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How do Banks help secure and bolster the economy during Black Swan Events?
Banks aren't always the bad guys. Below is a blog post from 2020 explaining a monetary policy that would ultimately help cushion the blow of Covid-19, but increase the rates of inflation.
Right now it’s hard to not be flooded by COVID-19 in the news and if you are an investor or have been keeping up with the markets, it’s been ugly. Out of the noise around infection rates and quarantine protocols, there’ve been some big movements set in place to combat the virus economically and financially. Recently, the Federal Reserve, our central bank, cut interest rates to 0% and pledged to inject $1.5 trillion into the markets for liquidity in response to the coronavirus.
Investors all have varying opinions around these decisions and quite frankly the moves by the Fed haven’t quelled much of the volatility in the markets. However, I have seen what seems to be a popular criticism of the Fed’s monetary policy on social media and I think it would be interesting to double click into this and explore more.
I’ve seen a fair amount of people on Twitter upset about the Federal Reserve slashing rates to 0% and injecting crazy amounts of money into the markets as liquidity. Where most people take problem with this is that it seems like the monetary policy is a big bailout for Wallstreet and the 1% instead of small businesses and the American people who are affected the most.
I completely share their concerns for the service workers and restaurants that cannot weather months of “shelter in place;” however, I think the current frustration and ire is misdirected at the central bank policymakers. The Federal Reserve’s change in monetary policy is directed to help those in need, not to appease the 1%. To know how 0% interest rates will benefit the American workers and why liquidity injections are in place for the stock market, we need to take a look at the economy and the concept of wages and credit, which are components that are not easily understood.
Let’s start with a very high-level introduction to the economy. An economy is the sum of all transactions that occur. When I go purchase groceries at a store, food is exchanged for my money and the transaction happens because there’s value for both sides. In this case, I need to eat and my money has value to the store. For this example, I am the buyer and Morton Williams is the seller; however, if we sum up all the transactions between all buyers and sellers we have the makeup of the economy.
Credit is introduced into the economy when there’s an agreement between two parties for a transaction into the future. When you use a credit card to buy those loafers, you essentially go into an agreement with the RealReal or more realistically Visa, that you would receive the loafers today but will pay for it at the end of the month. Store credits work in reverse — you’ve paid money upfront and have entered into an agreement to receive goods worth that value in the future from the store. You can say at this point the store is indebted to you.
Credit is built on the trustworthiness of those that owe it. In the example above, the buyer of the loafers has to be trustworthy for a business to allow them to take the loafers and pay later — this is why credit score matters to determine how much can be charged on your credit card or the terms of a loan you need to take out. Similarly, if you have accepted store credit, you reasonably believe the company will not go bankrupt or fail to meet its obligations to you in the future.
The trustworthiness or creditworthiness is determined by income and assets. Income matters because the more income you make, the higher the chance that you can hold up your end of the bargain for what you owe. Assets are important because if you, the debtor to who the credit was extended by the loaner, are unable to repay or meet your obligations, you can sell your assets to uphold your end of the agreement. More in either category results in higher loans or more credit and the opposite is true.
Credit allows people, businesses, and governments to borrow money they don’t have to spend right now with the promise of paying everything back later. Why this is important is if we look at the transactions that occur within an economy, the income earned is directly proportional to the amount of money spent. For example, if credit enables me to buy more right now, all of the sellers of the goods I buy make more money. Those sellers now have a higher income and are more creditworthy so they can borrow more themselves and spend more. You can see how this quickly cascades into the growth of income and credit. Eventually, this all makes it back to me because the economy is in a boom and the business that employs me pays me more.
When the central bank cuts interest rates to 0%, it is to encourage borrowing or the creation of credit because the cost or the burden to borrow is nonexistent. As we know already more credit leads to continual spending or the bolstering of incomes. It’s important to understand that the central bank can only lend to the commercial banks that common people use. As in I cannot go get a 0% mortgage because the Fed Funds Rate is at 0%. The credit created in this way is not only accessible by banks, but it can only be used to buy financial assets.
The detail most people don’t know is that the central bank’s monetary policy cannot directly be issued out to the public. However, the US government can issue stimulus but the government doesn’t have a way to create more credit or money supply. So what actually happens is the central bank extends credit to the US government by buying up US Treasury Bonds, so that the government can then take that money and distribute it. By cutting rates to 0%, the Federal Reserve enables more government borrowing in hard times.
By making sure markets are liquid, the central bank tries to stave off major price movements from assets being oversold. Overselling happens when, in a panic, everyone wants to sell and convert their assets into cash. The demand to sell greatly outweighs the demand to buy so the price of the assets plummets. This is called a crash, and the problem with a crash is that everyone’s asset values drop. When assets drop we know everyone becomes less creditworthy. Being less creditworthy means less borrowing, which leads to less spending, which means other’s incomes are lower and now we’re in a credit crunch. The credit crunch left on its own comes with a self-fulfilling prophecy that a recession is well underway. We all know who is impacted the most in a recession — it’s the small businesses and the American people. By injecting $1.5 trillion of liquidity, the central bank is doing what it can to prevent a recession.
Policymaking is often very difficult and politically charged. I am not here to make a statement that I stand behind the recent monetary policy nor do I have any predictions on the efficacy of these policies. I do think as individuals, an increased understanding of how the major cogs underpinning our financial future turn and function is essential. This helps us with more informed discussions, clarity in voting, and less panic when times of stress occur.
The reality of the situation is that as global and domestic travel and commerce comes to a stop due to preventative measures to contain the virus, economies will be affected. The stock market that’s been growing unimpeded for 12 years will sell off and eventually, the virus will be under control, businesses will reopen, and everything will recover. When the dust settles there will be a great, once in a decade, the opportunity for new investors to enter the markets and set themselves up for the future. I implore everyone while we’re practicing social distancing to take a proactive approach to learn more about the financial markets and investing today.