must keep this in mind at all times. For instance, the common stock you own in your brokerage account did not just magically appear there; it was issued by a firm. The bank deposit you hold in your bank account did not just magically appear there; it was issued by a bank.
43		36	Gold and silver—Gold and silver are unique assets because they are not only commodities but a form of money. Gold and silver are a few of the closest things we have to a global medium of exchange. In addition we’re still just a few decades removed from the time when gold was considered the purest form of global money. This makes these assets unique in the way they are perceived. I think we ultimately have to view gold and silver more like commodities and less like money. The probable future of modern money does not lie in physical money but in electronic money. That is, money is increasingly becoming a record of account that exists in computer systems and on accounting statements. Money is being used less and less as a physical item. Therefore owning gold in the belief that it is a form of money requires a particularly high level of faith (or distrust in the fiat monetary system) and historical mysticism. This is what I would call a faith put. In other words embedded in the price of gold and silver is a premium above and beyond their actual productive value as a real resource.
44		37	An asset that has no cash-flow stream but whose users view it as valuable because it is money derives its value largely from mere perception, not from its actual economic utility. This makes gold and silver potentially dangerous assets to own because their value as purchasing loss protection assets lies primarily in the belief that they are valuable rather than any actual productive use. This means they expose you to substantial permanent loss risk with relatively unreliable purchasing power protection. This creates sizable permanent loss risk in these assets if society were to view them merely as commodities and not as forms of money. And, as I’ve noted previously, commodities don’t tend to generate positive real terms. Therefore gold and silver should be viewed as hedging vehicles, not essential pieces of the financial goals spectrum.
45		38	Once you understand the general premise of the financial goals spectrum, you need to understand where your priorities lie so you can apply this understanding to an actual portfolio. Are you more concerned about purchasing power protection or are you more concerned about permanent loss protection? The savings portfolio scale in Figure 5.13 provides a visual representation of how to apply the spectrum to the savings portfolio concept. The savings portfolio scale shows how financial goals relate to asset allocation. As you can see, the saver who allocates 100 percent of their assets to stocks will have less protection against permanent loss, while the saver who allocates 100 percent of their assets to cash will have less protection against the risk of purchasing power loss. Once again balance provides the answer.
46		39	Some people will look at this asset allocation approach and wisely ask: Why do we need to reinvent the wheel here? Why can’t we just understand asset allocation along the same lines as the efficient frontier and modern portfolio theory? The purpose is not to reinvent the wheel but to improve it by clearly defining what our financial goals are and applying more realistic solutions to achieving those financial goals. The purpose of this perspective is to get away from the dangerous idea that risk equals return and the concept that we can ride out risk if we have a long enough time horizon.
47		40	In terms of gauging the business cycle, keeping a close eye on cyclical indicators is crucial. Some key indicators of the business cycle and its relationship to the market cycle include • The Conference Board Leading Economic Index (http://www .conference-board.org/data/bcicountry.cfm?cid=1). • Initial jobless claims—one of the best real-time cyclical indicators (see the St. Louis Fed FRED database for many of this and many of the other indicators—http://research.stlouisfed.org /fred2/). • GDP, Markit PMI global indexes, German ZEW, and EuroCoin Index—broad indicators of global growth, prices, and employment. • Corporate profits, corporate revenues, earnings—specific corporate indicators. • Rail traffic—one of the best real-time economic indicators. • Credit indexes (Merrill Lynch High Yield Bond Index, St. Louis Fed Financial Stress Index, Fed Funds Curve, debt-income ratios, ten-year break-even)—indicators of bond market health and future interest rates. • Private investment, durable goods orders, industrial production—broader corporate sector indicators. • Purchasing power parity—an indication of the relative value of differing foreign exchange rates. • Z.1 Financial Accounts of the United States—one of the most comprehensive data sets for the American economy. This will provide you with everything you need to understand the sectoral balances and the health of the different sectors in the economy.
48		41	Building a behaviorally robust portfolio is essential to financial success. This process involves constructing a realistic risk profile and then applying the strategy that you can remain loyal to. This begins with understanding your needs versus your wants. Asset allocators too often reach for a return they want without knowing that they’re reaching for risk they don't need. For example, they often overweight stocks based on some hypothetical long-term 10 percent average return only to realize that the path to that average return is filled with fairly regular 20, 30 and 40 percent downturns. The behaviorally optimized asset allocation begins not by targeting a return but targeting a financial goal and then taking the appropriate amount of risk necessary to achieve that goal within the constraints of your profile. For instance, a conservative asset allocator who needs a predictable 4 percent annual withdrawal in retirement shouldn’t reach for a 10 percent return as that portfolio will necessarily involve large downside uncertainty at points. They would be better off accepting lower returns by diversifying across shorter duration and more stable assets. In doing so they increase their likelihood of meeting their goals by creating a portfolio they’re more likely to stick with. In reducing their wants they increase the probability of meeting their needs.
49		42	A good starting point for macro portfolio construction is the Global Financial Asset Portfolio (GFAP). This is the outstanding composition of financial assets based on market cap weighting and reflects what an Efficient Market Theorist would call “the market portfolio”. That is, this is the portfolio you would try to hold if you wanted to simply reflect the market and not deviate in an “active” manner. At present that portfolio is comprised of a 47 percent stock weighting and 53 percent bond weighting. An interesting aspect of this portfolio is that it is relatively “active” in the sense that, throughout its history, its relative weightings have shifted materially. For instance, in 1990 the portfolio was comprised of just 35 percent stocks and 65 percent bonds before growing into a 50 percent weight in 1999 before crashing back down to 35 percent in 2002 during the Nasdaq Bust.
50		43	William Bernstein has written extensively about what’s referred to as the “rebalancing bonus”. This is the tendency to generate alpha due to rebalancing. There are many theories around why this might work, but my view is that rebalancing does two important things: It will, on average, bring our asset allocation closer to the GFAP. It will help us maintain a more behaviorally robust asset allocation. Rebalancing is an essential aspect of maintaining one’s risk profile over time as it reduces the procyclical risk of the stock market in the portfolio. For instance, 60/40 stocks/bonds rebalances back to 60 percent equities every year in order to maintain a certain profile and avoid letting the portfolio grow into a larger and larger stock allocation over time. And while this procyclical reduction is helpful, the GFAP’s procyclicality highlights the fact that this rebalancing back to a static weighting of 60/40 still might not be enough. In fact, an investor who owned the GFAP over the last 40 years would have earned superior nominal and risk adjusted returns by inverting the weightings in that portfolio. In many cases, this would have been compounded by improved behavior because the asset allocator who owned the less volatile countercyclical portfolio would have been exposed to smaller drawdowns and less behavioral risk.
51		44	In a 2018 interview Jack Bogle explained that he used to rebalance his portfolio in a countercyclical manner to reduce volatility and make himself more comfortable: we want to do something to protect against behavioral mistakes and to give some stability in your account … so I've been 65/35 [stocks/bonds] and for whatever sound reason, unemotional reason you can come up with and the market looks substantially overvalued - don't worry about it if you think it's 20 percent over valued or 25 percent undervalued - but if it seems to get out of line by a substantial amount take the 65 to 50 and the 35 to 50. What Bogle is highlighting is this tendency for the stock market to exacerbate behavioral risk in a portfolio, especially when valuations are abnormally high when the market has been through a large boom cycle. By rebalancing back to a more countercyclical allocation we achieve something similar to what a Risk Parity portfolio does by creating better balance between the relative asset class risks across time when compared with more traditional allocations like a static 60/40 index. Importantly, this not only creates better balance in the portfolio, but it optimizes “behavioral alpha” and the ability to earn better returns by being more disciplined with a portfolio across time. In other words, by reducing the variance in the portfolio and better buffering the equity market risk we create a more sustainable portfolio by reducing the risk of overreacting to large drawdowns thereby creating a better return than the counterfactual scenario.
52		45	Bobby Jones, the world famous golfer, once said that the game of golf is played primarily on the five-inch course between your ears. Golf, however, is won not only with your mind but with your physical abilities. The world of money, on the other hand, is something that exists almost entirely in our minds and is used as a way to represent the physical world in order to give us access to it. Money is really nothing more than something we created in our heads. And understanding its many uses, the macroeconomic system, and the financial system is largely about understanding how we think and react to the uses of money.
53		46	In 2011 Dr. Andrew Lo wrote a superb research paper, “Fear, Greed, and Financial Crises: A Cognitive Neurosciences Perspective.”2 Lo used a variant of prospect theory, developed by Daniel Kahneman and Amos Tversky to describe how we tend to value gains and losses differently.3 Lo’s paper asks us to consider two investment opportunities. In the first you’re guaranteed a $240,000 profit. In the second you’re offered a $1 million lottery ticket with a 25 percent chance of winning the money and a 75 percent chance of winning nothing. The first opportunity has an expected value lower than the second one, but most people will choose the first option because of the guarantee. They are naturally more risk averse. But Lo then asks us to consider a different scenario. In this case option 1 guarantees a loss of $750,000 and option 2 is a lottery ticket with a 75 percent chance of a $1 million loss and a 25 percent chance of $0 loss. In this case Lo found that most people gamble and take the riskier option, even though the expected value is exactly same as in the first example. Lo notes that the payoffs for the two most popular decisions have a lower overall probability of gain than the two options people tend not to choose. We tend to become more irrational when confronted with the potential for losses. In other words our natural instinct leads us to make inefficient decisions.
54		47	We have a difficult time thinking in absolute terms. We always compare our current position to something else—a benchmark, our neighbors, our coworkers. The second bias is loss aversion. Humans hate losing anything of value they have obtained. So in a misguided attempt to save money, we actually take more risk at times. Sound familiar? Ever held on to a stock just hoping to break even? Ever been in the red in Las Vegas, taking money out of the ATM and telling yourself you will just get back to even? It’s exactly the same thing.
55		48	Humans are pack animals. And pack animals herd. And animals travel in herds because they feel safer traveling in herds. No one wants to be the outcast. This is one of the most powerful dynamics that drive irrational markets.
56		49	Friedrich Nietzsche once said: “Madness is a rare thing in individuals—but in groups . . . it is the rule.”6
57		50	A bubble is an environment in which the market price of an asset has deviated from its underlying fundamentals to the point that its current market price has become unstable relative to the asset’s ability to deliver the expected result.
58		51	The Market is a Heartless Beast When you consider the reality that someone is always going to hate rising stock prices (as a result of being left out), we must also realize that the market doesn’t care at all about the way we feel. The market doesn’t have emotions or feelings. As Adam Smith succinctly put it: A stock is, for all practical purposes, a piece of paper that sits in a bank vault. Most likely you will never see it. It may or may not have an Intrinsic Value; what it is worth on any given day depends on the confluence of buyers and sellers that day. The most important thing to realize is simplistic: the stock doesn’t know you own it. All those marvelous things, or those terrible things, that you feel about a stock, or a list of stocks, or an amount of money represented by a list of stocks, all of those things are unreciprocated by the stock or the group of stocks. You can be in love if you want to, but that piece of paper doesn’t love you, and unreciprocated love can turn into masochism, narcissism, or, even worse, market losses and unreciprocated hate.7 Markets do not care about you. They don’t care about your family or your feelings, and they particularly don’t care about your wallet. The market is a heartless beast that has no feelings. When you approach these markets, you have to always remember that the less emotionally involved you get, the better off you’ll be. Don’t fall in love with a financial asset. Fall in love with a process. By having a process you’ll avoid the heartache involved in often thinking that the market cares about you.
59		52	Thinking in a macroeconomic sense isn’t just about understanding the big picture but also about understanding how to think about the way those around you are thinking. Thinking of the markets like they’re a beauty contest means you have to understand that you’re trying to understand the markets from your own interpretation while also being forced to respect the interpretation of those around you. If you believe a $100 stock is worth $200 and the market never agrees with your findings, you’ve lost the beauty contest.
60		53	If there’s only one lesson you take away from this chapter, I hope it is that the world of money is extremely complex and will result in your making many mistakes as you navigate that world. But as you sail through it, you can understand it better so you reduce the number of mistakes you make. In a lot of ways navigating this world of money is not so much about getting everything right but about minimizing your mistakes.
61		54	The primary role of money is to serve as a means of payment. Money can take many forms, but in the modern monetary system the final means of payment comes primarily from within the private banking system in the form of bank deposits. In other words the most important form of money in the modern monetary system is issued almost entirely by the private banking system.
62		55	The private sector drives the economic machine. While government assists in the economic process, the private sector ultimately is the primary driver of innovation, productivity, and economic growth. The private sector is what primarily propels increases in living standards; its activities are the most important factor in giving value and viability to fiat money.
63		56	The private banking sector issues bank deposits (inside money) and the public sector issues coins, paper cash, and bank reserves (outside money). Nowadays most means of payment involving private agents are transacted in bank deposits; as such, inside money is vital to understanding how the modern monetary system functions. While the private sector component of the monetary system takes center stage in the daily business of market exchanges and economic progress, the public sector also plays an important role through the use of outside money.
64		57	The MR approach is modeled on Leonardo da Vinci’s approach to medicine and human anatomy. He viewed the human body as a machine, and as one of the first anatomists he provided the world with a better understanding of how that machine functions (e.g., how its pieces work together). To da Vinci it was all about finding out what is, not what can be. Only through rigorous analysis of how the machine worked were he and others able to offer advice about medicine and surgery. This superior understanding of the human body’s operational realities provided the information that led to better medical approaches to solving problems with the human machine. I take a similar approach with economics by first trying to understand basic principles of how the machine works.
65		58	Fiat money: A form of money that is widely accepted because a government has designated it as legal tender. Unit of account: A standard monetary unit for measuring the value of goods, services, and financial assets. In the United States the unit of account is the US dollar, in the UK it is the pound sterling, and in Europe it is the euro. Medium of exchange: A widely accepted intermediary instrument that facilitates the sale, purchase, or trade of goods and services.
66	X	59	It is best to think of money as the social tool with which we primarily exchange goods and services. Money has its highest level of moneyness when it is widely accepted as a final means of payment for goods and services. Of course money is more than merely a medium of exchange, but its primary purpose and most prominent use is in exchanges for goods and services. Throughout history many things have served this purpose, and in modern transactions many different instruments can be classified as money.
67		60	Bank money is what MR calls inside money. Inside money is created inside the private sector. You might hear money referred to as endogenous money at times. This means that we all have a version of money we can create within the financial world, but the trouble with money, as Hyman Minsky, a renowned American economist, once noted, is in getting others to accept it. For instance, I can create CR notes, but it’s unlikely anyone would find them valuable.
68		61	In the modern monetary system, inside money primarily includes bank deposits that exist as a result of the loan creation process (loans create deposits). This means our money supply is elastic—it can respond and flex with the changes in the economy and the needs of its users. When the economy is healthy and banks are lending, the money supply can expand or contract to meet the economy’s needs.
69		62	Cash and coins are created by the Treasury while bank reserves are created by the central bank (reserves can be thought of as deposits held on reserve by the central bank). Although cash and coins are becoming obsolete in some money systems, they remain prevalent forms of money in most economies. This form of money primarily serves as a convenience that allows us to draw down a bank account of inside money (by using an ATM, for instance) to make transactions in physical currency. In other words cash and coins are used primarily by those who have an account that contains inside money for the purpose of conveniently transacting business in physical form.
70		63	In the United States the most important form of outside money is bank reserves or deposits held on reserve at Federal Reserve banks. These deposits are held for two purposes: to settle payments in the interbank market, and to meet reserve requirements. Bank reserves are used only by banks and the central bank in the interbank market and do not reside in the nonbank private sector. It is best to think of reserves as deposits held in accounts at the various Fed banks to settle payments within the banking system. It might be useful to think of bank deposits as the money that nonbanks use to access the payments system while bank reserves are deposits used by banks to access the interbank market. In other words deposits are the money most economic agents use to transact with one another, while reserves are the money banks use to transact with one another.
71		64	What’s crucial to understand here is that outside money serves primarily to facilitate the existence of inside money. That is, the creation of outside money is almost entirely a facilitating feature to influence or stabilize inside money. Through its vast powers the government can serve as an important stabilizing force in a system that is designed primarily around inherently unstable private competitive banking.
72		65	Different forms of money exist within any society, and they have varying forms of importance and moneyness. Moneyness can be thought of as a form of money’s utility in meeting the primary purpose of money, which is as a medium of exchange. The thing with the highest level of moneyness also trades at par. This means that one dollar is one dollar in nominal terms. You don’t generally have to worry that your bank deposits or dollar bill are not worth a dollar in nominal terms except in rare situations.
73	X	66	As Minsky once said, anyone can create money, the trouble is in getting others to accept it. Getting others to accept money as a means of payment is the ultimate use of money. And while many things can serve as money, they do not all serve as a final means of payment.
74		67	Bank deposits have the highest level of moneyness within the modern monetary system because they are the primary means of settling payments. As users of the modern electronic payment system, we are all users of the payments system, which requires us to transact in bank issued deposits. The electronic payment system is, by a wide margin, the most widely used means of payment in developed countries.
75		68	Acceptance value represents the public’s willingness to accept something as the nation’s unit of account and medium of exchange. This is achieved mainly through the legal process. That is, the government and the people deem a specific thing (such as the US dollar) the accepted unit of account and medium of exchange. The government also regulates the monetary system within which that unit of account is used. But the government cannot force currency acceptance upon its users merely by stating what is usable as the nation’s unit of account.
76		69	Quantity value describes the medium of exchange’s value in terms of purchasing power, inflation, exchange rates, production value, and so on. This is the utility of the money as a store of value. While acceptance value is generally stable and enforceable by law, quantity value can be quite unstable and result in monetary collapse in a worst-case scenario. Quantity value is more important than acceptance value as it can actually cause acceptance value to decline in instances such as a hyperinflation.
77		70	While the government plays an important role in setting the acceptance value of money, money is not necessarily valuable only because the state says it is money. The value of money involves the other linkages. Keynes once compared money to a theater ticket, saying: Money is the measure of value, but to regard it as having value itself is a relic of the view that the value of money is regulated by the value of the substance of which it is made, and is like confusing a theatre ticket with the performance.5
78		71	This is a good way to think of money in a modern fiat monetary system. Fiat money, in and of itself, has no intrinsic value. Similarly a theater ticket has no value aside from the paper it is printed on; however, if they value the performance, theatergoers will be eager to attribute a certain value to these tickets because the theater has made them the tool of entry to the show. If the theater mismanages the number of tickets in circulation, the ticket will be devalued. In much the same way the government deems a dollar to be the ticket with which we can see (and interact in) the economy. If the show is good (output and productivity are high), the number of outstanding tickets is not mismanaged (the banking system prudently manages the money supply), and the tickets are sustained as the viable forms of entry to the show (the tax and legal system sustains itself), this money remains a viable medium of exchange. But ultimately the value of the tickets is dependent primarily on the quality of the show, which is determined by the quality of the nation’s productive output.
79	X	72	There are two general types of inflation. The first is called demand-pull inflation. The second is cost-push inflation. Demand-pull inflation is when demand outstrips supply, resulting in a rise in prices. Cost-push inflation is when the cost of business increases, resulting in firms’ passing along those costs to their consumers. A common cause of inflation is an increase in the money supply. This is generally a benign occurrence in a credit-based monetary system because the demand for credit will usually rise over time in a healthy credit-based system. In other words, when the economy is expanding, firms and households will generally be borrowing to consume and invest. This will result in an increase in the broad money supply as banks create more loans, resulting in more deposits, leading to more money chasing (more or less) goods and services. The key to understanding whether this is a positive or negative development requires knowledge of how credit is used within the economy and whether it is increasing our living standards.
80		73	This is important when considering the quantity of money within a monetary system relative to the aggregate supply of output and its impact on living standards. For instance, it’s not uncommon to hear someone in the mainstream press state that the US dollar has lost more than 95 percent of its purchasing power since the Federal Reserve was created in 1913. This is technically true because inflation has increased substantially (about 3.2 percent per year), but despite the decline in the dollar’s purchasing power, our standard of living has increased dramatically because we have become so much more productive. An American in 2013 lives a much higher quality of life than an American in 1913. This is because we have been afforded (through productivity) the luxury to use more time as we please. In other words it takes far less time to purchase one hour of output today than it did in 1913.
81		74	If the purchasing power of the dollar has declined by more than 95 percent, how come the United States is so much better off than it was a hundred years ago? Inflation-adjusted GDP per capita was just $5,300 in 1913 but surged to more than $51,000 in 2013. We are far wealthier as a country than we were a hundred years ago, even though the US dollar has lost substantial purchasing power. This is largely the result of enormous advances in our productivity. Our labor hours produce far more today than they did a century ago because we are much more efficient than we once were. That means our 2013 wages actually buy more goods and services than they could in 1913 despite the decline in purchasing power. Our increased productivity makes us better off because it gives us more time to consume and produce other goods and services. This increases our living standards despite some inevitable rise in price.
82		75	Understanding the money system, its structure, and its purpose is ultimately about understanding how it is a system of flows from transactions. The money system exists so we can exchange goods and services. Someone spends, another person earns this income, this person invests, the recipient spends, and the cycle goes on. Without the cycle of spending the monetary system essentially dies. That is, if there are no flows, incomes decline, profits dry up, output goes unsold, workers get fired, and so on. The money system is similar to the way the human body works. The human body is largely based on a system of flows. So long as the blood flows, the body receives the nutrients necessary for survival and every day operation. But the flow is not necessarily enough on its own to sustain the system. The system must be properly nourished and taken care of. A human being who sits on the couch every day eating unhealthy food is likely to experience an interruption in this flow at some point as the system deteriorates in health over time. And when the flow stops (for whatever reason), the system dies.
83		76	The monetary system in the developed world is designed specifically around a competitive private banking system. The banking system is not a public-private partnership serving public purpose, as the central bank essentially is. The banking system is a privately owned component of the system run for private profit. The thinking behind this design was to disperse the power of money creation away from a centralized government and put it into the hands of nongovernment entities. The government’s relationship with the private banking system is more a support mechanism than anything else. In this regard I like to think of the government as being a facilitator in helping to sustain a viable credit-based money system.
84	X	77	The key lesson here is to understand that money in the modern monetary system is largely endogenous and exists through the creation of the loan process within the private sector. The central bank and reserves play a far smaller role in the broad money supply than is often perceived.
85		78	Shadow banks look like banks and operate in a similar fashion to banks but are not issuers of insured bank deposits and do not have access to the central bank’s emergency backstop facilities. In essence shadow banks often transform less safe assets into safer assets by repackaging many different instruments into one securitized product, thereby creating an element of reduced risk through diversification and reselling the product. This allows a shadow bank to offer credit by issuing liquid short-term liabilities against less safe longer-term assets.
86		79	The money supply in most modern monetary systems is largely determined by the credit cycle. And the credit cycle is largely the result of how economic agents perceive the future potential of economic expansion.
87	X	80	Most modern monetary systems are designed around the private banking system, thereby placing private competitive entities in control of the broad money supply. To the surprise of many in the mainstream, and even in the field of economics, the government has far less control over the money supply than most presume. But this system designed around private money issuance has proved terribly unstable at times and in need of a stabilizing force. The aforementioned credit cycle has proved extremely vulnerable to depression at times. What has evolved over hundreds of years is a complex private-public hybrid system. That system involves a complex set of public institutional structures that play a facilitating role for the private banking system.
88		81	The US Federal Reserve System was established by an act of Congress in 1913 and can best be thought of as a public-private hybrid. The Fed system created what is known as the interbank market, where banks can settle payments within one centrally regulated market. All member Fed banks are required to maintain reserves on deposit for the purpose of meeting reserve requirements and helping to settle interbank payments. This system was created after a series of banking crises in the late nineteenth and early twentieth centuries exposed the fragility of private banking.
89		82	Before the Federal Reserve System the United States had what was essentially rogue banking dominated by private entities. And when one of these entities experienced a crisis, the system was often thrown into turmoil as Bank A would refuse to settle the payment of Bank B because of solvency concerns. The New York Clearing House and other regional clearinghouses were helpful in times of crisis but far too small to help ease nationwide panics. The Federal Reserve System reduced this risk by creating one cohesive and internal national settlement system. Banks are required to maintain deposit accounts with Federal Reserve banks. You can think of this market as the market exclusively for bank payment settlement as it is not accessible to the nonbank public. This market creates one clean market where banks can always settle payments and where the Fed can intervene and provide aid and oversight when necessary. As the Federal Reserve has explained: By creating the Federal Reserve System, Congress intended to eliminate the severe financial crises that had periodically swept the nation, especially the sort of financial panic that occurred in 1907. During that episode, payments were disrupted throughout the country because many banks and clearinghouses refused to clear checks drawn on certain other banks, a practice that contributed to the failure of otherwise solvent banks. To address these problems, Congress gave the Federal Reserve System the authority to establish a nationwide check-clearing system.
90		83	One point of confusion with the Fed is its ownership. It exists as a result of an act of Congress. But it is also considered an independent entity because it is not part of the executive or legislative branches of government. The Fed exists because Congress created it, but it doesn’t execute policy measures with congressional or presidential approval. Politically this makes it a very independent entity.
91		84	The Federal Reserve System is an imperfect but rather innovative clearinghouse. Its structure as independent within government makes it difficult to determine precisely who owns it. I prefer to think of the Fed as an entity designed to help support the US payments system (which thereby makes it a bank-facilitating entity), which serves public purpose and private purpose. In other words it’s better to think of the Fed as a public-private hybrid not really owned by anyone.
92		85	The central bank is the most important bank in any economy because it is the central clearinghouse. The US Federal Reserve is the most important central bank in the global economy because of the comparative size of the US economy in the global economy and also because the US dollar has become the key international currency. In the United States the Fed has a dual mandate to promote full employment and price stability. The key policy lever in the Fed’s toolkit is its direct control over the federal funds rate. The federal funds rate is the interest rate (i.e., price of money) that private banks pay on overnight loans. This rate can have a substantial influence on the spread at which banks make their loans because it can influence the profits banks earn. For this reason the fed funds rate is widely thought of as having a substantial impact on the credit cycle.
93		86	The Fed’s manipulation of short-term interest rates is often called a blunt policy instrument. Why? When the Fed lowers or raises interest rates, the impact on economic activity is indiscriminate. Take, for example, a decision by the central bank to moderate mortgage lending. The policy option of lowering or raising the federal funds rate will influence mortgage interest rates in addition to other interest rates. But the Fed targets only the overnight rate and not the entire curve. So the Fed loosely influences the profit spread that banks earn on their lending, but the Fed does not necessarily control the demand for loans, which is what allows banks to maximize that spread. In this regard monetary policy and interest rate setting are a rather blunt and indirect tool.
94		87	Now that you understand that an autonomous currency issuer cannot run out of money, it’s important to also understand that there are real constraints on a government’s ability to operate. Aside from the obvious constraint of real resources, the true constraint on a contingent currency–issuing government is never solvency but inflation. Inflation becomes problematic when a nation’s spending outstrips productive capacity. This leads to a real reduction in the standard of living and in some cases can lead to a balance-of-payments crisis (currency crisis) and even hyperinflation. Governments must be extremely mindful of their influence on private sector output as misguided government policy could result in reduced private sector output and increased spending on goods and services, thereby leading to a decline in living standards.
95		88	An exorbitant privilege is bestowed upon a country with substantial output, population growth, and access to natural resources. Some nations, generally less-developed countries, sometimes are forced to peg their currencies to or borrow in a foreign denominated debt, which can reduce their sovereignty. In the case of the Eurozone all the nations have relinquished their ability to act as a currency issuer because there is no full integration with a central treasury and what is essentially a foreign central bank (the European Central Bank). Therefore it’s important to understand each specific economy in its own environment. Exorbitant privilege creates advantages for economic strategy, but it does not create an invulnerable currency.
96		89	The deficit of the entire government (federal, state, and local) is always equal (by definition) to the current account deficit plus the private sector balance (excess of private saving over investment). To be more precise: net household financial income equals current account surplus plus government deficit plus business nonfinancial assets. The surplus of the private sector (households and businesses) represents its net saving of income after spending, whereas the deficit of the public sector is the government’s budget deficit. This is the essence of the sectoral balances approach made famous by the late great Wynne Godley.
97		90	The sectoral balances can be broken down according to gross domestic product as follows: The three main sectoral balances must, as an accounting identity, add to zero. In Figure 7.7 what stands out is that the US government has run budget deficits for the majority of the last 60 years (in fact for more than two hundred years). Keep this in mind as I discuss the true constraint of the federal government and its ability to avoid running into the perpetual solvency constraints seen in the private sector.
98		91	The federal government has the authority to tax 22 percent of all global output, giving it access to a revenue stream that is unmatched by any other entity on the planet.
99		92	Congress has the theoretical authority to allow the central bank to buy all bonds issued by the US Treasury. In essence the US government could become entirely self-funded by an entity it created. This eliminates the potential risk of “running out of money.” If you had the potential to turn on a press next door to print dollars to fund your credit card payments, I am sure you wouldn’t worry about solvency, would you?
100		93	The United States, on the other hand, has a symbiotic monetary union with a unified federal government, a central treasury, and a central bank that all work together. The reason the states in the United States don’t run into similar periodic solvency issues is because they receive an extraordinary amount of federal aid. The states that would most closely resemble Greece in the EMU pay far less into the federal pool of funds than they receive. This keeps them solvent and helps keep their economies from collapsing into periodic depressions like we’ve recently seen in Greece. The EMU has no federal government or central treasury to collect funds and redistribute from the strong to the weak. This means that imbalances will periodically lead to solvency crises that will require a central bank backstop or government bailout. Therefore EMU members benefit from the partial unification and increased efficiencies of the EMU but also suffer as a result of its incompleteness.