The Takeaways:
- The intrinsic value of cryptocurrency comes from being a part of decentralized finance ecosystem, where we divert the power of central authorities of the Fed and the FDIC and to distribute it among more agencies and entities.
- Decentralization does not mean getting rid of central authorities, now and in the future sometimes only central authorities possess the power to make a drastic difference.
- Decentralization does mean strengthening rules and regulations that are to be applied to all players and closing legal and financial loopholes as early as possible.
- Quantitative Easing monetary policy can work magic but can also induce inflation. The key is to turn the extra QE money into productive or non-productive uses. The former works to create new assets/wealth while the latter merely changes the ownership of existing assets and pushes the price up along the way.
- Transforming QE money into productive uses is easier said than done as creating new assets requires time and selective fund allocation to the best players while QE money can be created almost overnight.
- The reason central banks should work through local commercial banks is to turn the latter into local reservoirs that can release the QE flood of money slowly and selectively to the best value adding players, instead of overflowing to the entire economy indiscriminately overnight, which will push up overall price level.
- During the Covid, the Fed established multiple programs of “going direct” or sending money directly to firms and consumers on the ground, failing to take advantage of local money reservoirs, or overflowing them.
- The fiscal stimulus of directly distributing cash to households also exacerbate the inflationary risk, although out of necessity due to Covid.
- Institutional decentralization (through local banks) is one way to build fund reservoirs, the other is household savings (and /or purchasing life insurance policies) to avoid too much money hitting the market at the same time. Firms and entities can inject cash into R&D projects, buying CDs and investing in money market funds.
It has been a long pause since the Kingstons last gathered together at the dinner table to talk about financial issues that interest them. Greg (the father) has been traveling out of the country for a multinational research project, while Joy (the mother) has been promoted to be the managing director of her consulting firm. Lily (the first daughter) is about to graduate from college but already started working full time for a financial service company, while Kimberly (the second daughter) just started her freshmen year in a local college. The Kingstons have finally found a day to all sit down at the dinner table to chat.
Kimberly: Gosh it feels like years since the last time we all had dinner together!
Lily, Jason & Cleo: I know!
Joy: So should we vote for the biggest event or largest change we’ve seen since we last met?
Greg: It has to be the collapse of the Silicon Valley Bank in my view.
Jason: I think it’s ChatGPT and artificial intelligence chatbot.
Cleo: What about Russia’s invasion of Ukraine?
Kimberly: I’ll vote for Donald Trump’s indictment.
Lily: Dad, you mentioned the Silicon Valley bank, what about the Signature Bank, the one that had a heavy hand in cryptocurrency?
Jason: Yeah, speaking of crypto, it seems that we’ve wasted all our time talking about it before.
Joy: Why did you say that?
Jason: Well, just look at the news. It seems every day someone from the crypto world is getting arrested or suited. We had no idea there were so many bad guys out there.
Kimberly: But should we separate the idea of cryptocurrency from its promoters?
Greg: That’s exactly what I was gonna say. Crypto as a new idea still has its value even though we have seen enough of the bad players.
Lily: So what is the value of crypto anyway in your view?
Greg: Nobody can deny the value of decentralized finance. That is ultimately where the intrinsic value of cryptocurrencies and blockchain is. In other words, the most fundamental value of cryptocurrencies is not directly measurable in money. Instead, it is measured by the value added from decentralized finance and decentralized professional services.
Joy: I agree. To be sure, it is still possible even today for any single cryptocurrency to fail or to crash just like Terra’s UST did, and the crypto prices will go up and down, sometimes significantly. Theoretically speaking — even though unlikely in reality — Bitcoin itself could die one day, making many Bitcoin haters or scoffers happy, allowing them to claim, “I told you so!”
Greg: If you think of it, the intrinsic value of blockchain and crypto is just like ChatGPT or large language models: They empower individuals and entities to reduce their reliance on third party entity whenever possible and whenever necessary. This is a part of the bigger trend, anything working toward that should be embraced.
Lily: But we can also learn a regulatory lesson from Silicon Valley Bank and the crypto world: Encouraging and embracing changes but working diligently on the rules and regulations to close the potential legal and financial loopholes as early as possible.
Greg: Excellent point there. Decentralized finance is not unregulated finance. It actually calls for more and tighter rules and regulations to provide guidance and guardrails, so everyone follows the same path. What I am saying is that the concept of decentralized finance needs to be clarified: It doesn’t mean to delete central authorities but rather to diversify and to spread the power to more parties and entities.
Jason: Excuse me, I know we talked about it before but what is decentralized finance?
Joy: Instead of asking us, why don’t you ask ChatGPT?
Jason: Actually I’ve been using Perplexity.AI lately. It allows current website search with no time delay. Okay, here it comes: “Decentralized finance (DeFi) is … a financial ecosystem based on blockchain technology that offers services such as lending, borrowing, and trading without intermediaries. DeFi operates on decentralized platforms using smart contracts, which are self-executing contracts with the terms of the agreement between buyer and seller being directly written into lines of code.”
Lily: Sounds like getting rid of the central authorities and middlemen.
Greg: I probably won’t get rid of central authorities and all middlemen altogether. Sometimes a central authority can do magic with unmatching power from decentralized agents. Decentralization simply means adding more active agents to the system without completely destroying central agents. It’s about dividing the power of authority among more people to allow more to use financial services anywhere, anytime.
Kimberly: The idea sounds good, but I can’t stop thinking that in reality, all we’ve seen is the power of central authorities like the Fed and FDIC as this time for the Silicon Valley Bank.
Lily: I agree. Sometimes only government intervention can get the job done. Look at the First Republic Bank: After the nation’s top 11 banks pledged $30 billion to its deposit, the bank’s share was still down by 33%.
Greg: Like I just said, centralized and decentralized players each have strengths and weaknesses and it’s best to integrate the two. But the other thing we should not forget is that currently we only have a centralized system. So of course we can only see the Fed & FDIC acting to make magic differences.
Joy: I agree. The current system works because everything moves around central authorities like planets moving around the sun. People have little idea how decentralized systems work so they always turn to central authorities for solutions.
Lily: Are you saying in the future the decentralized system will become mature and people won’t panic and only ask the Fed or FDIC for solutions?
Greg: That’s the hope, and we have reasons to expect a brighter, decentralized future. For one thing, I’ve seen commentators pointing to the Fed as the source — not the solution — of the Silicon Valley Bank crisis this time.
Joy: I’ve noticed that, too. There is one article by the pioneer of Quantitative Easing, Richard Werner, who basically says the central banks created the inflation crisis.
Greg: Are you talking about that article on Conversation.com, I believe it’s called “Why central banks are too powerful and have created our inflation crisis”?
Joy: That’s right. I still remember what he said about how central banks managed to get more powers with less oversight, despite repeated policy failures.
Lily: So this guy, Werner, created the idea of quantitative easing?
Kimberly: Wait, what’s quantitative easing?
Joy: Werner did come up with the QE idea when he worked in Japan, which later became a widely used monetary policy after financial crisis of 2007-2008. To answer your question, Kimberly, QE is a monetary policy used by central banks to stimulate the economy. Central banks can increase money supply in two ways: buying short term treasuries or buying long term, riskier assets like treasuries and mortgage backed securities, even stocks. QE mostly does the latter.
Greg: Historically the Fed has been controlling money supply by adjusting the federal funds rate, or the (very short) rates that banks charge each other for overnight loans. The problem there is that sometimes we are out of luck — when the fed funds rate was already cut to zero or near zero and the economy still needs an extra push. QE is then used as another tool to reduce interest rates and encourage lending.
Lily: Can we use Federal funds rate and QE together at the same time?
Greg: Yes. The two work differently in two ways. First of all, the federal funds rate works on short term interest, while QE on longer term interest. Secondly, reducing the federal funds rate does not increase money supply directly, only indirectly through reducing the cost of borrowing money. QE on the other hand increases money supply directly.
Jason: What does it mean to increase money supply? You mean the government printing more money and adding it to the market circulation?
Lily: Printing money is an old way of increasing money supply. Although it is still used today, it is not the most efficient and most used way because in the modern economy, physical money is only a small portion of total money. The Fed today has better ways of doing it mostly through electronics.
Joy: Yeah, remember a central bank is still a bank, so it does what banks do the best: working with other banks, except a central bank works only directly with large national banks, not smaller ones at street corners. These banks largely make up the money supply system, energizing the economy like the blood vessel does to a human body.
Lily: That’s right. The details can vary but basically increasing money supply means a central bank gives more money to commercial banks, which then lend the money to businesses and consumers. When more money becomes available, the price of money goes down just like anything else.
Kimberly: But what’s the price of money? I know money is used to measure the price of everything, but I never knew money has a price itself. Isn’t a dollar always a dollar regardless of how much money is out there in the market?
Lily: You are talking about nominal value of money, which always stays the same: $1 is always $1 like you said. But “price of money” is different, and it can mean two things. One is the nominal interest rate, or the price of borrowing money. If I lend you $1,000 at 5% interest today, it means one year later you’ll have to pay me back $1,050. The extra $50 is the price you pay to be able to borrow $1,000. This is what we mean by “price of money.”
Kimberly: I see. What’s the other meaning of “price of money?”
Lily: It can also mean purchasing power of money, meaning the amount of goods or services each unit of money can buy. Purchasing power has more to do with inflation. By definition inflation always means lower purchasing power of money, meaning the same amount of money buys fewer goods and services.
Greg: Here is a good example. I visited Venezuela a couple of years ago and I can tell you how crazy inflation was in that country. In 2018, the hyperinflation rate was 1,000,000%, meaning the prices of goods and services have been up by 10,000 times.
Joy: Anyway, going back to Werner’s article that says central banks are the source of the problem. His arguments are interesting by separating two kinds of QEs, “productive” versus “unproductive.” The first one spends the extra QE money on real economy, while the second spends on buying and selling existing financial assets like bonds, stock shares and futures. Those transactions only change the ownership of assets from one agent to another, pushing up asset prices without adding real value to national income. Werner believes this is where QE can go wrong and leads to inflation.
Lily: Let me make sure I understand it. So Werner says “good” and “bad” QE totally depend on how the QE money is used. Using it wisely, we can stimulate the economy and avoid recession; using it unwisely, we will run into inflation.
Kimberly: But how to use the money wisely? Is the key on investing the QE money for tomorrow, not spending it today?
Joy: Not exactly. Bear in mind not all investments are equal, and the key is to create new assets or add new value to the economy. When people are competing for the ownership of existing assets, they are still investing for the future, not exactly spending for today. What Werner is saying is that we really need to invest money to create new assets, not redistributing the existing ones.
Lily: If value added is the key, does it mean to invest to revitalize the manufacturing sector for the US, like the US government is currently trying to do?
Joy: Interesting questions! I believe it takes years or even decades to bring all manufacturing jobs back to the country, even if we assume that’s a smart thing to do. At the end of the day, economic principles still rule the game: Production flows to where the cost and risk are low, even after we take national security risk into account, even after we take governmental subsidies into account.
Greg: Yeah. This is not a financial matter, but have you noticed that Washington is quietly copying the moves of Beijing? China boasts its strength in manufacturing, so the Biden administration is trying to bring manufactures back to this country.
Joy: Speaking of that, sometimes this country moves not by long term strategic thinking but by reacting to its enemies in the short term. When Putin expected the US will stop supporting Ukraine after a while, Biden claims we will support Kyiv for as long as it takes. When Beijing wants to retake Taiwan, Biden then says we’ll send US military to defend Taiwan.
Greg: Let’s go back to financial matters. To answer your question earlier, Lily: No, creating new assets does not necessarily mean investing in manufacturing, although that would help. The good news is that this country is still the best in the world when it comes to innovations. All we need is a little financial push to make it better. A perfect example for creating new wealth is ChatGPT or AI Chatbots. Look at how much time we are saving each time we are search for answers to the questions we have in mind.
Jason: That’s true. Now that we have ChatGPT or Perplexity.AI, we are not going back to Google search, which was such a waste of time. Every time you ask a question, Google gave you millions of websites but just not the straight answer you need the most. It’s really a lose-lose game: You lose your precious time, and Google loses in giving you too much information that you never really needed.
Joy: Another good example of new asset is the mRNA based Covid vaccine. We were able to create a brand new drug in such a short period of time that beats China’s vaccine hands down in efficacy.
Greg: But here is a problem: Financial resources and innovation do not always go hand in hand. There will be mismatches. For one thing, it takes much longer to achieve innovations and breakthroughs, while financial resources can flow in and out of the economy at a much faster pace. We need to think about how to best spend the QE money, which can come quickly, almost too quickly to allow the economy to be absorbed and turned into value added assets.
Lily: Yeah, I see your point. Perhaps it’s easier said than done to follow Werner’s advice. It’s almost impossible to let the flood of QE money flow into new assets quickly, but it’s easy to use the money on consumption for today, not worrying too much about tomorrow.
Kimberly: Yeah, people were not allowed to work during the pandemic lockdown, but still needed money to buy groceries if nothing else. We can’t tell them to stop normal spending. So here is a problem: as workers we were not creating new wealth, but as consumers we were giving money for spending. This is a problem created by nature though, beyond human control.
Greg: Werner believes there is another problem with central banks that has direct bearing in inflation. He devotes an entire section to the cause of the current inflation and says the Fed was following the proposal of a private entity to go direct, meaning to get central bank money directly to the hands of businesses and consumers. Going direct means bypassing retail banks, who are in the best position to create credit by making loans to those most capable of creating wealth.
Joy: So we had two direct channels of money flowing: from central banks to businesses — bypassing commercial banks — and from federal and state governments to consumers in those stimulus checks to households.
Lily: Is it true that the Fed really went direct like Werner claimed?
Greg: Some evidence says yes. There is an article by the Brookings Institute that did a good job summarizing all the monetary programs by the Fed during the pandemic. Turned out that the liquidity was added to corporation (through the Primary Market Corporate Credit Facility , Commercial Paper Funding Facility , Secondary Market Corporate Credit Facility, supporting loans to small- and mid-sized businesses, Supporting loans to non-profit institutions), households and consumers (through Term Asset-Backed Securities Loan Facility or TALF) and state and municipal borrowing (through Direct lending to state and municipal governments, Supporting municipal bond liquidity).
Kimberly: Guess what I was thinking? If QE money flows too fast, especially without going through local banks, there is a simple way to avoid or reduce the bad consequence: Having businesses and households save the money and then slowly release it for the best time to use it.
Lily: I don’t see your point. Could you explain it?
Kimberly: Think of the QE money like a huge reservoir. When we open the dam money flows out too fast and too much at a time. Werner suggests that we use local banks to distribute the money more efficiently for creating new value. In a way the local commercial banks are like smaller reservoirs all over the country. When money flows from the big reservoir to many smaller ones, it protects the economy from being flooded by too much money, right?
Lily: Yeah, it makes sense. So instead of relying on local commercial banks, we can achieve the same result by asking households to save the money they receive from governments, not spending it right away.
Kimberly: Yeah, we essentially turn households into tiny reservoirs. That way, even though the Fed may have gone direct, bypassing local banks, households are still protected from the instant flood of money by saving it for the future.
Lily: We can also ask business firms to do the same. They can deposit money in the money market, in CDs and more importantly, inject it to R&D projects.
Joy: These are all good points. We may not be able to achieve those as most Americans don’t have a strong taste for savings.
Lily: We could suggest people invest in future oriented purposes like buying life insurance policies.
Greg: Speaking of the future, with today’s technologies we must rely on local banks to find the best value adding players but who knows, maybe in the future we can rely on ChatGPT to get the job done without so many local bank branches.
Everyone: That’s true!