Money can be used to purchase things now or saved to purchase things later. If individuals want to save their money to purchase things in the not too distant future, they can invest in what are known as cash equivalents. These include savings accounts at banks or money market mutual funds. Cash equivalents pay a little bit of interest while also having price stability in that the value of deposits varies little from day-to-day.
Money Is Debt Backed By Debt
Gary Gorton, Professor of Finance at Yale, points out that one reason cash equivalents have stable prices is they are debt instruments backed by debt.
A bank savings account is a liability of the bank. It is a form of debt that can be redeemed on demand by the depositor. That is why checking and savings accounts are called demand deposits Those demand deposits are backed by assets that the bank holds including loans and bonds. Bank loans are debt owed by borrowers. Bonds are debt owed by governments and corporations. So a bank savings account is a debt obligation of the bank that is backed by assets that are also debt in the form of bonds and loans.
A money market mutual fund is a vehicle that invests in short-term debt including government notes, commercial paper, and repurchase agreements. Commercial paper is an unsecured debt issued by corporations. Repurchase agreements are a form of short-term borrowing secured by collateral, usually Treasury bonds, which of course are also debt.
When individuals store money at a bank or money market fund, they don’t typically research what is backing the deposit. They assume that bankers and money market mutual fund managers conduct due diligence on the loans they make directly or when they buy commercial paper and bonds, or enter into repurchase agreements.
No Questions Asked Trading
Gary Gorton and other academics refer to this type of trading as “no questions asked.” Trillions of dollars of cash equivalent instruments and short-term debt are traded daily by institutions and individuals. Participants in these money markets assume they will be repaid and that the collateral is good so they don’t need to ask many questions. Not questioning the value of collateral or the creditworthiness of the issuer allows trading to proceed more smoothly. There is more liquidity because transactions are not delayed due to a need to conduct additional analysis. It is similar to how individuals assume that the currency they receive when selling goods or services is not counterfeit. It would be too time-consuming to verify that every dollar bill we receive is authentic and not fake.
What Causes a Financial Crisis
Most of the time money market trading proceeds smoothly. Problems arise when market participants start to doubt the value of what is backing a cash equivalent instrument. If individuals or institutions are concerned about the value of collateral or whether they will be repaid then they exit the market and don’t trade.
When trading is curtailed because money market mutual fund and other traders are less willing to purchase short-term debt instruments then companies who were funding their daily operations by issuing that debt run short on cash. They are forced to sell assets to cover operating expenses. Forced selling and an unwillingness by market participants to trade and lend can lead to a full-blown financial crisis as asset prices fall, liquidity dries up and corporations collapse. That is exactly what happened during the Great Financial Crisis.
Such crises require governments and central banks to step in as the lender of last resort by providing loans and guarantees to market participants. Eventually, government and central bank actions calm markets and restore confidence so that market participants are again willing to trade. The cycle begins again.
We see then that most money, such as currency, bank deposits, money market mutual funds, and repurchase agreements, is really short-term debt, often backed by other debt. As a result, money is subject to runs when investors lose confidence and don’t want to own it. That can lead to financial crises. In Episode 285 of Money For the Rest of Us we explore what individuals can do to protect themselves from these types of financial panics.
Topics covered in this episode include:
- How counterfeiting currency works.
- Why most money is debt backed by debt.
- How a loss of confidence in money leads to bank runs and other financial crises.
- How demand for U.S. Treasuries as collateral is keeping interest rates low even though the U.S. federal budget deficit is growing.
- Why the Federal Reserve is considering capping interest rate yields on U.S. Treasuries and what are the risks of doing so.
- What can individuals do to protect themselves against a financial crisis caused by runs on banks and financial securities.
Podcast Episode
Show Notes
Ignorance, Debt and Financial Crises by Tri Vi Dang, Gary Gorton, Bengt Holmström
Money-Market Fund ‘Breaks the Buck’ by DealBook—The New York Times
Understanding Deposit Insurance—Federal Deposit Insurance Corporation
The Regulation of Private Money by Gary B. Gorton
Financial Section of Federal Deposit Insurance Corporation Annual Report
Investors at home and abroad are piling into American government debt—The Economist
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Transcript
Welcome to Money for the Rest of Us. This is a personal finance show on money, how it works, how to invest it, and how to live without worrying about it. I’m your host David Stein. Today is episode 285. It’s titled, “Money is Debt.”
Counterfeit money
Last month when LaPriel and I were in Mexico City, we decided to order a wood-fired pizza, carry out. When I went to pay for the pizza, I handed the server a 500 peso note. He looked at it briefly and said, “I can’t take this note. It’s counterfeit.” I got this 500 peso note from an ATM machine, from the bank, and yet it was counterfeit.
The best counterfeit notes in the world come from Peru. In 2016 Peter Holley of the Washington Post interviewed Jose, he’s a U.S. Secret Service agent who leads the crackdown on counterfeiters in Peru. Jose said, “A lot of these organizations are family-run, making a counterfeit note is a skill that has been passed down. It’s an art. And the skill isn’t easily transferable.”
He mentioned that it takes 10-12 people to create a note; financiers, designers, printers, cutters, and the artists who recreate watermarks and raised textures so that the notes appear quite real. He said, “They’re very good at creating texture on the note, which makes it passable, not just in the U.S. economy, but also in South American and abroad.”
A $100 note can be sold for $20. The cost of materials and labor is $3–5. And most of these notes are smuggled into the U.S. from Mexico. And then they might be spent at a big-box retailer. Jose said, “Most big retails have relaxed return policies. And the individual will return their items and get cashback, making a 90% profit.”
And these counterfeiters, once they get their notes, they might hit 14 stores across 7 states in 1 day. He points out, it’s very organized. But that’s as far as it gets because most banks have counting machines that can separate out fake bills from authentic ones because there’s a magnetic ink on the legitimate currency. As a result, only a very small percent of U.S. dollars are counterfeit, less than 0.01%.
Banknotes, such are the 500 peso bill, are issued by central banks. Pesos by the Bank of Mexico. Dollar bills by the Federal Reserve. And these banknotes are perpetual non-interest bearing debt of these central banks. They are fungible, which means you can interchange a $1 bill with another one. We don’t spend the time to think about whether the bill is counterfeit or not.
Now in Mexico, they’re a little more careful. On our trip, I gave peso banknote to a taxi driver, and he handed it back to me and said, “I won’t take this because it’s ripped.” It had a little bit of a tear in it. But in the U.S. if it has a little bit of a tear, we’ll still continue to use the note.
In fact, I remember when I was small, you would often see Canadian pennies, and would just use them when a penny was worth something. They were used interchangeably with U.S. pennies to buy candy or whatever.
No-questions-asked debt and repurchase agreements
Academics Tri Vi Dang, Gary Gorten, and Bengt Holmstrom wrote a paper titled, “Ignorance, Debt, and Financial Crisis.” And they mention that with debt, short-term debt, or even perpetual debt, like cash, that the approach is no questions asked.
We don’t really stop to think about whether a note is counterfeit or not. We just use it. Nor do we consider whether the Federal Reserve will honor that dollar, which is a liability of the Federal Reserve. We just go about our trading activity, buying and selling things, using cash, currency, and coin, and don’t really think about or consider whether it’s real or not.
This no-questions-asked approach to trading debt is very common. Episode 270 was on repurchase agreements. A repurchase agreement is when one entity sells a security or securities, usually government bonds, to another entity, usually overnight, but sometimes longer, and then promises to buy that security back, usually the next day at a higher price.
The seller gets cash and the buyer gets collateral that secures the repurchase agreement. The buyer of the securities essentially earns interest, which is effectively the difference between what was sold and what was bought back. Now the collateral is usually a debt instrument, a U.S. treasury security or bond.
The volume of repurchase agreements is staggering and it works because most of the time, the traders don’t question the value of the underlying collateral. The treasuries bonds or some other security. If there’s doubt about that collateral, they might want additional collateral, or they might choose not to trade at all.
In some circumstances, they might want a higher interest rate, which effectively means they want a bigger discount for that collateral because they’re buying the asset and then returning it. It’s that difference between what was bought and sold for—that’s the interest rate. So it could be what’s known as a haircut, a bigger discount.
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