Shadow Puppets

#49: A Little Cash Goes a Long Way.

According to the Federal Reserve, households in the United States had an aggregate net worth of $139.9 trillion as of the end of 2022. The large majority - $124.9 trillion - of this “net worth” is comprised of non-cash assets such as stocks, bonds, and real estate, after subtracting household debt, such as mortgages. Cash and bank deposits makes up a relatively small portion.

The value of non-cash assets comes from the utility that they provide. A house provides direct utility in the form of a roof and walls. Financial assets like stocks and bonds provide future cash flow, which can be exchanged for other assets in the future. The nominal value of these assets is measured by an arbitrary ruler - the dollar.

Cash, by contrast, provides no direct utility. You can’t feed or clothe yourself with greenbacks, but cash can buy food and clothes. Cash is the wild-card asset. Dollars are for economic record keeping; a measuring stick that helps normalize the value of diverse, non-cash assets. Dollars are backed by everything and nothing, all at once. Which begs a big question…

If non-cash assets are valued based on their convertibility to cash, how does $124.9 trillion of non-cash net worth exist if there are only $8.7 trillion¹ actual dollars?

The $124.9 trillion of non-cash asset value can never be realized all at once². Rather, the total value is extrapolated based on the small percentage of assets that are traded for cash across markets every day. These transactions provide a market price that we then apply to the rest of the non-traded assets.

It’s like measuring a football field with a ruler. The ruler can’t reach from end to end, but if you can measure a small unit of the field and can guess how many more units are left in the field, you can estimate the total length. But in the case of financial markets, the football field doesn’t have fixed dimensions. It’s an imagination - one that inherently assumes stable demand for cash vs. non-cash assets.

In the most extreme hypothetical, imagine that U.S. households wanted to trade all their non-cash assets for all the actual dollars in circulation today? The maximum number of dollars that could be exchanged for all non-cash assets held by households at one point in time is $8.7 trillion³. In this mass liquidation event, non-cash asset holders would see a 93% write down in nominal value (from $124.9 trillion of non-cash asset value, exchanged for $8.7 trillion of cash proceeds), even though the utility of those assets has not changed.

Or, what if all commercial bank depositors demanded⁴ cash back in physical bills all at once? There are $17.3 trillion of commercial bank deposits while banks only hold $3.2 trillion in cash. Without central bank intervention and assuming banks could instantly convert digital reserves to physical currency, all depositors would receive just $0.19 for every $1.00 deposited. The banking system is massively undercollateralized on a cash basis by design.

Neither hypothetical is possible, but both highlight that nominal wealth is an extrapolation, which can change dramatically based on the market actions of a few, and the availability and demand for cash.

Shadow Puppets

Here is an analogy: Shadow puppets.

By holding your hands up to a flashlight, you can turn hand-sized bunnies and doggos into massive projections as the angles of light and shadows expand across the distance between your hand and the wall.

When we think about market capitalization of stocks, or the value of a bank’s bond portfolio, or the total household net worth, we are talking about the projected image that is created by much smaller moving pieces.

During its COVID money printing operation, the Fed created $4.7 trillion of new cash. By contrast, household net worth increased by $34 trillion or over 30% - from $110 trillion at the end of 2019 to $144 trillion at the end of 2021. For every dollar the Fed printed, more than seven dollars of household net worth was created⁵.

The result was a massive increase in nominal net worth during a period in which nominal GDP increased by only 12%. The wealth gains of asset holders far eclipsed the value of any direct stimulus to individuals. On the flip side, household wealth has decreased marginally in 2022, due primarily to the decline in stock values, even as nominal GDP continues climbing at a brisk pace.

However, these calculations of wealth are just the long shadows. It’s better to focus on the puppets.

In the case of FTX, the FTT token was a multi-billion “market capitalization” illusion. The company used FTT’s market cap as collateral for borrowing and to justify its commingling of client assets. Meanwhile, actual analysis of the puppet showed that FTT had no real market other than insiders defending its price. The collapse of FTX occurred days after these revelations.

Similarly, the US stock market has a total market capitalization of around $40 trillion, but the daily trading volume was $425 billion yesterday⁶. The Fed’s pandemic QE policy created $120 billion of new cash per month, representing just 0.3% of the total “value” of the stock market but more than 25% of recent daily traded volume. Similarly, the Fed’s current $95 billion maximum monthly rate of QT is huge relative to actual exchange of cash and shares daily. This helps explain how seemingly small tweaks to liquidity can result in such large movements in market value⁷.

Finally, how does a single bank losing $18 billion on its bond portfolio create a “systemic risk” in a country worth over a hundred trillion dollars? Partially because the Fed rapidly raised rates, skewing an entire universe of bond valuation. Partially because QT and the RRP eliminated $1 trillion of bank reserves over the past year - a small percentage of commercial bank assets but nearly 25% of all banking cash holdings from 2021. Partially because the entire banking system is always at some risk of a run since total bank deposits far exceed cash on hand.

Conclusions

In some senses, the financial system is much smaller than we are led to believe. We tend to think about the vast implied market value of non-cash assets, but forget that these values are ultimately extrapolated by a small portion of cash-for-asset exchanges. We measure a football field with a ruler. Ten trillion dollars don’t exist.

Instead of focusing on the long shadows, some of our best insights come from looking at the puppets. How does cash move, and what does it tell us about the shadows on the wall?

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-TLBS

1. For simplicity in this hypothetical, let’s use the Fed’s total balance sheet, which includes all physical currency, bank reserves and deposits at the Fed. This number is smaller than the $15 trillion of cash and bank deposits included in the household net worth figure, because there are more bank deposits than actual cash due to the inherent leverage of the banking system.

2. Our willingness to share our wealth in large liquidity pools like banks or financial markets creates economic value in and of itself. It allows for more efficient allocation of resources from savers to borrowers, putting money under the mattress to work. Because sudden demands for cash are rare and are often buttressed by central bank intervention, we accept this fragility in exchange for the benefits it provides.

3. Of course, this is purely hypothetical for a number of reasons. Never will all non-cash asset holders demand cash at once. Since the value of cash decreases over time due to debasement (inflation), and provides no direct utility, individuals try to minimize their ownership of cash in favor of non-cash assets that will retain or appreciate in value. We seek to raise cash when necessary to transition between non-cash assets or to purchase utility-providing items.

4. Of course, not all deposits are demandable. This is a purely hypothetical mass liquidation of all bank deposits.

5. There are many variables that impact asset valuations, including the market’s expectation of the future (including the effect of inflation on nominal earnings) and the policy decisions of central banks. For debt securities, the largest variable in determining changes in market value is change to interest rates - largely a decision of the Fed. For real estate and stocks, there is no single formulaic method to determine value - nevertheless, interest rates play a significant indirect role.

6. Per Cboe Global Markets, using data on April 6, 2023 as an example.

7. Of course, it’s not that QE or QT are directly adding or subtracting from flows in the stock market. QE and QT directly involve US Treasuries and Mortgage-Backed Securities. But when bond is sold to the Fed in QE, new cash is handed to the seller, who is free to do whatever he or she wants with it - including buying equities.