Unit 3 Lecture Notes

The above represents the classical Austrian school theory on business cycles, developed by Mises and Hayek based on the principles laid out by Carl Menger. Beyond this theory and based on it, I have found a mental model that is useful for understanding how financial crises occur. Exter's pyramid, developed by the late New York Federal Reserve Bank vice chairman John Exter, provides a visually intuitive way of understanding the mechanics of how the boom-and-bust cycle occurs in manipulated market economies. This is a good interview with Exter in which he explains the main ideas behind it.

The starting point of this model is an environment where individuals and investors attempt to maximize their wealth in the future, but naturally, the higher the reward of an asset, the higher the risk associated with it. The more the risk and reward of an asset, the less likely it is to be liquid. Exter's pyramid organizes financial assets in terms of their potential returns and risk on the one hand, and their liquidity on the other. At the narrow bottom of the pyramid is gold, which offers no returns, but is the safest asset because it is nobody's liability. It also has the highest liquidity, because it is a financial asset that has been accepted in the vast majority of times and places in history, and is an asset whose value is not dependent on anybody fulfilling any obligations. History shows that no matter how many newfangled new monetary inventions are made, once the going gets tough people flock back to the familiar, alluring, liquid, impersonal, and trustless safety of gold.

As we move up Exter's pyramid, assets' riskiness increases, as do their potential rewards, while the liquidity of the asset declines. Right above gold is the USD, which offers no return and is highly liquid, but is riskier than gold because its value is dependent on the behavior of the US Federal Reserve. Above it are government bonds, which are less liquid than paper money, but offer returns. Above them come various financial assets with in
creasing riskiness and decreasing liquidity, since the riskiness of strongly compromises the suitability as a medium of exchange. The pyramid grows wider as the size of the assets increases along with their risk, with each asset's section of the pyramid representing its relative size. The size of the global gold market is in the range of $8 trillion dollars, but the notional value of derivatives is in the quadrillions. A pyramid is the most stable geometric structure, but an inverted pyramid, like Exter's, is only stable with a heavy gold base. If it becomes too top heavy, it begins to collapse in on itself. The more the growth in the pyramid the more the forces accumulate to bring it crashing back down.

Figure 1: Exter's Pyramid

Exter's analysis of the business cycle is firmly in the Austrian tradition: When the central bank engages in monetary expansion, investors seek higher returns to avoid wealth erosion from currency depreciation. Lower interest rates lead to the creation of more financial assets, increasing the size of the pyramid into riskier and less liquid assets and instruments, employing ever-greater maturity mismatching. A quickly expanding pyramid would look like modern day Venezuela: a currency quickly depreciating as citizens desperately search for any asset that would hold value. A more responsible central bank will want to limit the growth of the pyramid to keep faith in its currency. The problem, however, is that starting the inflation process is far easier than arresting it. Raising interest rates and reducing inflation will make refinancing difficult for the riskier assets near the top of the pyramid and liquidity crises would squeeze all asset classes dependent on low interest rates (Mises' malinvestments).

Exter's pyramid can grow in a healthy manner through economic growth producing more goods and creating more value for people to purchase.

The value of all goods and services increasing causes the pyramid to grow, and gives the money at the base more purchasing power by offering more assets available for it. But credit expansion, fractional reserve banking, rehypothecation, maturity mismatching, and other forms of financial wizardry cause the triangle to grow in an unsustainable way, essentially by creating more than one claim for each asset in the pyramid, thus decreasing the purchasing power of the base money on the real assets in the pyramid, in other words, causing a rise in asset prices. Thus manipulation of interest rates may initially seem to produce economic growth by growing the pyramid, but since the new assets being created are just the same old assets being given additional owners through credit expansion, rehypotheciation, fractional reserve banking, or maturity mismatching. This is then followed by a contraction that can only happen with a messy deflationary crash and liquidity crunch that drives holders of assets at the top of the pyramid to scramble down to its bottom in search for safety. This explains why the US Dollar, US Government bonds, and gold were safe havens during the 2008 financial crisis. US government policy of bail-outs, slashed interest rates, and fiscal stimulus were the desperate attempt to re-inflate the pyramid back into its previous shape and to drive investors to hold risky assets instead of treasuries, dollars, and gold. The dollar did not depreciate in spite of the enormous quantities of it that the Frederal Reserve injected into the banking system, and the reason is that an even bigger force was the scramble for dollars from holders of collapsing illiquid assets at the top of the pyramid. In a fiat monetary system, money is created not when the central bank bails out the holders of assets, but when the central bank allows them license for the creation of these assets in the first place.

Exter's pyramid is another way of understanding the issue of rehypothecation discussed in September's Bulletin. Rehypothecation is how one $1 in cash deposited at a bank can lead to the creation of several dollars in checking account balances in banks, or how financial institutions manage maturities in order to monetize their assets. The number of assets produced is larger than the underlying as set, thus the move up Exter's pyramid, with more reward possible, along with more risk.

Whereas the 2008 financial crisis witnessed the most spectacular collapse in Exter's pyramid ever, the policy response after it has been even more spectacular in its attempt to prop up the pyramid back in place. Governments worldwide made illiquidity their biggest enemy, and effectively showered every large firm with liquidity, even those whose problems were solvency rather than liquidity, and even those who did not need the liquidity. You can understand that process as the central bank giving institutions that hold the assets at the top of Exter's pyramid cash reserves at the central bank to ensure that their liquidity and solvency is not compromised. To the extent that it averted a collapse in Exter's pyramid, that scheme largely worked. Whether returning to the shape of the pyramid that brought about the collapse is desirable in the long-run, however, is a completely separate question which the modern high time preference bureaucrat and economist has been trained to doggedly and skillfully avoid confronting.

The problem here is that the success and stability of this system is in itself destabilizing to it. The more stable the pyramid appears, the less likely it is to collapse, the more that central banks are lenient in their monetary policy and regulations around capital creation, the higher and wider the pyramid grows, the more risky the top of the pyramid be comes, and the more likely it is to collapse. But on an even more basic level, the problem with this scheme is that if the rehypotheticated creation of any asset in the pyramid is profitable, there are no effective defenses against the inflation of the supply of that asset. So, if Wall Street banks succeed in marketing mortgage-backed-securities, not only will this create enormous demand for mortgage-backed-securities, it will even create enough demand for the creation of more houses, as banks search for any person, regardless of their creditworthiness to buy a house. If people make good returns on stocks, there will be increasing demand for stocks beyond their profitability, incentivizing the creation of many more new companies and listing them on the stock market, as was the case with penny stocks and countless stock market scams.

This brings us back to the familiar story of monetization of assets which forms the beginning of the Bitcoin Standard. Exter's pyramid helps us understand why certain things can get chosen as money throughout history and not others. As people select various things as stores of value, gold remains firmly at the bottom of the pyramid due to the uncompromising hardness of its supply. When people choose anything else as a store of value, its producers make more of it, bringing it further up in the pyramid as its size increases, bringing down its value, and making it less desirable as an acceptable means of payment, bringing down its liquidity. Gold, offering no returns, while maintaining superior salability across time and space with a longer track record than any competitor, continues to remain the hardest to produce, and so remains firmly entrenched at the bottom of the pyramid.