Let's be real: It should be obvious to anybody that debt doesn't meaningfully drive up interest rates.

For the past decade, the finance world has been fixated on unconventional monetary policy. Here's the mechanism in a nutshell. Replacing government bonds with interest bearing reserves reduces the supply of duration in the market place, this lowers bond yields because a scarcity of long-dated assets pushes up the prices of longer-term securities. For a time, I was fascinated by this research. I dug deep into the measurement of the effects of the so-called 'scarcity channel.' I read lots of papers and crunched the numbers myself.

Of course, the scarcity channel is at odds with any arbitrage-free model of the term structure.  That is:

1) Long rates are merely the expected geometric average of future short rates.

2) The market is efficient at pricing bonds, thus, over the long term, nobody can earn more than the short term risk-free rate whether they hold securities or money market instruments. (Or some portfolio with bonds of multiple tenors and cash)

In the real world, some segmentation exists in the capital markets. Certain investors find it particularly costly to hold securities outside a limited range of maturities. This might allow for some supply and demand effects to exist in certain sections of the yield curve. Also, the compensation required by investors to take on duration risk rises in times of uncertainty, mainly because the path of short rates becomes less clear.  For this reason, the yield on the ten-year note was around 350 basis points for much of 2009 and 2010. It just wasn't clear yet how long rates would stay at zero.

For the reasons above, it is certainly plausible that QE lowers long term rates both via the scarcity channel, and by removing duration risk from private sector balance sheets during times of financial or economic stress. And it would be naive to assert that the effects of QE or the supply of long term debt are zero. (Although some efficient market fundamentalists have claimed this.)

That said, traditional monetary policy, is traditional because historically it has worked. At least insofar as central banks have been able to tightly control interest rates regardless of the supply of government debt. The past week has borne this out. Despite the US Treasury posting record deficits, longer-term interest rates fell as the Fed signaled that it would likely stop hiking rates.  Strikingly, despite a much higher debt load, and a strong economy, the 10 year note yields110 basis points less today than in 2009 when the US economy was on life support. Oh, and Japan.

Some may claim that this is all very convenient for me. I am a fiscal dove who is sympathetic to MMT and its historical antecendents. However, I seriously investigated the effects of QE, which operates on the idea that excess long term government debt drives up rates. Thus, loose fiscal policy financed with long bonds could be seen as a form of reverse QE. Indeed, buying into the power of QE requires one, for consistency's sake, to be concerned about the level of long term public debt. I approached this issue with an open mind. I thought the effects were larger, but today, given bond market pricing action, I am convinced that forward guidance is what really matters.  Deficit hawks do themselves no favors by ignoring the lessons from QE and its small effects. In fact, by relying on such flimsy arguments, deficit hawks are letting the doves soar and make much stronger claims than they otherwise would. 

 At some point, the evidence just becomes overwhelming. Forward guidance is a much more powerful tool than QE.  The debt doesn't affect interest rates in any meaningful way when money markets are working normally. And if sudden market segmentation develops, the Fed can do QE or the Treasury can do debt buybacks financed by issuing the securities that end investors actually want to hold.  It's time to move on from the faulty claim that government debt meaningfully drives up interest rates.

What Riding Metro Taught me about the National Debt

Here's a nightmare that all frequent users of public transportation have:

It's morning, you've just woken up, the sun is shining bright. Suddenly you realize that you've over-slept your alarm, and you've got an important meeting. You scramble out of bed. You somehow manage to get your disheveled self to the metro station. Then disaster strikes. As you pull out your metro card, you realize that you have a negative balance. So you race over to the pay kiosk and whip out a bank card. But it's too late, your train has literally left the station.

Obviously, there's an easy way to prevent this series of unfortunate events, and many metro riders employ it, including yours truly. I basically never let my metro card balance fall too low. (Actually, I have an auto-refill that is triggered at ten dollars, but you get the picture) Many, if not most, metro riders always keep a balance on their cards that they never spend. This has policy implications for the metro system. And, as I will show, the US government.

Keeping a non-trivial balance at all times on your card, crucially never to be spent, is effectively an insurance policy against being caught flat footed. That is, there is a demand for metro credit that is beyond merely the desire to take rides on public transportation.  Owning metro credit (as opposed to filling your card every time you take metro) has value beyond just taking metro rides. And metro earns a premium for providing this value. Effectively, all those metro riders are floating WMATA an interest free loan.

The consolidated Federal government also issues liabilities.  Rather than metro credit, it issues Treasury debt, reserve balances at the Fed, and physical currency. Like metro credit, they have special properties which provide value beyond simply exchanging them one day for real goods or services. Physical cash provides an anonymous, secure, and easy way to make payments.  As of now and probably forever, it is the only way to pay anybody on Earth.  As with WMATA, these benefits earn the US government a premium.  The government is issued an interest free loan. (The supply of cash is expanded by having the Fed purchase government debt.) Treasury bills serve as a medium of exchange in the financial system, and are frequently used as collateral. Again, the special properties of government issued financial liabilities increases the demand for them. This demand in turn greatly expands the capacity of the government to issue debt without fears of inflation. 

Many economic models fully support this line of reasoning, which points to the obvious conclusion that the government is not subject to the strict solvency constraint that applies to private agents. (That is, the discounted value of net assets over the infinite time horizon must be greater than zero.) When someone in the private sector attempts to systematically to violate this constraint, we call it a Ponzi scheme.  It fails because there are a finite number of potential 'investors.'  However, suppose that the debt issued by Ponzi scheme had uses beyond merely the present value of the promised payoff. Thus, even with a finite number of economic agents, a permanent demand for Ponzi debt would exist, and the scheme may be able to continue indefinitely. In economics, this phenomenon is known as a 'rational Ponzi game.' 

The recent surge of interest in modern money theory, or MMT, has been met with scorn and disdain from the establishment. However, a crucial insight of MMT is that since the US government is a monopolist on risk free dollar denominated financial assets which can never be defaulted on in nominal terms, and demands tax payments in US dollars, its financial assets are special. There is a demand for them other than as a store of value. MMT rightly points out that this demand isn't unlimited, but also gets it right that solvency fears about the US government are misguided to say the least. Again, the capacity to run deficits (For example, to close the output gap and achieve full employment) without fears of inflation is much more than conventional wisdom suggests.
 
A simple thought experiment will put the debt fears to rest. Suppose WMATA didn't allow any metro credit, and riders simply had to pay for rides as they took them.  The metro system would never go into 'debt.'  It would never owe anybody metro rides. But riders would be worse off. They would lose their 'insurance policies' and be inconvenienced by constantly having to refill their cards.  WMATA should not be worried about the outstanding level of metro credit. In reality, as more and more riders join the system and keep that extra ten dollars on their cards for emergencies, the outstanding stock of metro credit will grow indefinitely.  That's right, most metro systems are issuing debt that they will never and should never repay. It's a rational Ponzi game.  By the same token, the US government, must continue to let its debt expand to meet the demands of population growth and a growing economy which will only want to hold an ever increasing quantity of financial wealth as the stock of real capital grows. We can therefore only reach the conclusion that fiscal policy should be set with respect to macro-economic outcomes, not achieving a specific budget target for its own sake.  

It's been said many times, but it bears repeating. Governments are not households. Because their debts hold special properties, such as acting as a medium of exchange, or as collateral in the financial system, governments with their own free floating currencies can and should maintain positive and increasing debt stocks into the indefinite future.  The kids are alright. We're not crushing them with the burden of debt. They won't cast scorn upon past generations for fiscal profligacy. In fact, if we leave future generations with an ample and abundant supply of government debt so that the financial and payment systems function smoothly, they might even thank us.  
   
         

My Letter to the Fed

The Fed is seeking public comments on a proposal to limit the payment of interest on reserves to institutions holding a substantial portion of their assets as reserve balances. The text can be read here. 

I submitted the following: 

To whom it may concern:

Scaling back or limiting IOER is counter-productive on several fronts, and the concerns of the FRB about so-called PTIEs are unwarranted. I will address those concerns in turn.

Monetary Policy Implementation:

It strains credulity to assert that allowing the private sector to strengthen the rate floor created by IOER would somehow weaken the transmission mechanism of monetary policy. On the contrary, it would provide an even firmer price floor for the short term funding markets. Concerns about rate volatility in the Federal Funds market are also overblown. Frankly, under a system of IOR which exists today, it is the expected path of rates paid on balances at the Fed, not overnight interbank lending that serves as a benchmark to price other forms of short term lending and even long dated securities. Fed Funds trades include non-negligible counter-party risk, thus while a widening spread between IOR and the Federal Funds rate would undoubtedly signal a heightened period of financial stress, it does not reflect the stance of monetary policy per se.

Balance Sheet Issues:

The release rightly points out that if the Federal Reserve allows the establishment of PTIEs, that it would in effect be supplying an unlimited quantity of reserve balances to the market.  To accommodate this, the Fed would likely need to maintain a large balance sheet for the indefinite future. However, it is unclear why a shift out of Treasury bills and into reserve balances is undesirable on its face.  Reserve balances are just one of many liabilities issued by the consolidated Federal government. Proper debt management would dictate that the demand for reserve balances be fully accommodated. The shifting out of Treasury bills and into reserve balances would merely be the marketplace substituting a more desirable financial asset for another. If anything, this would strengthen, not weaken financial stability.

PTIEs are a promising way to both strengthen the rate floor and improve Federal debt management. Furthermore, by acting as intermediaries between the Fed and public, PTIEs are an excellent avenue for the Fed to create a rock solid floor for short term rates without having to interface directly with individuals or businesses.  In sum, the Fed should welcome the emergence of PTIEs, not seek to constrain it.

Respectfully Submitted,

Michael Fellman

 

Orthodox Assumptions about Debt Support Heterodox Fiscal Policy

Acknowledgment: I thank J.W. Mason and Arjun Jayadev for inspiring this paper. Their work related to this subject can be viewed here.

All policy arguments rely on underlying assumptions. Therefore, the debates between policy wonks often center around fundamental worldview. This paper seeks to avoid that trap. Often times, it is possible to reach the wrong conclusions even if one starts with correct assumptions. Although I disagree with mainstream views on fiscal policy, I am going to take the mainstream assumptions about government debt as given. In what follows, I show that the policy conclusions drawn by most budget groups and professionals are exactly the opposite from what is correct. In fact, even under mainstream assumptions, proper analysis actually supports a heterodox view of budgeting and fiscal policy.

From my interactions with budget hawks I have determined that two key assumptions underline their arguments. First, there is some debt to GDP boundedness constraint. This can be formulated in various ways. Under its strictest form, the debt to GDP ratio can never exceed a certain level. We can relax this constraint along either levels or time. Relaxing the constraint with respect to level, it might be technically possible to breach the danger zone level, but severe negative economic consequences ensue. Relaxing this constraint along a temporal axis, it might be possible to temporarily breach the danger zone level, but over an infinite time horizon, debt to GDP must converge below some finite level. While I haven’t fully worked it out (and this post is meant to spur discussion) I do not believe the particulars of the debt to GDP constraint matters for the analysis which follows.In any event, the calls to stabilize the debt to GDP ratio by various budget groups has been remarkably consistent over the years.

The second main assumption is that government debt and government money are not perfect substitutes. This can be observed in various blog posts by groups like the CRFB. Specifically,

In explaining his earlier comments, Donald Trump argued that the federal government would never have to default because it could always print money. In a mechanical sense, this is true: because the US has its own currency and monetary policy, it can print money to buy bonds if investors are unwilling to buy debt at all or only at very high interest rates (assuming that the Federal Reserve is willing to print the money to do so). Of course, there are clear limits to this policy, and running up large amounts of debt and financing it by printing money would cause a jump in inflation….

Budget hawks mostly content that deficits financed by bonds aren’t inflationary per se. Money financed deficits are inflationary, and replacing bonds with reserve balances (QE) is inflationary, and if done on a large scale would result in hyper-inflation. Monetary policy is therefore the sole determinant of inflation in economies where no money financed deficits are allowed. If we take monetary policy as where the central bank sets interest rates, the rate of inflation is a decreasing function with respect to the level of the monetary policy rate. (Rate hikes, ceteris paribus, reduce inflation and vice versa)

Again, I want to make it abundantly clear that for purposes of this analysis, I am not discussing the soundness or problems with these assumptions. Rather, I am stipulating that they hold and examining the policy implications. The intellectual exercise might seem useless to some, especially since I disagree with the conditions I outlined above. However,  from a purely policy perspective, (not theoretical) it can bridge a great divide between heterodox and mainstream fiscal views precisely because the mainstream draws the wrong policy conclusions even if their assumptions are assumed to be true.

Fiscal Policy under the Mainstream View

The fiscal authority must set spending and taxing to level over time where the debt to GDP ratio never exceeds the hard ceiling. (A popular number often proposed is 100 percent of GDP, but the actual number doesn’t matter for this analysis.) Another popular proposal is that debt to GDP ought to be held constant, since it is might be impossible to know the exact hard ceiling level. (Again, assuming it exists)

For simplicity’s sake, let’s assume that the fiscal authority sets the primary balance to zero in perpetuity. That is, the budget is balanced excluding interest expenses. To hold debt to GDP constant, the growth rate of GDP, g, must equal the interest rate, i. This is true no matter the size of government. Primary spending could be very high, and set equal to the amount of tax revenue. Conversely, primary spending could be set to zero and there could be no taxes. In either case, all interest expenses are paid by issuing more debt. Therefore, the annual growth rate of the debt stock is simply the interest rate. The debt to GDP ratio is constant if GDP and debt grow at the same rate. That is g=i.

Under this arrangement, the sole determinant of debt sustainability is monetary policy and growth rates. (Again, primary spending is fixed). If debt to GDP need only stay below a known danger level, then for some years g<i is acceptable, so long future years have stronger growth or lower interest rates, or some combination of the two.

Finally, although I set the primary budget to zero to keep things simple, primary deficits, denoted by b, are also possible. The growth rate of the debt is now just the interest rate plus the primary budget deficit relative to the size of the existing debt stock, d. That is, debt to GDP never reaches the danger level if g>= i+b/d

In modern economies, the interest rate is a policy variable set by central banks. Therefore, given any fixed path for growth and primary spending, the monetary authority can always set the interest rate such that the preferred debt to GDP ratio is reached. (This includes taking interest rates negative)

Of course, returning to our second assumption, if the central bank sets the interest rate to satisfy the debt to GDP constraint, it may have to abandon its inflation target. If a rate of interest greater than g is required to reach the desired level of inflation, the central bank faces a difficult trade off. It can let inflation rise above target, or it can allow debt to GDP to exceed the danger level and accept the accompanying negative economic consequences. (The exact consequences don’t matter for this analysis. Usually, budget hawks believe that lower growth and less investment are the main result)

Under the first scenario (often described as ‘fiscal dominance’) the interest rate and therefore inflation has been mapped to fiscal policy. In other words, a real resource constraint, not a financial constraint, limits the spending of government provided that it desires to keep inflation low. This can also be viewed in the following light. In the long run, g is ultimately limited by the supply of labor, capital, and technological progress. Since faster growth would permit higher interest rates without violating the debt to GDP constraint, and the interest rate is ultimately set with regard to the path of government spending, the true constraint on government deficits is the economy’s capacity to produce.

Some may argue that the central bank might refuse to set the interest rate such that the debt to GDP ratio is on a sustainable path and instead focus on delivering low inflation. However, it is crucial bear in mind that while central banks are independent within government, they are not independent from government. The decisions to meet a debt to GDP constraint with budget cuts, tax increases, or changes to the interest rate all have different distributional issues and are thus fundamentally political questions. That debate should be had openly. It should not be swept under the rug by insisting that changes to the path of primary budget balances are the only way to stay within the debt to GDP constraint.

Put another way, if the central bank keeps interest rates above growth rates in order to combat inflation, the fiscal authority must shift into primary surplus to keep debt to GDP below the danger level. Thus, those who lose access to government services (in the case of spending cuts) or those who pay higher taxes (increased revenues) bear the cost of controlling inflation. While inflation (and deflation) also produces winners and losers, it abandons all notions of equity to assert that concerns about inflation must always trump the interests of those adversely affected by changes in fiscal policy.

This analysis has shown that even if we accept the prevailing view of the limits of fiscal policy, the mainstream reaches the wrong policy conclusions. The mainstream insists of ‘getting our fiscal house in order’ and ‘reigning in spending’ and ‘enhancing revenues.’ However, interest rates, along with taxing and spending, are a large determinant of the debt to GDP ratio. If it is indeed necessary to achieve some target for the debt relative to the size of the economy, it is equally valid to argue for interest rate cuts rather than fiscal consolidation. This effectively ties monetary policy to fiscal policy, and thus puts the fiscal authority in effective control of the price level. The constraint on the budget position is therefore the acceptable level of inflation. But this is exactly the same conclusion drawn by heterodox economists, admittedly with a different set of starting assumptions. While I respect the community of DC budget wonks as professionals, their analysis is deeply flawed in that it fails reach the proper conclusion even when their assumptions are taken as fact.

Commentary: The Fed should never "normalize" its balance sheet

Fed balance sheet normalization is coming. Here's why the Fed shouldn't do it.


1.A big balance sheet makes implementing monetary policy simpler.

First, by targeting rates by simply paying interest on reserves is operationally cleaner. Before 2008, for the most part, the Fed did a very good job of hitting interest rate targets by closely monitoring the amount of liquidity in the banking system. But the real question is why bother. Why bother having large trading staffs, constant coordination with Treasury payments and taxes, bond auction schedules, and the Treasury's cash balance, ect? Most foreign central banks have simply paid IOR to control short term rates. It's goofy for the US to use such a wasteful and inefficient system.

A big balance sheet also provides a large pool of risk free short term assets to the public. The private sector can synthetically supply these assets in the form of repo or MMMFs, but these systems came under severe stress during the financial crisis. Truly risk free zero duration assets ought to be a public utility.  The Fed's massive balance sheet provides that. Why on Earth would we want to go back to the old system?

2.Under IOR, the size of the Fed's balance sheet does not reflect the stance of monetary policy. Nor does it contribute to asset bubbles

The Fed targets rates, not the quantity of reserves. For this reason, adding interest bearing reserves to the financial system does not ease financial conditions, nor does it make it easier for banks to lend. Bernanke never expected banks to 'lend out' the reserves created by QE. In fact, if profitable loans existed, the Fed had already engineered the money market to supply liquidity to the banks at zero interest. Their was nothing that the banks could do after QE that they couldn't do before QE. Under a monetary regime which targets rates, bank credit is price constrained, never reserve constrained. 

Therefore, keeping a large balance sheet and controlling rates by paying IOR does not imply a looser policy stance that controlling rates by closely monitoring (and actively intervening in) the money market. Thus, we can keep the advantages of a big balance sheet which were discussed earlier with little risk of undermining the effectiveness of monetary policy.

Finally, the stupid chart rolling around the internet which graphs the Fed's balance sheet against the S&P 500 index is silly. The conspiracy theorists are contending that hyperinflation is occurring the asset markets instead of the real economy.

As Glenn Hadden points out, we can dispense with this myth with a simple thought experiment. Suppose the Fed announced that it would stop reinvesting all maturing Treasurys and principal in its MBS portfolio. However, one half of the proceeds would be invested in equities.  This would dramatically shrink the Fed's balance sheet, but would make the stock market soar.  The point is that the first order effect is on what the Fed is actually buying. (And closely related assets. Eg, AAA corporate debt in the case of Treasury bonds and notes)

3. The maturity structure of the Federal Government's liabilities could still be used as an economic policy lever. 

First, given that the MBS and Treasury markets are huge, its nonsense to suggest that the Fed must unwind so that it could ramp up purchases to fight the next recession. But, even if the Fed owned the entire Treasury and Agency MBS markets, either the Fed or the Treasury could alter the duration of the consolidated government's liabilities by engaging in swap agreements. (Eg, electing to receive the fixed leg and pay the floating leg to do the equivalent of QE) 

Its also worth noting that a policy of passive roll off to achieve a 'normal' sized balance sheet essentially just punts debt management back to the Treasury, which will make the ultimate decision on how to refinance maturing bonds.  Instead, the United States needs an articulated debt management strategy. Priority one would be figuring out whether the Fed or the Treasury should be in charge of it.  

The Fed wants to normalize its balance sheet. I don't know why. I don't think the Fed knows why either. It reminds of the toxic, innovation killing corporate culture of "well, that's the way we've always done it." When it comes to central bank balance sheets, bigger is indeed strictly better.  

Commentary: Trades for 2018

Some quick investment ideas as we ring in the new year. 

1. Long US equities, with focus on names which received a windfall from tax reform. 

I hate Donald Trump, but that doesn't change the fact that many big companies are about to receive a windfall of cash. The US corporate tax code is Swiss cheese. Some companies like GE and Apple can structure themselves in ways to pay virtually no tax or defer taxes indefinitely. Financial firms, and companies like General Mills, have until 2018 paid virtually the full 35 percent corporate rate.  That means many of these firms are about to see a big increase in their after tax earnings. 

For example, after tax earnings for Wells Fargo will be 3-4 billion dollars higher per year because of the tax cut. That's worth at least a 10-15 bump in its share price. Some of that has been priced already, but markets still haven't fully grasped how much this means for the bottom line of many companies going forward.

As such, I expect a 'normal' return year for stocks, with equities returning 7-10 percent in 2018, and with companies receiving the biggest tax cuts outperforming.

2. Long Mexican 10 Year Government Bond 

Mexican presidential elections will happen this July, with Andres Lopez Manuel Obrador being a slight favorite.  The uncertainty of the electoral process will weigh on the Peso and Mexican stocks. Thus, the 7.6 percent guaranteed yield on the Mexican 10 year is attractive in peso asset space. Although the Bank of Mexico will likely raise rates 2-3 times more early this year, it will begin cutting rates in early 2019 once the effect of the removal of gas subsidies fully works its way through the economy.  Overnight rates in Mexico will probably be in the 5-6 range by 2020, which will be supportive of bond prices.  

Non-Mexican investors should wait until after the presidential elections to make this trade, because I believe the Peso will depreciate during the first half of the year before recovering after the outcome of the election is known. 

3. Long ARS/TRY 

Turkey's politics are a mess. Argentina's aren't much better. Inflation in both countries is still in double digits. That said, Argentina is slowly but surely bringing down inflation from nosebleed levels. Turkey's central bank on the other hand is under intense political to keep rates low despite high inflation. 

Given the large interest rate differential between the Peso and Lira, a weird opportunity has arisen. The 28 percent paid on Pesos more than makes up for the 8 percent is costs to borrow Lira. Meanwhile, the exchange rate between the Peso and Lira has been remarkably stable since Argentina floated the Peso in late 2015. This is largely the result of the fact that both countries are highly vulnerable to shifts in over all risk sentiment. This means the two currencies tend to move in the same direction.

Given the 20 percent net carry, a low leverage 2-3x long ARS position looks very attractive indeed.

 

 

  

  

Commentary: My fun but ultimately disappointing foray into cryptoland

Okay, so despite being a crypto skeptic, I don't live under a rock.  With bitcoin's insane surge this week, and the launch of a futures market later today, I finally fell into the rabbit hole and studied the economics and market structure of cryptocurrencies.

First, there is nothing novel nor particularly innovative about bitcoin itself. A distributed ledger (the block chain) is a horribly inefficient way to record and process payments. The main advantage bitcoin has over traditional digital money is that it is not a liability of a financial institution, so in theory it carries no counter-party risk. However, the downside is that it relies on a brute force method to keep track of payments which uses a tremendous amount of electricity and computational resources.  The block chain completely unscalable. And to be frank, except inside the dark musings of libertarian fantasy, with modern deposit insurance, the counter-party risk of holding deposits denominated in major currencies issued by governments with stable politics is essentially zero.  Bitcoin proper is a solution in search of a problem. Speculators might run the price up some more, but it has no staying power.  Bitcoin is nothing more than a digital beanie baby. 

But let's explore two very popular platforms which attempt to solve the scalability problem, Bitshares and Ripple. Both of these systems reintroduce some counter-party risk in order to make block chain technology more practical for widespread use. 

Ripple processes payments between gateways, essentially digital transfer hubs. Block chain technology processes payments between gateways, rather than everyone having to keep an updated copy of the ledger. Gateways themselves are de facto financial institutions. They issue liabilities which are used to settle payments. These liabilities (called issuances or deposits) can be denominated in anything, but for the most part in are denominated in national currencies or crypto-currencies. Liabilities can be redeemed on demand at gateways. 

The result is that end users of the Ripple network must take on a non-negligible amount of counter party risk. Any balance that one holds on the Ripple network is by definition the liability of a gateway. (Except for XRP, Ripple Lab's own crypto-currency which is the only token which exists natively on Ripple) 

Technically speaking, traditional digital money (aka bank deposits) also has this 'flaw.' However, in most countries depositories have the backing of deposit insurance combined with a theoretically unlimited liquidity backstop from their respective central banks. The system of gateways is essentially a banking system operating with no liquidity backstop, limited regulation, and no government guarantees.  Nothing stops gateways from investing in dubious assets and sticking it to their depositors when things go south.  Again, this might tickle the fancy of readers of Reason magazine, but it's a system which has failed spectacularly over the course of history. One only needs to study the free banking era in the United States. When banks operate with no liquidity backstop, the failure of one prominent institution can set off a wave of panic which leads to system wide collapse. This happened time and time again during the 19th century, and I have no doubt that failure of a popular Ripple gateway would bring the whole system down. 

 Finally, forcing depositors to impose market discipline on banks has its own cost.  It means that while there may be a common unit of account, there is no common currency. Because a US dollar held on the Ripple network is not really a dollar, but a promise by a gateway to pay a dollar, these assets do not trade at par. In other words a dollar denominated deposit at one gateway won't be worth the same as a dollar denominated deposit at another. This was how banking worked in the United States until the 1860s, when Congress passed the National Bank Act. It regulated banks on the asset side of their balance sheets, while simultaneously requiring nationally chartered banks to accept each other's notes at par value. Imagine if Wells Fargo dollars were not worth the same as Capital One dollars.  That was the reality of free banking and it's the current state of affairs on Ripple. 

At first, I was intrigued by Ripple. (I even applied for a job there, one I am now very unlikely to get!) It claims to be a real time payments system which uses actually currencies.  Then I realized it was essentially a resurrection of a deeply flawed system which has rightly been relegated to the dustbin of history. 

Government guarantees are one way to address counter-party risk. Collateral is another. Bitshares attempts to use the latter to solve the counter party risk issue. In theory, so long as one's collateral is good enough, any debt could be considered safe. I might willingly lend a homeless man one million dollars if he pledges 1.2 million in Treasurys. This means that unlike on Ripple, any user can issue liabilities on the Bitshares network.  But unlike shadow banking system, the form of collateral is not US Treasurys or Agencies, but BTS, a token native to the Bitshares network.  Current margin rules require 175 percent collateralization. That is, to short one US dollar, one must pledge USD 1.75 BTS equivalent of collateral. This may seem conservative, but consider the extreme volatility realized this year in virtually all crypto currencies. The Bitshares platform pledges to close out positions which don't meet collateral requirements, closing out the least collateralized positions first.  The claim is that this means collateral would be automatically liquidated before default could occur. However, its unclear if the platform could handle a daily swing of say fifty percent in the price of BTS, something which is hardly hypothetical given historical realized volatility in all crypto-currencies including BTS.

Bitshares is just the crypto equivalent of shadow banking. But unlike shadow banking in the real world which uses rock solid collateral (US Treasurys, Agency MBS) combined with over-collateralization, Bitshares relies on shaky collateral which is almost guaranteed to experience high levels of volatility. (Can positions really be closed out fast enough? What happens when a big price decline occurs and BTS liquidity dries up?)  For all its flaws, shadow banking is at least backed by government issued collateral. Bitshares uses untested collateral whose volatility can and will put enormous strain on the platform's systems.  Again, this is not hypothetical. Many currencies brokers went bust when Swiss Franc soared in value after the SNB ended its exchange rate floor for EUR/CHF. The CHF surged in price, liquidity all but evaporated, and lots of big players couldn't close out their clients' short CHF positions fast enough and got caught holding the bag.  One silver lining may be the platform's rather strict margin requirements. But again, given the level of price swings seen in the crypto-space, putting faith in that alone seems foolishly optimistic. 

There's nothing new under the sun. Both Ripple and Bitshares are based on flawed systems. Ripple is free banking 2.0 dressed up with fancy technology. Bitshares is shadow banking based on questionable collateral. Both systems have existed at various points in history and at times have failed spectacularly. Far from being a financial paradigm shift, cryptoland is just a collective of bright eyed neophytes eager to repeat the financial follies of the past.