I recently came across an investment service called Epsilon Theory. They have an enormous range of articles and reports that are among the best-researched and easily understandable of any that I’ve read anywhere else. I’ve taken up their (limited) free subscription offer, and I recommend it to you as well.
I found their article, published in early October, dealing with the British banking blow-up and titled “A Brief History of the Past 10,000 Years of Monetary Policy and Why Last Week Was a Big Deal“, to be an excellent summary of money and monetary policy. I sent it to several people who hadn’t had much exposure to issues such as monetary policy, and they uniformly reported back that they’d found it easy to understand and it greatly simplified the subject for them.
Here’s the beginning of the article. I’ve added the links embedded below.
In the beginning, someone with a business wanted money from someone with money.
There are two and only two voluntary (i.e., without the threat of physical violence) ways of doing this. In exchange for the money, the person with a business can promise the person with money a share of the future economic activity of the business, or they can promise to repay the money in the future along with more money. In general, we call the former promise “equity” and the latter promise “debt”, and people with money have been collecting these promises from people with businesses since money was invented. These collections of promises are called “investment portfolios”.
About a nanosecond after money and equity and debt were invented, the business of facilitating these transactions was invented. Today we call this business “Wall Street”, but of course it goes back thousands of years, way before there were things called streets. The business of Wall Street consists of two and only two things: thinking up news ways to create a transferable share of some future economic activity, and thinking up new ways to borrow money today for a promise to repay that money and more in the future. We call the former activity “securitization”. For example, equity promises are securitized into “stocks” and debt promises are securitized into “bonds”, which makes the sale and resale of these promises sooooo much easier. We call the latter activity “leverage”, which is just a ten-dollar word for borrowed money.
Every bit of financial innovation over the past ten thousand years or so – all of it! – has been in service to one or both of those two activities: securitization and leverage.
There’s much more at the link.
I highly recommend this article if you find yourself wondering what’s going on in our financial markets, why the economy is tanking, or why the Federal Reserve is doing what it’s doing. By the time you’ve read the whole thing, you’ll understand far more than most of our politicians!
Frankly, one simply can’t keep one’s head above water in today’s economy unless one understands the effect that money and monetary policy have had, are having, and will continue to have on our nation. This article will give you enough of a foundation, expressed in very simple terms, to do that.
The concepts are simple (and ancient, as you point out) and the current activity with Western banking is equally easy to grasp. Yes, derivative contracts can be complicated but once you work out the algorithm, they're really not. Anyway, following the death spiral that is going on is depressing because it's a shit sandwich and we are all going to have to take a bite.
Concur with LL, and we've had this conversation…
Close, but not far enough back.
Money ( and writing! ) was invented by Sumerian priests trying desperately to keep track of who has paid yearly tithes. If you paid, you got a baked clay bisquet with cuniform depictions of the goods paid on it.
Later on, the priests would accept a measure of silver for the tithe. Which created silver as money.
Greeks and Chinese started coining it a lot later.
Note that the article misses a trick. And it's an important one.
The government in the UK (and other places too) requires pension funds and the like to have a significant fraction of their funds invested in the safest securities (government bonds). This is justified because of the safety issue i.e. that the fund will not lose that money but it's wonderful for governments because it means they have a guaranteed market for their debt. It's also not wonderful for the pension funds because (as the article does note) yields on government bonds over the last decade or two have been rather limited (1-2%/year vs 5-10% for corporate shares).
So the clever people on Wall St came up with a way that banks could borrow money based on that nice secure investment and then use that borrowed money to invest in stocks (this is another way to look at the LDI described) and yes the margin calls on it were nasty and yes the BoE stepped in as purchaser of last resort and bailed out the funds but in fact the BoE didn't buy much, just enough to set a floor with a promise to buy more if required (which it then wasn't), and it may make even a profit on this in the medium term
However the important part of this is that the rule that says that pension funds must buy government bonds is still present and is globally common. So this is going to pop up all over the place unless pension funds are willing to take the hit on annual returns and very carefully deleverage their bond holdings. Since bond yields are going up with interest rates that's a logical move but the deleveraging is not risk free. If they all deleverage too fast they'll cause a stock market crash and that crash could be global because while they were forced to buy local government bonds many of the best returns have been on the US stock market so they could crash that simply by trying to sell all those US investments to deleverage the bonds
The government typically requires a certain percentage of investments to be in "safe assets". There are options besides government securities, such as certain types of real estate, corporate bonds, in some countries gold and silver, etc, but government securities are widely used because they are much easier to buy and sell.
This requirement is not just for hedge funds but also for banks and many other financial institutions.
Francis and LL are both right. But the devil is in the details. The financial instruments that have been created are nothing more than speculative bets where one party thinks they have inside information or a time advantage over the other side of the bet, or think they have some insurance against losing (which is again just a similar bet with yet another party, ad infinitum). Nobody makes these bets without thinking they are winning and the other guy is losing, or like a casino, they may lose once in a while, but in the end the vast majority of suckers will lose so they will win overall. But this isn't a game with well behaved odds. This is a complex system and it can behave in grossly asymmetrical ways. Which is how we got the 2008 crisis. The bankers are counting on being too big to fail, and the government subsidizing their giant losses whilst letting them skim off their winnings for years.
I get this part: "the price of a bond goes up or down inversely with interest rates"
I do not get this part: "Selling those UK bonds drove the price of the bonds lower still, which created still more upward pressure on interest rates"
Earlier, the article explained quite nicely how and why bond prices react to changes in the interest rate. However, this second statement is NOT explained. Why should the interest rate be driven by changes in bond prices? Seems to me as if all of a sudden, the arrow from cause to effect is being reversed, with no explanation why?
If the interest rates don't rise, then no one will buy the new government bonds, but instead buy the older discounted bonds.