In high school economics, you may have learned that the Federal Reserve controls the money supply.
When inflation is low, the Fed prints money. They unleash this money by purchasing bonds. When people have more money, they’ll spend it, so inflation rises.
When inflation is too low, the Fed contracts the money supply. They sell bonds. Cash leaves circulation. With fewer dollars in hand, it’s more difficult for people to buy things, and inflation slows.
This is a nice theory. It’s logical and the math works well.
The only flaw is that it isn’t true.
The Federal Reserve doesn’t control the money supply – banks do.
If you walk into a bank and apply for a loan, you might expect for them to check how much money they’re holding in deposits, how much money they’ve lent already, whether there’s any more on hand for you to borrow.
That won’t happen. They’ll investigate you, certainly, to assess whether you’re likely to default. But if they like the look of you, you can walk out of there with money.
The bank creates this money. They claim that it exists, and then it does.
I first learned about the distinction between who theoretically controls the money supply (the Federal Reserve!) and who actually controls it (banks!) from economic historian Robert Skidelsky in his book Money and Government.
Skidelsky includes an instructive quote from the investigative report Where Does Money Come From? by Josh Ryan-Collins, Tony Greenham, Richard Werner, and Andrew Jackson:
The theoretical support for deregulation was based on the unrealistic assumptions of neoclassical economics, in which banks are mere intermediaries.
This does not recognize their pivotal role as creators of the money supply.
Since the 1980s, bank credit creation has expanded at a considerably faster rate than GDP, with an increasing amount of bank credit creation channeled into financial transactions. This is unsustainable and costly to society.
As we were taught in high school, increases to the money supply accelerate economic activity.
And our economy is booming. But you might not have noticed. See, banks have been greatly expanding the money supply, but they’ve been injecting all that cash directly into the financial sector.
Investment banks, hedge funds, and the like have been blessed with easy money, and there’s been dramatic inflation in this segment of our economy.
Brokerages lend stocks.
This is another way to create money – brokerages might lend more stocks than actually exist. At times, this may be inadvertent – if I own a stock, my brokerage can lend it to someone who’d like to short sell it.
When the short seller puts the stock up for sale – hoping to profit if the stock falls before they’re obliged to return it – someone who uses a different brokerage might buy it.
And then that brokerage might also lend it to a short seller – they have no way of knowing that this particular share has already been lent.
All this lending creates money – with each additional sale, the short seller is pulling the stock’s share price out of thin air, subject only to the contract with the brokerage that a share must be returned later – without anyone necessarily intending to break the law.
When I read poetry with guys in jail, they’ll sometimes mention what they’re in for. Not everyone is telling the truth – according to police reports, somewhere near half are there on domestic assault charges, but out of some thousand men I’ve worked with, only three have said they were in on a domestic, and they all told elaborate stories to explain away the charges.
A guy said that his wife was all bruised because he had to resuscitate her from a medical emergency. Another guy told me that he and his girlfriend were “talking loudly,” some neighbor called the cops, and they saw him throw a towel at her. A third said they busted him for domestic violence after all he’d done was chuck a television at the wall (although this guy had been telling me for weeks that he was in on possession of marijuana).
My point being that I’m never quite sure how much credence to give these stories.
Still, I’ve worked with several guys who said they were doing time for increasing the money supply. In practical effect, what they’d done was the same as a bank lending money it doesn’t have – the money supply increases.
Here’s some money that previously didn’t exist, and there will be repercussions if an investigator can prove that it happened.
A guy was printing bills in his basement. Another passed bad checks. Somebody claimed he was there for credit fraud, but I doubt he was busted for the sort of thing the Russian hackers were doing, trawling the internet for unsecured connections – more likely, he’d lifted somebody’s wallet and got nabbed using their cards.
When individuals get caught at this, we bring the hammer down. Bad check guy caught four years (and the prosecutor was originally trying to get him to plea for twelve, he told me).
The stock for Gamestop, in and of itself, is worth very little.
The company doesn’t pay a dividend. And the company is failing. They have to pay rent, they have to pay the salaries of living, breathing human employees. They have to maintain an inventory.
They depend on consumers’ willingness to get in the car, drive somewhere, and make eye contact with a living, breathing cashier in order to buy a thing.
But game systems can be bought online. The games themselves can be downloaded. The stylish figurines of people’s favorite characters are cool, and can presumably be sold at a markup in shops since they look more enticing in person than they would as tiny pixelated photos on a telephone screen, but these are heavy and bulky and awkward to ship to the store and keep on the shelves.
I agree with the hedge fund guys who think there’s a high probability that Gamestop was going out of business. That Gamestop might’ve gone under even without the Covid-19 pandemic, and that things look even worse now – the new Gamestop executive’s plans for bringing in money all relied on turning the shops into social spaces, but now nobody’s socializing, and certainly not inside small, poorly ventilated strip mall outlets.
Several hedge funds borrowed lots of shares of Gamestop and sold them, hoping that the price would fall before they were required to return them.
Their positions – short tens of millions of shares of Gamestop – were known. And so people intentionally raised the price of the stock.
The hedge funds were (and possibly still are) contractually obligated to return those shares to the brokerages that they were borrowed from. They’d have to buy shares even if the price became absurd.
So lots of regular people realized they could make a quick buck by buying the shares and then selling them to the hedge fund at a ransom price whenever their loans were up.
And, yes, when people drove up the price of Gamestop to grift money out of the short-selling hedge funds, that was collusion. Which would be illegal if done in private, but I don’t think there’s any problem when it’s been done entirely on a public forum.
What the banks and brokerages have been doing – creating money by lending things that don’t exist – isn’t illegal. Perhaps it should be – the practical effect is the same as when somebody starts printing money in their basement – but it isn’t.
If the hedge funds are contractually obligated to buy shares of Gamestop, then is this a good bet?
Should you jump in, too?
I don’t think so.
Please note that I’m not a particularly savvy investor – I’ve put my family’s money in Canadian agriculture, air conditioners, coolants, all sorts of things that will presumably accrue value if the planet Earth becomes less hospitable – nor have I studied contract law. I’m a trained economist and reasonably logical thinker, but not an expert.
I do own a single share of Gamestop – I bought it because I appreciated that people wanted to flip off the hedge funds – but, honestly, I don’t have much personal stake in this.
I do think that the financial sector has been creating large, needless drag on our economy. I’m vaguely anti-capitalist. I believe strongly in a global wealth tax and guaranteed basic income. So I’d like for the hedge funds to go bankrupt.
But I don’t think they will.
The hedge funds have contracts, but their contracts aren’t with me – even if they’ve borrowed my share of Gamestop, they didn’t borrow it from me, they borrowed it from my brokerage.
And my brokerage is run by some reasonable people wearing business suits. They know that the Gamestop company itself is troubled. They would probably rather have money than shares of GME.
I think it’s very risky to gamble on a contract between people who aren’t you. The signing parties of the contract could renegotiate it – as a bystander, I can’t influence their negotiations at all.
Still, there’s a chance that some of the short sellers will tank. So although I wouldn’t recommend buying a bunch of shares of GME, it seems prudent to convert some of your retirement savings to cash, just in case the short sellers have to unload a few of their long positions to cover and the prices of those shares fall. You might have a chance to buy other stocks at a discount soon.
Again, I’m not an expert, nor a savvy investor. That’s just what I’m doing.
Usually, nobody notices when banks or brokerages create money. We simply assume that they have sufficient holdings to cover whatever they’re lending out.
They often create phantom shares of stocks, and then, when the short sellers resolve their contracts, the phantom shares blip back out of existence, leaving behind only some money – not coins or bills, mind you, but an increased number on a ledger – to indicate that they ever existed.
Account values are like the contrails in a bubble chamber that tell us whether elementary particles briefly existed after a high-energy collision between nuclei.
But Reddit readers’ collusion is causing the contrails to ossify. I don’t have a sell limit set for my single share of Gamestop. Millions of shares are held by people who think short selling ought to be illegal and are planning to let mounting interest payments undermine the hedge funds that were doing it.
The turbulence here is obviously unrelated to Gamestop.
The issue isn’t even short sellers – financial markets are obviously irrational, but short selling does push stock prices toward fair valuations for their underlying companies. Which isn’t necessarily helpful, or sufficiently important that we, as a people, should reward the people who do it will millions of dollars.
And the issue isn’t hedge funds.
Rather, it’s whether we want a world that conforms to the fictions we teach in high school economics – the Federal Reserve controls the money supply! – or if we want the world we have now, where guys in my poetry class landed in jail for printing money in their basements but bankers and brokers are rewarded lavishly for printing money in their offices.
I’ve written about this previously, here and here, but the ramifications are much more visible now.
And I should mention that, although I think these behaviors ought to be illegal, I’m not saying that bankers have necessarily done anything wrong.
Brokerages, in this whole mess, presumably weren’t trying to break the law. Each brokerage may have thought they had real shares in hand when they lent them.
But they didn’t.
As it happens, we could easily prevent situations like this from arising again.
I have a rather dour view of Bitcoins – they’ve not as anonymous as people think, and the system is incredibly wasteful, creating more greenhouse gases by design than other forms of currency – but blockchain technology would make the stock market less awful.
A blockchain is like a bunch of stickers plastered to the side of a suitcase – it’s an ordered list of where something has been. You could use blockchains to prevent food-borne illness – for each tomato used for ketchup, you could track its journey from fields to processing plants to restaurants. A blockchain is simply a long list of prior addresses.
With shares of stock, you could track whether that share has previously been lent to a short seller, preventing a single share to be lent twice – which is how brokerages inadvertently counterfeit shares – before the first contract has been resolved.
The problem, of course, is that people who are currently wealthy benefit from being allowed to create money.
It’s convenient to own a money printer – you get to buy what you want and donate to charities and feel good about yourself.
And it’ll take a bit of work – not much work, as I described above – to shut the money printers down. Still, any effort at all is hard to muster when the people who currently have power would like to keep things as they are.