In this post I want to introduce some thoughts on why the actions of the Federal Reserve are distortionary, why the creation of money within the shadow banking system is more organic, and propose a more formal definition of inflation or deflation of the money supply.

Milton Friedman identified that the point of introduction of money into the economy benefited the person who introduced it the most, with its effect lowering as it spread further into the economy. Here the money being introduced isn’t aware of the overall size of the economy. It thinks based off of its one interaction that I am worth such and such and as it interacts more and more with the larger economy it begins to poses more information about the action that it can induce.

I am trying to stay focused here, but it is complex. Money and any other thing that is a part of the economy does not carry an intrinsic value. Value is determined solely through information. This is how things (including money) have different values at different times and different locations. So asking what is a dollar worth can only be really answered at the time of the transaction or transfer. Money and everything else does possess aggregate properties. These are statistical quantities and are determined through repeated interactions, each exchanging a portion of information. This is why Hayek had such profound respect for the informational content of price signals. That there is no one true price. However, we can express our knowledge of the price under a Bayesian framework. It is expressed by Bayes Theorem. Using all prior information of things that affect the price of something we obtain a posterior distribution that integrates over all of this information to give us the marginal distribution of the price of what it is that we seek. This distribution can have any shape and only contains the information for what we know based upon our interactions.  We can describe the statistics of this distribution in various ways, but more commonly we refer to the “price” of something as the average price within some temporal and geographic location, with some general gut feel for the variance.  The purpose of markets is to create a place where we can increase the density of our interactions to obtain more accurate pricing information.

Back to our money gaining knowledge of the economy and the economy gaining knowledge of the money. The knowledge of the perturbation in the money supply diffusion in the economy can be succinctly described using Langevin diffusion, sort of a diffusion of information based on interactions. This can explain why there will always be an opportunity for arbitrage. There is always and everywhere an information asymmetry.  Some people bemoan informational asymmetry and state that we should remove it and get rid of it or flat out ignore it. This action ignores the natural state of the world around us. Information asymmetry is what creates opportunity, without it there would be no action. This is the third law of statistical economics. That as the entropy goes to zero, action as measured by temperature becomes zero.

The Federal Reserve actions for how they add money into the economy is distortionary because of how that money is added. It is added in a few locations. First, is debt monetization. In this scenario the money is given to the government for the government to spend. I actually like this because it is a way to fund the government without taxes. Imagine that.  The government doesn’t even need to sell debt to do this. The Treasury could be entirely funded through this mechanism.  However, historical precedent shows that such an approach gives free reign of the printing presses to people who want more power and will do anything for it. So let’s x-that off the list. It also shows the moral hazard that we cary with the Fed’s open market operations.

The other way that the Fed injects money into the economy is by lending money to the banks in various and sundry ways, typically at some discount. One such way is the “Open Window”. (If somebody has more information on how the Fed gets money to the banks I appreciate any clarification/correction that you can provide specific Fed operations are more of a black box) The Fed controls these various interest rates to control the rate at which they give money to the banks. These rates are what are affected by such policies as the ZIRP. How this becomes distortionary is that banks become less reliant on investor and depositor equity to fund their lending. They get as much money as they could possibly need from the Federal Reserve. This  artificially suppresses the risk premium for which they charge, because they have access to all of this money. This money is then funneled into various activities even displacing capital and hiding the actual price of the investments. It is this price control of risk that is what is distortionary. It prevents the banks from accurately assessing the risks of the debtor when making the loan, causing capital to become misallocated in the economy. It causes the banks to not charge the appropriate price for risk and they then do not have adequate capital to cover the losses when the loans are defaulted upon. Bank failure is the consequence of underpricing risk. On the flip side overpricing risk (assuming debt has an infinite price) limits all investments to be made with 100% equity. This restricts the overall action of the economy and can be as bad if not worse as underpricing price due to missed opportunity.

Every way that the Fed has to affect the money supply is distortionary or creates undesirable moral hazard.  How is shadow banking, really an extension of the fractional reserve system, an organic way of creating money? Let’s take the shadow banking sector as a number of people each interacting with people around them. The same can be said for the traditional banking sector.  All of these people interact with other people in the act of making loans within the economy. These interactions carry some content of information. Thus each of these people have the most information about their immediate surroundings. If you added this all up you would have the sum of knowledge for that group. While the aggregation seems simple in theory it is impossible in practice. Which is why the Fed presuming to know where to best introduce money and to who is a fatal conceit.  Only those people out there acting in their own self interest competing against others for customers or for providing the loans at the highest rate they can while the customer is seeking the lowest rate, ensures rapid and the best possible assessment of market prices in each specific situation. Vernon Smith has done some seminal work using experimental economics to observe how such a process rapidly establishes reproducible prices.

Each of the actors has some expectation of deposits or loans and an assessment of the likelihood of them being called due. Based on this information they lend at a competitive rate. The banking system in the past depended a great deal on reputation to secure deposits, and if the depositors lost confidence the bank folded, this would have broader impacts, but the loss of a particular bank created opportunities for other banks to come in and take business. The same can be said for the shadow banking sector. Fortunately the Shadow banking is so big there is no physical way for the Fed or government to bail anyone out.    The organic banking sector creates money out of thin air just like the Fed. However, it is created with much more detailed information and the primary beneficiary of the money is the individual or company receiving the loan. Thus the creation of money, and conversely the destruction of money occurs within the entire economy, and is not particularly concentrated.

How I described the organic banking sector is as a system that is not self adjoint and which may or may not be linear, where the output is a part of the input. Because of this state of the system can be described through the use of eigenvectors and eigenvalue. The fundamental eigenvalue is the key indicator if the system is self sustaining, growing or contracting. Borrowing from nuclear engineering where we use similar mathematical relationships we call these states critical, super critical, or sub critical respectively. Thus we can refer to the economy if it is in one of these states. It is also entirely mathematically and physically possible to have increasing economy and money supply while in a subcritical configuration. This is what I think we are seeing with this jobless recovery. That we need an ever increasing source of money being exogenously injected to maintain a slowly increasing or decreasing economic output.  I also think that the overall price declines that we are seeing is a result of the economy being subcritical causing contractions in the shadow banking sector and in the paper gold and silver markets. I also think this is why we are saw the price decline of bitcoin.

By stopping recessions through policy interventions we inhibit the necessary economic restructuring needed to make the economy critical again. Technological innovations like, the industrial revolutions, nuclear age, information age etc each restructure the economy allowing it to become supercritical and expand. We can’t depend upon technological innovation to ride in and save the day. We know that it happens and that it can’t be planned for, so we need to allow the restructuring to occur so we can move forward. By inhibiting this restructuring we allow an ever increasing negative reactivity to develop, meaning we need more and more stimulus to maintain our current economic output.

This is enough for tonight. Thank you for reading. As always please provide me with any feedback. I am trying to understand this all myself.